When struggling with debt, one of the first steps to getting your finances in order is to make a list of the balances, monthly payments and interest rates for each of your debts. This step creates a visual picture that is overwhelming and shocking. In another article, we discuss strategies for paying down this debt with our existing cash flow [link to article, “Which debts should i pay off first?”]
It might also be tempting to consolidate your debt in an attempt to pay them off quicker and for less money. But, as with any major financial decision, debt consolidation requires that you make an educated decision that is best for you. Debt consolidation isn’t really helping you pay off your debt; it’s simply putting it all into one location, with one (hopefully lower) payment.
One option for homeowners who are interested in debt consolidation is to use a home equity line of credit to pay off personal loans, credit cards, or vehicle loans. With current low interest rates, this may seem like an appealing option. However, it is also risky, because your home is now collateral for the bills you’re paying off. If you fall into default on these payments, you could lose your home. Bankrate.com offers this calculator to help with deciding if using your home’s equity is worth it.
Borrowing from your 401(k) is also another tempting option. However, even if your 401(k) plan allows you to borrow, if you ever switch or lose your job, you typically must repay the entire loan within 30 to 60 days. You likely won’t have that money if you used it to pay off other debts. Moreover, it is challenging to replenish your 401(k) because the government caps how much you can contribute each year. So this type of borrowing risks your retirement.
Another option is a debt-consolidation loan, which is offered by most banks and some private companies. But this option frequently ends up being laden with fees and hidden costs that will end up costing you more in the long run. Relative to non-bank institutions, banks tend to have a lower interest rates and be more upfront with loan terms. Just as with any loan, you will be paying interest on the borrowed money and this loan will probably extend the repayment length of your debt.
If you have several credit cards to pay off, you might also be lured into transferring all of your credit cards to a single card with a lower interest rate. Credit card companies often advertise “zero- percent” interest rate balance transfers. These offers are meant to entice you. But in reality, to qualify for a zero percent rate, you have to have an excellent credit score, which probably means very little credit card debt in the first place. Moreover, these credit cards often have additional one-time charges that undo their value. Make sure to check the fine print.
While debt consolidation may seem like an easy way out of debt, it is simply a bandaid to a much larger problem. Just as it’s important to GET out of debt, it is just as important to develop a plan to STAY out of debt. Creating and sticking to a strict budget will help you avoid digging into a deeper hole of debt.