Consolidating your debt is one of the best ways to lower your interest payments. In this article, you'll learn about debt consolidation strategies to help you achieve financial freedom sooner, rather than later.
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Debt really has an easy way of sneaking up on people. Between credit cards, personal or student loans, and a financed vehicle or two, you might really be feeling the burden of debt on your back.
When you're stuck in a debt hole, the key is to stop digging, and start climbing. You need to assess your situation to one day be financially free.
Debt consolidation is one of the best strategies for getting out of debt. Let's discuss in more detail.
What Is Debt Consolidation?
Debt consolidation is a way to consolidate your higher interest rate debt into one, lower interest rate debt. Let's say you have three credit card bills with an average interest rate of 18% followed by a car loan at 9%.
You should consider consolidating your debt via a personal loan for an overall interest rate under 9% to save. Or, you can just consolidate your credit card debt to an interest rate under 18% to save and leave your car loan alone.
The easiest way to consolidate your debt is to check out Credible, a leading lending marketplace where lenders compete for your business. They are based in San Francisco and have lenders to help you reduce your debt payments via a personal loan. The more lenders compete for your business, the better your terms.
By consolidating debt, borrowers have the ability to lower the interest rate on their debt and lower their monthly payments. This, in turn, can make paying down debt and providing for other expenses more manageable.
Things That Lower Your Interest Rate
Your #1 goal for debt consolidation is to get a lower interest rate on all your debt than you are currently paying.
Therefore, the key factors that help you lower your interest rats are:
- Your credit score / credit report
- The platform you use to apply for debt consolidation
The higher your credit score and the cleaner your credit report, the lower your interest rate. Below is a chart that shows what affects your credit score.
The Main Components That Determine Your Credit Score
There are five main components that determine your credit score:
- Payment History (35%)
- Amounts Owed (30%)
- Length Of Credit History (15%)
- New Credit (10%)
- Types Of Credit Used (10%).
The weightings of each component are rough estimates that depend from person to person. For example, someone who just started taking out credit may have a lower percentage weighting in the Length Of Credit History component vs. someone who has used credit for over 30 years. Let’s discuss each category.
Payment History (35%)
A lender wants to know whether you’ve been a good creditor or a bad creditor with other financial institutions. The longer you can demonstrate you’ve consistently paid a lender on time, the higher your score. The more you’ve been late or have not paid, the lower your score.
If you are first starting out, lenders will base your creditworthiness on your occupation and debt levels. They understand everybody has to start somewhere and most are willing to lend with an initial small credit line.
Amounts Owed (30%)
The goal is to figure out how much credit is too much for a given borrower. When a high percentage of a person’s available credit is being used, it may signal that the borrower is overextended.
The credit scores want to determine: 1) the amounts owed on all accounts, 2) the amounts owed on different type of accounts e.g. credit cards, mortgages, car loans, student loans etc, 3) whether you have balances, 4) how many of your accounts have balances, and 5) how much of the installment loan do you still owe vs the original amount e.g. car loan.
Owing a lot of money doesn’t necessarily mean you are a bad creditor. But owing a lot of money on multiple accounts which are maxed to the limit show credit risk which may negatively hurt your credit score. Lenders don’t want to lend more money to people who are already using up all their line of credit.
Length Of Credit History (15%)
The general math is that the longer your credit history, the higher your credit score all things being equal. Credit score companies will ascertain the age of your oldest credit account, your newest credit account, and the average age of all your credit accounts to get a big picture. Another variable is the frequency by which your credit accounts are used.
New Credit (10%)
If you open up multiple new credit lines in a short period of time, research shows you are of higher credit risk. The theory is that there may be an emergency cash crunch you are facing that encourages you to open up new lines of credit with the risk of not paying them off.
Types Of Credit Used (10%)
Credit score evaluators will consider your mix of credit cards, retail accounts, installment loans, finance company accounts and mortgage loans. More is not better, just like only having credit card and a mortgage isn’t better.
