Editorial Policy

Consolidate or transfer debt? Maybe neither!

Erica Sandberg

February 11, 2016

Q Dear Erica,

I am trying to decide if I should take out a debt consolidation loan to pay off my credit card debt or get another credit card that has 0 percent APR for a period of time. I have been approved for a debt consolidation loan at 11.95 percent, but that’s not much lower than my credit card’s APR. What are some of the pros/cons of each method? — Jane

A Dear Jane,

First, I must clarify: When a financial institution takes over a credit card balance and turns it into a loan, you aren’t paying off your debt load. Nor is the lender. It’s a horizontal move, as the amount you owe remains the same until you erase it.

erica-box4That said, the main advantage of a debt consolidation loan is that it’s close-ended. You can’t increase the balance. Payments are fixed at an amount set by the lender. No guesswork on your part. More, most loans are written for a fairly short term, often up to five years. This lets you to know when you’ll get out of debt. A few inputs into a basic loan calculator will give show you how much you’ll pay per month and total interest over the term of the loan.

For example:
$5,000 loan
5-year payoff term
11.95% APR
= payment of $111, costing a total of $1,665 in interest

A secondary benefit to consolidation loans? If you are committed to not getting into further debt with your now cleared-out credit cards, you’ll expand your credit utilization ratio. That can help your credit scores, as the less you owe relative to the amount you can contractually borrow the better.

Credit cards, on the other hand, are open-ended. You can add to the balance as soon as you have available credit. If you hit your limit of $5,000 and then made a $1,000 payment, you can immediately charge that back up to where you started. Minimum payments fluctuate, too, as they’re based on the balance you are carrying.

The problem with credit cards is that it is possible to get into a never-ending cycle of debt. Pay some, charge some, and you spin your wheels, all while interest racks up.

Yet while it may sound like I’m advocating a consolidation loan, I’m not. One of the reasons is the initial cost. Most lenders will tack on a fee of 1 to 5 percent of the balance. A 3 percent fee on $5,000 is $150.

As long as you’re committed, you can enjoy the same benefits of the consolidation loan with a credit card. It’s pretty simple — treat the balance as you would a loan, with fixed monthly payments and not adding to the debt. Using a credit card payoff calculator for the figures above  ($5,000 debt, 5-year payoff term, and monthly payments of $111), you’ll see that the end result is the same as the loan.

However, instead of the lender telling you how much you need to pay each month, you’ll have to figure that out yourself. Review your budget and determine a fixed sum to send each month. If you can manage $200 payments, you’ll be debt-free in about 2.5 years and it will cost $778 in interest.

And your credit rating? You may not get the big bump that a consolidation loan will give you, but as your balance declines, your rating will rise.

The second method is applying for a new balance transfer card in which you would move the balance from your old card to the new card with a 0 percent promotional rate. A balance transfer will increase your credit rating and can put money in your wallet. Note, however, that most balance transfer cards tack on a 3 to 5 percent balance transfer fee to the amount you move over.

If you qualify for a card offering 0 percent APR on transfers for 12 months and pay it off in that time frame, you really come out ahead, even with the transfer fee. No interest will be applied at all. However, payments would need to be at least $429  to repay a $5,000 balance. If paying in full within the 0 interest promotional time frame is not possible the remaining balance will be subject to interest.

Complicated? Not really. In short, the easiest method is to just power your credit card down with big, fixed payments while not adding more to the balance. Yet if you want to spend time manipulating it with a transfer, either to a loan or a new credit card, you can save some cash while pushing your credit rating up a little faster.

SEE ALSO: 2 ways to slay your debt dragon and a bonus DIY plan