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How to Consolidate Debt

There are 4 ways to consolidate your debt:

  1. with a secured loan (e.g. taking out a second mortgage)
  2. with an unsecured loan (getting a consolidation loan with a bank or a finance company)
  3. with a credit card balance transfer (taking advantage of credit card offers)
  4. with a Debt Management Program (DMP) offered by a Credit Counseling agency

If you have bad credit, you can consult the dedicated section: Debt Consolidation Loans for Bad Credit.

How to consolidate your debt will depend on your situation

The best way to consolidate your debt will depend on your personal situation. A secured loan requires placing your property as collateral, so you risk loosing your home if you fail to pay it back, but you will get a lower interest rate on the loan. Unsecured loans, instead, do not require putting your property on the line, but result in higher rates and less beneficial conditions. All options have pros and cons, but they can be preferable to continuing to struggle with high interest credit card payments. The consolidation options available to you will depend on the answers to the following questions:

Do you own a home?

If you are a homeowner, you have the option of taking out a secured loan such as a home equity line of credit (HELOC), home equity loan, or a second mortgage, in which you pledge your home as collateral for the loan. The advantages of these loans is that not only they usually have lower (and, if you want, fixed) interest rates, but that the interest is tax-deductible. On the other hand, you risk loosing your home if you fail to make your payments.

Do you own a car?

If so, don't even think about using a car title loan (in which you place your car as collateral for the loan) to consolidate your debt. Not so much because you risk loosing your car (90% of times this will not happen), but because title loan lenders can charge outrageous, triple digits, rates. It is not uncommon to see 250% APR or higher on a title loan, meaning you'll pay over 10 times as much in interest when compared to a credit card. This is why a car title loan is a very bad idea and can't be considered an available option for debt consolidation.

What is your monthly income and total debt payments?

Banks and lending institutions will be looking at your current monthly income and monthly debt payments (called "revolving debt") in order to determine how likely you are to pay back a loan. Lenders want to see a low debt-to-income ratio (DTI, which corresponds to debt divided by income). This ratio might be as important as your credit score. A DTI below 36 will increase your chances of obtaining the loan you are seeking. In order to find out your DTI number, add up all your monthly obligations: mortgage payment (including principal, interest, property taxes and home insurance) + home equity loan payment + car loan payment + student loan payment + all of your minimum monthly payment amounts on your credit cards and on any other loan that you might have. Add these together and divide the number by your gross monthly income in order to find out your DTI ratio.

What is your credit score?

Getting the right terms on an unsecured consolidation loan is determined in large part by your credit scores. The table below can provide an indication of what can type of debt consolidation options are available at each credit score level:

FICO score Grade Rating What you can typically obtain
A+ Excellent very easy to obtain an unsecured loan at a low rate
700-759 A Good easy to obtain a good rate
660-699 B Fair you should qualify for a decent rate unsecured loan
620-659 C Poor below 640 it will be hard - but still possible - to obtain an unsecured loan
580-619 D Bad see Consolidation loans for bad credit and Credit Counseling
< 580 F Very bad

An unsecured loan as a mean of consolidating your debt only makes sense if you qualify for the right terms: the interest rate should be lower than the one on the debt you are looking to consolidate. As a minimum, for temporary debt relief, the payment schedule must result in lower monthly payments. If you don't get the right terms on the loan, your debt problem could get worse rather than better. It is therefore essential to qualify at the right terms.

You will need a perfect or near perfect credit score to qualify for attractive terms. If you have a credit score above 700 (and possibly above 750 or 760), you can qualify for a low rate and great terms on an unsecured loan. However, if you have a score between 650 (or in some cases 660) and 700, you are not guaranteed the best rates (the ones that are usually advertised).

With a credit score between 600 (or in some cases 620) and 650, obtaining a decent interest rate and terms on an unsecured loan (or even just qualifying for a loan) becomes much more difficult. Below 600 (or 580) it is nearly impossible. The problem is that the same financial difficulties that have made you miss or be late on your payments will have often negatively affected your credit score as well. In a cascading effect, your financial problems might be preventing you from finding an effective solution.

What is your payment history?

Lenders want to see that you've paid back other loans and that you don't have a history of missed and late payments. For example, you don't want to have a collection in the last 12 months. Your payment history is reflected in your credit score, which is an indicator of how creditworthy you are.

How solid is your current income and budget?

How confident are you that you'll be able to make the payments on the consolidation loan? What are the chances of your employment situation changing for the worse during the repayment period? Should you loose your job, do you have any backup funds that you could access in between jobs if needed? And what about unplanned expenses that could arise? What is your health condition and healthcare coverage? A realistic assessment of the solidity of your personal and financial situation will provide an approximation of the probability of not becoming able to repay your new consolidation loan.

What is your risk tolerance?

