Is it a good idea to consolidate debt?
Paying off debt is all about creating a monthly payoff plan and sticking to that plan over time. Anything that you can do to reduce the complexity of that plan, as well as the amount of interest that you ultimately pay, is a good idea. That is where debt consolidation come in.
Debt consolidation is the process of using debt to pay off other debt, or in other words, taking out a loan to pay off another loan. It may sound crazy, but it could make sense the following circumstances:
Lower your interest rate
If you are paying a high interest rate, say on a 20% credit card, and another credit card offers a balance transfer with a lower rate, it could make sense to go ahead with the transfer as long as you understand all of the fine print.
Move to a fixed rate
Variable rates, especially in a rising interest rate environment like we are in now (2018), can be disastrous to someone trying to pay down debt. If you transfer balances to a fixed rate, do it.
Fix your payments
If you are just moving debt around without making any progress toward paying it down, you are not accomplishing anything. Debt consolidation only makes sense if it is part of a plan to ultimately get out of debt.
What are my options?
There are several types of loans you can look into to consolidate debt. Here are a few examples:
Transfer balances to another credit card
As long as the interest rate offered is lower than the current credit card you have, it could make sense to do a balance transfer. Make sure, if you go down this path, that it is part of a plan to ultimately pay off all of your balances. In fact, only do this if you are willing and able to cut up the older card, committing not getting into even more debt. Make sure you check for balance transfer fees and that you understand the interest rate on the new card. Don’t fall for short term come on rates or get caught paying higher fees than necessary.
If you are a homeowner, and your home’s value is greater than your mortgage, you have equity that can be used to pay off other debts. You can either refinance the entire mortgage for a larger amount (a cash out), or you can take out a home equity loan for a portion of the equity. Be careful of the payoff terms here though. It may seem like a good idea to lower your monthly payment, but the last thing you want to do is finance that dinner you had last night over the next 30 years. That’s why I recommend going to home equity path and paying off the loan as quickly as possible.
An benefit to using home equity as debt consolidation in the past has always been that the payments are tax deductible. Keep in mind that under the new 2018 tax laws, proceeds of a home equity loan not used for purchase, repairs, or maintenance of a home is no longer tax deductible. Additionally, if you refinance your primary mortgage, only the interest portion on the first $750,000 or mortgage is deductible.
Debt consolidation or other bank loan
Check with your bank or credit union, and shop around a little. Getting a simple loan from the bank to pay off higher interest loans may be, for many, the best option. These loans typically have lower interest rates compared to credit cards, and they generally have a fixed pay-off period so you know exactly when you will be debt free.
Borrow against a retirement plan
most 401(k) and 403(b) employer sponsored retirement plans allow loans. Many people use retirement plans as their first choice to consolidate debt, but I would use this method only as a last resort. Yes, you are borrowing your own money, but if you are younger than age 59 ½ and you don’t pay the loan off within 5 years, you will be hit with severe penalties. First off, the amount you have not paid back will be taxed as income, and since you are still working, you will be hit with high tax rates. Many middle-income wage earners fall in the 25% Federal tax bracket, and if you state has an average of 5% income tax, you are looking at losing 30% to taxes. Additionally, the balance not paid is considered an early withdrawal which will incur an additional 10% penalty paid to the IRS, so that pushes your taxes to 40% or more.
Additionally, the outstanding balance may trap you in the job as many plans require you to pay back to loan within 90 days upon termination of employment.
So, should I consolidate my debt?
If you are sure you are not just transferring balance around to keep afloat, then yes, you should look into one or more of the debt consolidation strategies listed above. Make sure you understand the interest rate, fees, monthly payments, and payment terms.