A debt consolidation loan is the most common form of debt relief. It’s a relatively simple way of lumping all your debts together and giving yourself some breathing room when things get overwhelming. Step one: take out a loan for the total amount of all your debts, preferably one with a lower interest rate than the one in your current accounts. Step two: pay off your debts with the loan amount. Step three: make monthly payments to your new lender instead of several payments to many creditors. If done right, this can ease your debt burden by letting you manage your debt more comfortably and successfully.
However, there are a few reasons why a debt consolidation loan may not be right for you. Maybe the interest rate you’re being offered is too high to make it worthwhile. Maybe the total amount of your debt exceeds personal loan limits. Luckily, there are other options available for consolidating your debts. Read on to find out what they are.
Use Your Savings to Pay Off Debt
If you have a savings account with a significant balance, you may consider using that money to pay off your debt. Whatever interest you are currently accruing on that money is bound to be less than the interest costs you are paying for your credit card and other debts. In other words, you’re paying more interest than you’re earning. After getting rid of your debt, you can start saving up money again, which includes put all your old interest costs towards your savings.
You may also be able to use the money saved in a retirement savings account, such as an IRA or a 401k, barring some restrictions. For one, once you withdraw money from a regular IRA or a 401k account, you are responsible for paying the taxes on that money, as well as a 10% tax penalty for using money that was meant to be used for your retirement.
In the case of an IRA account, if you return the money within 60 days, the IRS considers it a tax-free rollover, and you won’t be taxed. In addition, the early withdrawal penalty can be waived in certain cases, for example, if the account holder becomes disabled or if they are using the money to pay unreimbursed medical expenses or educational expenses for themselves or eligible relatives.
Similarly, some 401k accounts will only give you a “hardship distribution,” which will let you withdraw money for a specific reason, such as buying a new house, paying for tuition, or settling unreimbursed medical bills. Unlike IRAs, there is no way to return the money to the 401k, except by increasing your contributions to get back to the balance you had before.
With a 401k, however, you do have the option to take out a loan, with yourself as the lender. If your plan allows it, you may borrow up to 50% of your vested balance for 5 years at a “prime + 1%” interest rate, which means 1% is added to whatever the prime interest rate is at the time. In any case, you would be paying the interest to yourself. Keep in mind that, if you default on a 401k loan, the loan amount is considered an early distribution by the IRS and subject to taxes and tax penalties. And if you leave your job, the loan is automatically due within 60 days.
Check your IRA and 401k summary plan descriptions (SPDs) to see if these options are available to you.
Transfer Your Credit Card Balance
A credit card balance transfer consists of using a new credit card to pay off an old balance with a higher interest rate. The benefits are similar to those of refinancing a car: you keep the same loan amount but pay less interest on it, which would reduce your monthly payments and your overall obligation.
Some cards even have special introductory rates with 0% APR for balance transfers. These promotional rates tend to end after a certain amount of time, between 6 and 18 months, but most commonly 15 months. After that, the standard APR applies, which is usually determined by your creditworthiness. Therefore, you should aim towards paying off the transferred debt within that promotional period.
Before deciding to transfer your balances into a new card, do some math: check that you will be able to pay off the balance within the introductory period; otherwise, make sure the APR on the new card is lower than the APR you’re being charged on your other accounts. Also, keep in mind that most cards will charge you a transfer fee between 3% and 5% of the balance transferred. On small balances, this doesn’t amount to much, but once you get into the quadruple digits, the fees can rack up quite a bit, so make sure the balance transfer is worth it.
Refinance Your Mortgage
If your home has positive equity—the property’s estimated market value is higher than the current balance of your mortgage loan—you may be able to refinance or remortgage your house and receive a cash payment. One of the most common ways to do this is through a cash-out refinance.
As with a typical refinance, you use the new mortgage to pay off the old mortgage. In this case, you use your home equity to borrow more than your loan balance. The difference is paid to you in cash. Cash-out refinances have fixed interest rates, and you should look for a lower rate than the one you have now. One of the benefits of a cash-out refinance is that you get to change the terms of your mortgage—for a lower interest rate or a shorter loan period—and use the money to do improvements in your home, pay your children’s tuition, or consolidate your debts.
You also have the option of taking out a second mortgage. This can come in the shape of a home equity loan or a home equity line of credit (HELOC).