Below is a chart of the credit score (FICO score) ranges. You ideally want a score above 670, and preferably above 740. The people with over a 800 credit score will get the lowest interest rates available.
Getting A Lower Interest Rate With Debt Consolidation
Now that you understand the importance of getting a good credit score to get a low interest rate, your goal is to now get as many qualified lenders to compete for your business.
This is where Credible comes in. In under three minutes, you will get qualified lenders competing for your debt consolidation business. If you want to consolidate credit cards, or finance moving, home, medical, or other expenses, Credible lenders will help you out.
What's great about Credible is that you can compare the debt consolidation rates and lenders all in one place, rather than apply for a personal loan one-by-one. Credible is free and you'll get personalized prequalified rates in under three minutes.
Make Sure You Keep Paying Down Debt
Once you have consolidated your debt, make sure you keep paying your monthly bills and not get into more debt. Otherwise, you're taking one step forward and two steps back. Debt consolidation requires consistent focus in paying down debt.
It's imperative you come up with a budget and stick to it based on your income. Debt is a real anchor towards your financial freedom goal, especially if the interest rate is high.
One attractive strategy many people use to consolidate debt is via a 0% balance transfer credit card. This is a wise move IF you pay off the entire debt before the introductory 0% period is over. If not, you will end up paying more interest because credit cards generally have the highest interest rates.
Other Ways To Consolidate Your Debt
In addition to taking out a 0% balance transfer credit card and getting a personal loan, here are some other ways to consolidate your debt.
1) Cash-Out Home Refinance
Cash-out refinancing is when you refinance your mortgage for more than you currently owe, in an effort to take cash (your equity) out.
For example, let’s assume you owe $200,000 on a home that is worth $500,000, for a 50% loan-to-value ratio. Your cash out refinance rate is 5%, but you owe $25,000 in revolving credit card debt at a 20% rate.
You can cash out $25,000 or more from your home and use the proceeds to pay down or pay off your $25,000 credit card debt. Although your mortgage balance grows to $225,000, you're only paying a 5% rate instead of a 20% rate, for a 15% savings.
Advantages:
- Home mortgages offer some of the lowest interest rates available.
- The loan can be amortized over 30 years, resulting in lower payments for the consolidated debt.
- If you consolidate all of your debt in a cash-out refi, you reduce your monthly payments to just your mortgage.
Disadvantages:
- A home loan is secured by a mortgage on your home, meaning that if you fail to repay the loan, you could lose your home.
- Extending debt payments over 30 years could result in paying higher total interest payments on the debt.
- There are fees associated with refinancing a mortgage; depending on the terms of the loan, they could be significant.
To do a cash-out refinance, you can also check out Credible as well. You'll get competing offers from qualified mortgage lenders.
2) Home Equity Line of Credit (HELOC)
A home equity line of credit, or HELOC, allows you take a loan against the equity in your home. For example, let's say you have $1,000,000 in equity in your home and only $200,000 left in mortgage. You have a 83.3% loan-to-value ratio when a 20% loan-to-value ratio is usually good enough. You can easily take out a HELOC for $100,000 and use the proceeds to pay off higher interest rate debt.
A typical HELOC requires you to pay interest only on the balance for the first 10 years. The existing balance at year 10 is then converted into a loan amortized over 20 years. Once you have a home equity line established, consolidating your debt onto the line of credit is simply a matter of writing checks to pay off your other debts.
Advantages:
- HELOC rate is almost always lower than a credit card interest rate
- Easy to take out a HELOC and draw from it when needed
- In many cases, there are no fees to establish a home equity line of credit.
Disadvantages:
- As with a mortgage, a home equity line of credit is secured by your home. If you fail to make the required payments, you could lose your home.
3) Home Equity Loan
A home equity loan is very similar to a home equity line of credit, with one major difference.
With a line of credit, your outstanding balance can go up and down as you borrow and repay against the line of credit (again, much like a credit card). A home equity loan, however, works more like a car loan: you borrow a set amount of money and repay it over a fixed period of time.