Once you have assessed your non-payment risk by answering the previous question, you'll have to determine if that amount of risk falls above or below your personal risk tolerance level. In other words: do you feel comfortable with taking that amount of risk to the point that you are ready to place your home on the line in order to obtain a lower interest rate with a secured consolidation loan, which means lower overall interest expenses and the option of getting out of debt faster even though you pay less each month? Or do you feel the risk is too much for you, so you prefer not to put your property on the line even if that means having to pay more interest with an unsecured consolidation loan?

Before you consolidate

Before you do anything, you should contact your creditors (credit card or financial companies) directly to see if they can provide you with more favorable terms. See Credit Card Consolidation for more details.

How to consolidate with a loan: where to go

Once you have assessed your current total debt, overall interest rate, asset ownership, income, budget solidity, credit score, debt to income ratio, and personal risk tolerance level, you can shop around for the best loan that fits your situation.

For specific contact information and more details, consult our list of companies offering debt consolidation loans.

Following is a quick reveiw of places that offer products that can allow you to consolidate your debt:

  • Your local bank
    Talking with your local bank regarding getting a loan usually works much better in person than over the phone, so walk into the local branch of the bank holding the checking account where your paychecks are deposited each month and ask to speak with someone about the possibility of getting a loan to consolidate your debt. The people at your local bank know you personally and are familiar with your accounts and your financial history, so they will tend to trust you more than a distant entity that can only assess credit scores and financial ratios to determine if they can trust you to repay a loan. In addition, you can qualify for a lower interest rate if you can deduct payments from the checking account you have with them.
  • Other local community banks and Credit unions
    Local financial institutions value local business and the people assisting you live and work in your same community. They will be willing to work with you to help manage your debt. Moreover, credit unions are non-profit entities and could offer lower rates than banks. Visit findacreditunion.com to locate a credit unions near you.
  • Peer-to-peer lending (P2P) companies
    Companies such as Prosper and LendingClub in the U.S. (or Zopa, in the U. K.) connect individual lenders with individual borrowers without having to go through a traditional financial intermediary such as a bank or financial institution. P2P lending could offer you a loan with an attractive rate, in some cases even when you do not qualify for a traditional bank loan because of a less than perfect credit score.
  • Finance companies
    If your credit score is too low and your local banks, credit unions, and peer to peer lending companies have all rejected your loan application, you may have to resort to a finance company for a loan. A finance company will be willing to take on more risks but will usually charge a higher interest rate on your consolidation loan.


What to do once you receive the money

Once you're approved for a loan and receive the money, the final step is paying off your existing loans and credit card balances. It is key that you do not start accumulating debt again on your credit cards, otherwise your debt problem will get worse rather than better. If you continue to use your credit cards, make sure you pay the full amount of your balance every month.

Consolidating with a credit card balance transfer

Another option for consolidating your debt is using credit card offers. You might receive these in the mail or you can find and compare the best balance transfer offers searching online. Many credit card companies will offer a 0% rate on the balance transfer for an introductory period (typically between 6 and 18 months), after which the rate goes back up to the non-promotional standard APR (typically a variable rate between 11% and 23% ). For details and tips on this consolidation option, see Credit card balance transfer

Consolidating through a Debt Management Program (DMP)

A debt management program (DMP) is a repayment plan offered by Credit Counseling agencies. In exchange of a service fee, they will consult with you and review your financial situation (assets, liabilities, income, and spending habits), negotiate better terms with your creditors and work out a debt repayment plan. You will make a single monthly payment to the agency, which in turn will pay each of your creditors. There are reputable and not so reputable companies in this field, so be sure do read our Credit Counseling section.

How NOT to consolidate your debt

  • Debt settlement is not a consolidation option, even if it is often presented as such. The term "debt consolidation" is sometimes used by debt settlement companies to advertise their services, causing confusion and possibly misleading consumers on what's really being offered to them. Debt settlement is really another debt relief option, an alternative to debt consolidation. Learn about the difference between debt consolidation and debt settlement so you can make an informed decision.
  • Don't consolidate your debt with a payday loan - these are short term loans (to be paid back at your next paycheck) and come with extremely high interest rates and fees. For these reasons, they can't be considered as a debt consolidation option.
  • Don't consolidate your debt with a car title loan. Not because of the repossession risk (only 10% of people end up loosing their car), but because these loans charge horrendously high interest rates (250% ore more) and fees. Similarly to payday loans, car title loans are meant for short term (typically 30 days at most) emergency situations.
  • Consolidating with a higher interest loan
    If the loan you will use for consolidation has a higher interest than the interest you are paying on your current debt, it will not achieve one of the objectives of debt consolidation, which is to save on total interest costs. Only consider a higher interest loan when the lower monthly payment required on the loan (as a result of a longer repayment period) will allow you to not miss payments, as you would be forced to do otherwise, without consolidating.