A consolidation loan may be a reasonable and affordable alternative repayment plan. In this strategy, a loan is taken out to pay all other debts. It may reduce your total monthly payment and simplify payment to one instead of many but will extend the repayment time. Increasing the repayment time also increases the amount paid in interest or finance charges. However, you can sometimes refinance these loans at a lower interest rate and monthly payments are usually smaller.
Two points of caution: 1) if you consolidate your debts, be careful not to use the "freed up" money to buy something else on credit; 2) it is not usually a good idea to use a home-equity loan for debt consolidation. That debt is now "secured" by your home. If you get behind on repayments, you could lose your home.
Before considering a consolidation loan, see if you can work out a self-administered repayment plan. Investigate other alternatives for paying off your debts. Those alternatives have been discussed in sections 2 and 3.
The completed Know what you owe chart on pages 3–6 will be necessary to obtain a debt-consolidation loan. A well-chosen consolidation plan can reduce your monthly payments while still allowing you to meet your obligations. However, a poorly chosen one can put you deeper in debt. There are many ways to get money for debt consolidation, including borrowing from yourself, friends and family, life insurance, retirement accounts, pawn shops and finance companies. Each has advantages and disadvantages so choose wisely.
Money in savings accounts, Certificate of Deposits (CDs), stocks, bonds, or retirement can be used to consolidate debts. A banker or investment advisor can give you information about your options. Withdrawing money from your account or cashing in your investments is a major decision. Determine the cost by adding the interest the money is earning and any fees, taxes or penalties that would have to be paid.
Is the money in your savings account earning a small amount of interest? Would it be better to eliminate debts involving interest rates of 10–22 % or more? If earnings (interest) from the investments are low and you know you can repay yourself quickly, this may be an acceptable option. However, if earnings are reasonable and you do not believe you will be able to repay yourself in a short amount of time, it may be best to leave these funds alone.
Borrowing from your "rainy day" fund is a risk. It is important to have some money available for an emergency fund.
Loans from family and friends should be handled as if they were bank loans. Develop a written contract listing the terms. Include the loan due date, interest rate, late charges and when they would take effect, collateral or security to guarantee the loan (if any), and the payment plan. All parties should sign, date and keep a copy of the document.
Can your family member or friend afford to make this loan to you? If so, he or she may be able to set the interest rate lower than one available from another source. You also need to decide if you really want to owe this person money. If you are unable to repay the loan, you could destroy the relationship.
A cash-value life insurance policy could be used for a loan to yourself. You can often borrow most of the policy's cash value at a reasonable interest rate with the ability to repay as slowly or as quickly as you choose. It may be tempting not to repay at all, however, so the loan would reduce your death benefit.
It is important to find out how the loan affects the death benefits, cash value, interest rate you are paying (often higher than stated since the policy will earn a lower interest rate while the loan is being repaid) and whether you will have insurance in place while repaying the loan.
You may be able to borrow against your 401(k), 403(b) or profit-sharing retirement account. The interest is usually low and repayments go directly back into the account. However, if you withdraw the money without repaying, the IRS will require payment of penalties and taxes. If you leave your job before repaying, you may be required to repay the balance in full. Your investment may earn less while you are using the money for your debts, leaving less money for retirement.
Some people raise money for their debts by taking an item to a pawn shop. A pawn shop will lend 25–50 percent of the value of an item. Interest rates are as high as 25 percent per month or 300 percent per year. If you fail to pay the interest and redeem the item, it will be sold and the pawn shop will keep the money.
Home-equity loans are often used for debt consolidation. With a home-equity loan, the lender offers a line of credit, sometimes up to 125 percent of the home's appraised value minus the amount of the mortgage. Home-equity loans are available as a second mortgage (allowing you to borrow a predetermined amount of money for a specific amount of time) or as a home-equity line of credit (allowing you borrow up to a pre-approved credit limit).
Interest paid is tax deductible if you itemize deductions and the amount borrowed does not exceed the value of your home. If you have a good credit history and a steady employment record, interest rates may be lower than from other loan sources. Without a good credit history, expect higher interest rates, closing costs and other fees. Watch out for low introductory rates that jump after several months. Also use caution if you accept a credit card tied to the home-equity line of credit. It can be very tempting to use that card to accumulate even more debt.
Beware of putting your home on the line with a home-equity loan. Will you be able to make payments? If you have to move, could you sell your home at its current or a higher value? In general, it's not a good idea to exchange unsecured debt for secured debt.
Debt consolidation is often managed through a consumer-finance company. Most will combine your bills into one loan with a fixed monthly payment and a fixed repayment period. In most cases, the repayment time is extended. This longer repayment time combined with higher interest rates can greatly multiply the total amount of money paid.
Finance companies make secured and unsecured loans for debt consolidation. A secured consolidation loan requires you to pledge your house or car as collateral or a promise to pay. Interest rates may be 10–15 percent but could be higher. If you default on the loan, the finance company can foreclose on your home or take your car.
An unsecured consolidation loan would provide money without requiring that you pledge your home or car as a guarantee to repay. Interest rates are often as high as 25 percent. Additional fees (some hidden) can send the interest rate closer to 50 percent.
A potential future creditor will look at a loan from a finance company negatively since it shows you have had debt problems. Finance company consolidation loans are often used by people with high debt as a last attempt to handle the debt themselves.
Shop around before choosing a consumer-finance company. You want to know the annual percentage rate (APR), fees charged, monthly payments, length of the loan, total amount you will pay, what happens if you are late or miss a payment, and if there is a prepayment penalty. Watch out for bill paying services claiming to consolidate your debt. You will pay for their service and could get stuck with a dishonest company.
If a debt-consolidation loan is being considered, investigate banks, savings and loans, and credit unions. These may be better options than a consumer-finance company since others are often more willing to work with you if you have trouble repaying. If you are a customer and can have payments automatically deducted from your account, you may qualify for a lower interest rate.
A consolidation loan is a bad idea if you:
Harrison, Mary N. and Nayda I. Torres, Home Economics Department, Institute of Food and Agricultural Sciences, University of Florida. Debt Consolidation: Is It For You? San Francisco: Consumer Action, 1998.
Detweiler, Gerri; Marc Eisenson, and Nancy Castleman; Debt Consolidation 101: Strategies for Saving Money & Paying Off Your Debts Faster; Invest In U/Good Advice Press.
Knee-Deep in Debt; Federal Trade Commission, Bureau of Consumer Protection, Office of Consumer & Business Education; March 1997.
Feinberg, Andrew; Downsize Your Debt. New York: Penguin Books; 1993.
Leonard, Robin; Money Troubles: Legal Strategies to Cope with Your Debts. Berkeley: Nolo Press; 1996.
National Consumer Law Center; Surviving Debt: A Guide for Consumers. Boston: National Consumer Law Center; 1996.