Advantages:
- The advantages are the same as with a home equity line. You receive a check from the bank in the amount of the loan that you can then use to pay off your other debts.
Disadvantages:
- A home equity loan is secured by your home. Fail to pay the loan, and you could lose your house.
4) Low-Interest Credit Card
If you don't want to do a 0% balance transfer on a credit card due to a high balance transfer fee, you can consolidate your higher interest rate debt with a credit card with a lower interest rate.
You can expect to pay between 2% and 5% of the outstanding balance as a minimum payment each month. Low-interest cards generally require excellent credit to qualify, too, so this may not be an option for some borrowers. And if you have overspending issues, even a low-interest credit card can lead you into more debt.
You're likely not going to find a credit card that charges much lower than your current credit card interest rate. But every percent counts if you have the time to open up a new credit card.
Advantages:
- It’s easy to apply for a low-interest card online and to transfer balances to the card.
- The interest rates are not introductory teaser rates.
Disadvantages:
- These low-interest credit cards require excellent credit, and as a result, can be difficult for many to obtain.
- You might be tempted to spend more, and dig yourself back in a hole.
Here are the best rewards credit cards after doing hundreds of hours of research.
5) 401(k) Loan
I'm against borrowing from your 401(k) to pay for something, unless it's a life and death situation. Your 401(k) should be there for your retirement, and should be maxed out every year and left to compound for decades. Those who tend to pilfer their 401(k) tend not to have as much in their 401(k) when they retire! Go figure.
But if you're desperate, some 401(k) programs allow you to borrow up to 50% of your retirement balance (maximum $50,000), if needed. You then repay the loan with interest, but the interest is paid back to your own retirement account. So that's much better than paying interest to someone else.
Just be aware that if you leave your job for whatever reason, you must repay the outstanding balance immediately. If you fail to repay the loan within five years, the IRS will consider the outstanding balance to be a distribution, and you could end up paying a 10% penalty on top of taxes.
Advantages:
- Interest payments are made back to your retirement account, so you don’t lose the money, no matter how high the interest rate is.
- If your company allows 401k loans, they are very easy to obtain.
Disadvantages:
- The loan may be considered a distribution if you leave your job and are unable to repay the loan.
- The money borrowed will be removed from your investments.
6) A Combination Of The Above
There's no reason why you can deploy more than one of the strategies above. Just know that I believe everybody should concurrently pay down debt and invest, using my FS-DAIR methodology.
If all you do is focus on paying down debt, no debt is the only thing you're going to get. You want to not only pay down debt but grow your wealth through consistent investing.
Consolidate Your High Interest Debt
Debt consolidation can lower your overall interest rate payments. The interest rate spread between getting a personal loan and the average credit card interest rate is at its highest it's been in over 20 years. Borrowers should take advantage by consolidating their credit card debt into a personal loan.
We are in the golden age of economic growth. Economic growth has allowed investors in stocks, bonds, and real estate to get rich. But economic growth has also fueled more consumption spending and more consumer debt.
At the same time, interest rates have remained low. Therefore, more people can also take advantage of low interest rate opportunities to pay down debt faster and pay less interest expense.
The ultimate goal is to use debt to your advantage. Once you start feeling like debt is a drag, you need to be laser focused in paying down your debt as quickly as possible.
It felt amazing to pay off my $40,000 in MBA student loan debt. It also felt amazing to pay off my rental property mortgage. You will never regret paying off debt either.
To get a personal loan to consolidate your debt, check out Credible. My favorite lending marketplace today.
About the Author:
Sam worked in investment banking for 13 years at GS and CS. He received his undergraduate degree in Economics from The College of William & Mary and got his MBA from UC Berkeley. In 2012, Sam was able to retire at the age of 34 largely due to his investments that now generate roughly $250,000 a year in passive income, most recently helped by real estate crowdfunding. He spends most of his time playing tennis and taking care of his family. Financial Samurai was started in 2009 and is one of the most trusted personal finance sites on the web with over 1.5 million pageviews a month.
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