Debt consolidation can help you pay off what you owe faster and more conveniently, with one payment instead of many. But if you choose the wrong method, you could waste your money and end up deeper in debt.
The first step is understanding what debt consolidation is (and isn't). Then you need to decide whether it makes sense for you, and how to pick the best method. Finally, you need to shop smart. Here’s how.
Learn the Terms
Debt consolidation means you're replacing many smaller debts with one larger one — for example, transferring all your credit card debt to one card or line of credit. Or taking out one loan to pay off multiple balances. Either way, you're making one payment a month instead of several. Ideally, you would also pay less interest and therefore pay off the debt faster.
Debt management means seeing a credit counselor who sets you up with a plan to pay off your credit card companies, perhaps at a lower rate that they’ve negotiated with some (but not all) of the major credit card issues. You make your payments to the counselor, who distributes your payment among the card issuers. You can find legitimate, nonprofit agencies through the National Foundation for Credit Counseling.
Debt settlement is a method to get your creditors to accept a smaller amount than what you actually owe. Sometimes lenders will agree to a settlement if they believe the debt would be otherwise uncollectible or that you might file for bankruptcy. Trying to settle debts, though, can devastate your credit and leave you vulnerable to lawsuits — not to mention that a lot of debt settlement firms are scams. Most people who can't pay their bills are better off filing for bankruptcy.
Know Your Options
Low-Rate Credit Card
You could use a balance transfer offer to consolidate your debt onto a card you already have or, if your credit is decent, apply for a new low-rate card. Pay attention to how long the rate will last, since they're rarely fixed. And take note that piling a big balance on a single card can hurt your credit scores. If you can pay the balance off quickly, that might not be a big concern, since your scores will recover as the balance drops. But if you'll be stuck with this debt for a while, there may be better options.
Personal loans can help you pay off your debt, usually with fixed rates and fixed payments over three to seven years. They aren't secured by any collateral or property, so typically you need decent credit to get one — FICO 8 credit scores in the mid-600 range or above. The better your credit, the lower the rate you should get. Even if you get a lower rate than what you're paying on your debt now, though, you could wind up paying more overall if you choose a long payback period rather than a short one.
These loans are guaranteed or "secured" by property, such as a home equity loan or home equity line of credit. Avoid loans secured by your car (title loans) or your paycheck (payday loans) — they typically have high rates and may have predatory terms. Keep in mind when you take a loan against your home that you risk losing your home if you can't make the payments. Also, you're replacing debt that could be erased in bankruptcy with debt that can't, because it’s secured by your home.
Retirement Plan Loan
Loans from 401(k)s and other retirement plans don't require credit checks and you're paying yourself interest, rather than paying it to a lender. But retirement plan loans can be incredibly risky. If you lose your job and can't pay off the balance quickly, your loan becomes a withdrawal and triggers a hefty tax bill. In general, retirement money should be left alone for retirement.
Understand Your Situation
To understand how lenders are likely to view your application, you need to know your credit scores. You can get VantageScores free from several sites, including MyBankrate.com, Credit Karma, Credit.com, and Quizzle. These aren't usually the scores lenders use, but they will give you a general understanding of where you stand.
For a more precise picture, consider spending about $20 to buy one of your FICO 8 scores from MyFico.com. Along with the FICO 8, MyFico.com throws in five or six other commonly used FICO scores, such as the versions used by mortgage, auto, and credit card lenders.
Your scores typically affect whether your application will be approved and what interest rate you're likely to get.
Shop Around for Lenders
You can search for low-rate cards at one of the many card-comparison sites, including NerdWallet, CreditCards.com, LowCards.com, and CardRatings.com, which usually include how good your credit needs to be to get a card. For home equity borrowing, check out Bankrate.com, Lending Tree, and Quicken Loans, as well as your current mortgage lender and local credit union.
Credit unions tend to have good rates and customer service, so they should be the first place to check for personal loans, too. Don't stop there, though: Other potential lenders include your bank and social or "peer-to-peer" lenders like Prosper, LendingClub, SoFi, and PayOff Loan.
Debt Consolidation Isn’t for Everyone
Many people don't consider debt consolidation until they're really struggling, and by then it may be too late. If any of the following are true, you'll need to look for solutions other than debt consolidation:
You Have Bad Credit
Credit scores below about 620 reduce your options dramatically. If you do find a lender, at best you would face high rates and at worst you could fall into the grip of a predatory or fraudulent company.
Your Debt Totals More Than Half Your Income
If you can't pay your consumer debt within five years, bankruptcy is often the better option. Once your credit cards, personal loans, and medical bills equal more than half your income, it becomes less likely you'll be able to pay it off.
You've Been Sued Over Your Debt
You need to contact a bankruptcy attorney now. Even if you don't intend to file, you need legal advice about what to do next.
If consolidation is still an option, you first should figure out what caused you to overspend in the first place. If you don't fix the problem, debt consolidation won't solve it — you'll just end up adding new debts to the old ones.
If you need help with budgeting, you can turn to a credit counseling agency.
Liz Weston is an award-winning journalist and author of several money books, including the best-selling ‘Your Credit Score.’ She writes about personal finance at her site AskLizWeston. You can like her on Facebook and follow her on Twitter.