Debt Consolidation: The Pros and Cons of Your Major Options

Do you want to have fewer bills to pay each month and save money at the same time? Who doesn’t?! But simply consolidating a bunch of debts at a lower interest rate won’t necessarily get you there. Consider the pros and cons of all your options – and then manage your debts and cut back on spending over time.

Once you choose a debt consolidation method, make sure you keep the total cost as low as possible. Here are three tips to up the odds that your debt consolidation plan will work:

1. Don’t take the maximum amount of time possible to pay off your new loan. Instead, come up with a plan to get out of debt in three to five years.
2. Read the fine print so there are no surprises, such as a balance transfers or application fees.
3. Ignore all offers that sound too good to be true.

Tip for folks in really bad financial shape:
If you are in serious money trouble and are feeling overwhelmed by all the bills, before you do anything else, take advantage of Credit.com’s debt consultation service. It’s free, private, and a real live human being will go through your options with you, one of which might be to work with a non-profit credit-counseling agency that can negotiate with your creditors on your behalf.

Homeowners Have Great Options

If you’ve built up some equity and the interest rates remain favorable, it may make sense to refinance your home and use the additional cash you can borrow, over and above what you owe on your current mortgage, to pay off more expensive debts. Or you might be better off taking out a home equity line of credit (HELOC) or a fixed rate home equity loan.  You can start your research with Credit.com’s Mortgage Guide .

Pros:

• You can save a fortune by switching debts from the double-digits of typical credit card bills to the much lower rates on home equity loans and refinances.
• There’s the possibility of being able to deduct the interest on home loans, whereas that’s not possible with credit card debts.
• If you shop carefully, you’ll be able to get a good deal on closing costs, saving you more money.

Cons:

• You’re putting your home on the line, which is extremely risky unless you are certain you can trust yourself to stop over-spending and to faithfully pay off the home loan(s). 
• If you go for a variable rate loan, remember that what goes down may well go up, increasing your cost of borrowing.
• Don’t unwittingly extend the length of time you’ll be in debt or it might cost you more over the long run than if you’d simply paid off those higher rate bills.

Tips:

• Don’t pocket the money your refinancing frees up every month. Instead, use it to create an emergency fund (if you don’t already have one). Once that’s set up, use the money as a pre-payment against your home loan or to boost your retirement savings.
• Ditto with any tax refunds that come your way.

Cardholders Have Great Options

One of the easiest ways to consolidate your credit card debts is to call your current card issuers and ask them to give you a better deal. If the customer service representative seems unwilling, don’t be shy! Ask to speak with a supervisor.

Lenders know the competition is tough, and it’s cheaper for them to keep you than it is to get a new customer to replace you – especially if you’re a “low maintenance” borrower who pays bills on time. While you have them on the phone, ask about these three issues:

1. Getting a special rate on any new balances that you transfer to their card.
2. Getting the interest rate lowered on new purchases.
3. Getting any annual fee waived.

Pros:

• A phone call or two to a toll-free number is all it takes. It doesn’t get much easier than that!
• You have nothing to lose and you may save yourself a lot of money – now and over the long haul.

Cons:

• Especially if you have a spotty payment record, it may not work!
• Instead, try getting a new, low rate credit card at Credit.com. This is admittedly more of a hassle than making one toll-free call, but if you’re honest about your credit situation as you look over the offers, you may find a lower rate card without too much trouble.

Tips:

• Ask that any balance transfer fees be waived.
• Don’t apply for too many new cards at one time. It can hurt your credit score. So choose carefully!
• Watch out for teaser rates. While you can save the most by strategically transferring your debt to another low introductory rate card whenever the last "teaser" rate is about to expire, the constant balance swapping can burn you out, and if you flub it, you could pay for it. Instead, try to find a card with a steady, low interest rate.
• Be sure to plow your savings back into your debts.

Can You Borrow from Your Nest Egg?

The answer is “Yes!” if you have:

1. A 401(k), 403(b) or certain other kinds of pension plans
2. An IRA
3. Investments, such as stocks and bonds (loans against them are called "margin" loans)

The key word to remember here is borrow. It’s one thing to take a loanagainstyour future nest egg. That alone raises many issues worthy of your consideration! But if you were to withdraw retirement funds early instead, from your 401 (k), for example, you’d have to pay taxes and a 10% penalty.

The interest rates on these loans tend to be low – or even interest-free. For example, you can use money from your IRA interest-free for 60 days. However, you must “roll it over” to another IRA account within 60 days. Don't use your IRA to pay debts unless you are 100% confident the money will be replaced within two months, say, with a tax refund you are guaranteed to receive. Otherwise, you'll be hit with a penalty and taxes on the funds. (Of course, while you’re using your IRA money, it won’t be earning you any interest either.) 

