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How to Consolidate Debt (The Right Way)

By Todd Campbell - May 25, 2015 at 1:20PM

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Consolidating credit cards and student loans can save you money in the long run.

Source: Flickr user Sean MacEntee

The average American last year had close to three credit cards, and 15% had five or more credit cards, according to a Gallup survey. Couple the bills from those cards with student loan payments and it can be tough to stay on top of it all. But don't worry, we're here to help. Read on to learn how to consolidate debt, reduce your interest payments, and eliminate stress.

Drowning in debt
Despite the post-recession economic recovery, Americans' debt picture hasn't improved all that much.

According to the St. Louis Federal Reserve Bank, Americans as of March owed $889 billion in revolving credit, such as credit cards. That's down from its peak, but up from the low of $834 billion in 2011 and much higher than the $682 billion Americans owed exiting 2000.

Credit cards are a big problem for borrowers, particularly due to their high interest rates, but student loans are also increasingly becoming a big burden. As of the first quarter of 2015, Americans owed a whopping $1.35 trillion in student loan debt, up from less than $700 billion in early 2008.

The problem at hand
If you're struggling to keep up with all your payments, you're not alone. Although more people are current on their payments today than they were during the recession, 2.1% of borrowers as of the first quarter of were late on their credit cards and repayment rates for student loans remained low.

Only 29% of student loan borrowers as of 2014 were always current on their payments and were paying enough to push down they amount they owe, the New York Federal Reserve Bank found. It noted that a stunning 1.2 million people defaulted on their student loans in both 2011 and 2012 -- the vast majority of whom earn less than $60,000 per year.

Solving the problem
It's always best to pay down debt quickly, particularly for credit cards because credit card interest isn't deductible at tax time. Since credit cards usually charge higher interest rates, eliminating debt, rather than consolidating it, should be your focus. Even sending a little bit more money to the credit card company that is charging you the highest interest rate every month can save you a lot over time.

However, if paying off debt isn't an option, consolidating debt could make sense. If you consolidate credit cards so that the average interest rate being paid falls, and then pay a little more on that consolidated balance every month, or make an extra payment every year, then you can work that debt down pretty quickly.

Balance transfer options are a good place to start when considering consolidating credit cards. Balance transfers typically give you the option of choosing a low introductory rate or a fixed rate that is often lower than what you're currently paying.

If your payment history and credit score are solid, consolidating credit card debt can at least save you hundreds of dollars a year. But if you aren't in a position to pay off the balance transfer before the introductory rate expires, you might want to pick the fixed rate instead. Although you might be able to transfer that balance again later when the introductory rate expires, there's no guarantee lenders will offer that option. During the recession, for example, credit card companies became very stingy with balance transfer offers.

If you own a home, a home equity loan could be another option for consolidating credit card debt. You might be able to borrow against equity in your home at a rate that is much lower than what your credit card companies charge.

The interest on home equity loans has the added bonus of often being tax deductible, which can save you even more money. Also, shifting credit card balances to a home equity loan (and then locking the credit cards away so you don't use them again) could bump up your credit score, too. That's because the percentage of debt outstanding relative to the available credit on your credit cards is a key component credit scoring agencies use in determining your credit score.

Source: Flickr user Roger Blackwell.

If you need to consolidate federal subsidized or unsubsidized student loans, the first place to look is the U.S. Department of Education. The department manages the Federal Student Aid office and offers a number of repayment options, including direct consolidation loans. Those loans don't charge a fee.

At least one of the student loans being consolidated must be in a grace period or in repayment. If you want to consolidate a loan that is in default you'll have to make arrangements with your lender first, or agree to pay your new consolidation loan under an income-based plan or other repayment plan offered by the Department of Education.

The interest rate on a direct consolidation loan is the weighted average of the interest rates on the loans being consolidated, rounded up to the nearest one-eighth of 1%. Typically, these loans have a longer repayment period than the individual loans being consolidated, which means lower monthly payments. However, that longer payment period also means the total interest paid on the consolidated loans could be higher in the long run. For that reason, if you go this route you might consider paying a little extra on these loans every year to reduce the amount you owe and offset that interest risk.

If private education loans, rather than federal student loans, are the problem, your best bet might be to roll them into a home equity loan.

Tying it together
It's critical to address mounting debt quickly when your credit is good and you have more options, including consolidation. Taking action to reduce your overall debt, either by paying it down or refinancing it, can reduce the risk of late and missed payments and their resulting fees, and make your life simpler. Consolidating debt can be even more valuable if it frees up money for saving or investing for the long haul. 

 

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