Pros:

• If you have no credit history or a poor one, these borrowing options might make sense, since they require no credit check and are easy to get.
• The interest rates are generally low, and since you’re the lender, the interest gets paid to you (in the case of retirement funds). As far as margin loans and IRAs are concerned, you don't have to make interest payments on them at all.

Cons:

• Should you lose your job, you might have to pay back your retirement fund loan immediately … or pay taxes and penalties and have it treated as an early withdrawal.
• You could end up robbing your retirement fund if you rely too much on these loans.
• If you fall behind on your re-payments, even though they are to yourself, the IRS will treat a retirement fund loan as an early withdrawal -- 10% plus taxes.
• Since there’s always a risk of a “margin call” if the market crashes, most advisors urge caution here – that is, keep margin borrowing at 20-25% of your investment account. (With a margin call, you may be called on to immediately pay back the loan, which may mean selling stock at an unfavorable time.)
• Don't use your IRA to pay debts unless you are absolutely certain that you can come up with the funds within 60 days. Otherwise, you'll be hit with a penalty and taxes on the funds. Speak with a tax professional before undertaking an IRA rollover to be certain your plan is sound.  For example, the funds have to be returned to an IRA account (same one or different).

Personal Loans

1. From friends and family:

These loans can be your best bet or worst nightmare. Ideally, you offer your parents or another private lender an interest rate that’s better than what they’re getting at the savings bank. 

Pros:

• Everyone can win! They get a higher rate, you get a lower rate, and you’ll be able to quickly get out of debt.
• Depending on how the deal is structured, you both may even be able to get some tax perks. Talk to a tax pro or a lawyer.

Cons:

• If you blow it, and can’t pay the money back, you may ruin one of the most important relationships in your life. Even exerting some heavy pressure on hesitant loved ones can make things very difficult, whether you get the loan or not.
• The IRS can be a real pain when in comes to family loans. Below market interest rates may inspire Uncle Sam to look to your family for taxes on the interest you would have had to pay a traditional lender. And there may be tax consequences if you can’t pay back the loan.

Tips:

• Getting good tax advice is a must.
• Come up with a concrete plan before you approach family and friends. Know what interest rate you’d like to propose and how much your monthly payments will be. You can play around with the numbers using Credit.com’s Mortgage Calculator .
• Get the agreement in writing, and be sure it states what the late charges will be (not that you would dare miss a payment), and what will happen if you default on the loan.

A tip for Mom and Dad:

If your kids ask you for a loan – for debt consolidation or any other purpose – even if you can easily afford the requested amount – take a good, hard look before you agree. If you do go for it, keep it on as professional a level as possible. Not only will you be bailing out your children at an important time in their lives, but you’ll be giving them an excellent borrowing experience. 

2. From Banks and Credit Unions:

In days of yore, when people needed a hand catching up on their bills, they strolled into the neighborhood bank, spoke to branch manager, shook hands on a loan, and got a check for the amount they needed. These days, while you can still get personal loans from banks and credit unions, there are generally lower rate options, such as the ones we have been discussing.

The rates are better when the loan is secured and you’ve been a bank customer for years than when the loan is unsecured and given solely against your good name. So check where you currently bank. You can compare personal loan rates in your area here on Bankrate.com’s site. (You’ll be taken through a few steps based upon your location and credit rating. Eventually, you will be given a choice between various home equity loans and personal loans.)

Pros:

• Depending on your circumstances and the local competition between lenders, you may be able to get a great rate.
• If you set up the loan for three to five years, you will be “forced” to stay on your debt consolidation schedule. If you let the bank take the payments from your account automatically, you may get an even better rate!

Cons:

• If you have a spotty credit history with many outstanding debts, you will not be offered a great rate from a bank.
• While there are many online offers for personal loans, be wary. Only go to sites you trust before you even consider borrowing in this fashion -- for example, Credit.com.

Tips:

• Don’t hesitate to ask your bank or credit union to give you a better deal if they want to keep your business!
• Discuss the situation with a lender before your credit report is pulled. If the bank’s terms are not to your liking, there’s no reason to have its inquiry show on your credit report.

The Most Important Tips of All:

• Don’t ever let yourself get so deeply in debt again.
• Pay your bills on time – even if all you can afford is the minimum. Always try to send in more than the minimum.
• If you’re in a financial jam because of a situation that’s beyond your control – say an illness or job loss – get help now. You do have other options!

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*Nancy Castleman has been sharing ways to get out of debt, save money, and live better on less since 1984. For more of her ideas, visit her Web site, Good Advice Press.

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