With a home equity loan, you keep your first mortgage and use your home equity as collateral to borrow a sum of money, which is paid as a lump sum. Like traditional home mortgage loans, home equity loans have fixed interest rates. However, second mortgages tend to have higher APRs than first mortgages, because the risk to lenders is increased.
Another type of second mortgage is a home equity line of credit, also known as a HELOC. Like a home equity loan, your home equity serves as collateral for a new loan, but with a HELOC, the lender determines the maximum amount you can borrow and lends you below that whenever you want. Think of it like a credit card, which sets a credit limit and lets you charge amounts to the card up to that limit. Like a credit card, you only repay the principal and interest for the amount you borrow, but you always have the option to borrow more if the need arises. Unlike home equity loans and first mortgages, the APR on a HELOC is variable, which means you can end up paying more as time goes by if the market rate spikes or if your credit score dips.
With both types of second mortgages, there are restrictions on how much you can borrow, depending on your combined loan-to-value ratio (CLTV). This ratio is calculated by adding your current loan balance and the amount you want to borrow, and dividing that by your home’s value, as determined by an appraiser. Lenders usually require this number stay at or below 85%.
There have also been recent changes on how home equity interest costs are treated by tax authorities. Homeowners used to be able to deduct the interest paid on home equity loans and HELOCs from their taxes, but this is no longer the case after the Tax Cuts and Jobs Act of 2017, also known as the Tax Reform. Starting in 2018, interest on home equity debts will no longer be tax-deductible, until the current law comes back into effect in 2025.
A word of caution about borrowing against your home equity to pay off debt: adding a second mortgage to your debt obligations may do more harm than good when your financial situation is unstable. And defaulting on your mortgage would cost you your home. You should only consider this option if you are certain you will be able to make all your monthly mortgage payments.
Debt Relief and Debt Settlement
If none of the options mentioned above works for you, you might consider participating in a debt relief program, such as debt management and debt settlement.
Debt management includes working with a credit counseling agency that can advise you on how to manage your money efficiently in order to pay off your debts quickly. Credit counseling agencies focus on helping you change the habits that made you fall into a debt trap in the first place. Some credit counseling agencies also offer debt management programs (DMPs), which require you to make deposits into a special account. The agency then uses the money to repay your creditors according to a payment schedule you prepare together. The agency may even negotiate with your creditors to lower your interest rate or waive late fees. This option is especially useful for people with bad credit who fear damaging it further by taking on more debt or by defaulting. Enrolling in a DMP doesn’t directly impact your credit score, though it may show up on your history. As long as you continue to make full payments every month, your score should not drop, and as you eliminate debt, it should even increase.
Debt settlement is similar to a DMP in that you are required to make payments into an account with the debt settlement company. The company negotiates with your creditors to get them to accept a lower lump sum payment to settle your debt. This means you will effectively be defaulting on your account, which will have a negative impact on your credit score. According to FICO, settling a debt can subtract over 100 points from your score, depending on how high it was. And if you settle more than one account, the effect is multiplied. However, if your only other option is bankruptcy, debt settlement may be the way to go.
File for Bankruptcy
Bankruptcy is the nuclear option for debt relief. It will wipe out many—though not all—debts, but the fallout can be toxic.
Bankruptcy is a federal legal process that requires filing with the U.S. Bankruptcy Court. Though the law doesn’t require debtors to be represented by an attorney to file for bankruptcy, it is strongly advisable. Bankruptcy law and bankruptcy court procedures are complex. Fortunately, though, bankruptcy cases are fairly standard and lawyers have devised ways to streamline the process for their clients by handling hundreds, or even thousands, of similar cases. For this reason, going to an attorney who specializes in bankruptcy law is a good idea. You will have to pay your attorney, plus a $335 court fee.
Chapter 7 bankruptcy is designed for people who have debts and little to no income or assets. It can be utilized by people who have not discharged debts in a previous bankruptcy in the last six to eight years and who don’t have enough income or assets to qualify them for Chapter 13 bankruptcy.
Upon filing, the court immediately orders all people and companies to whom the debtor owes money to stop their collection efforts immediately. The debtor’s case is assigned to a trustee, who in effect takes over the debtor’s finances. The trustee’s job is to inventory the debtor’s assets, to determine which of those assets are exempt from liquidation and which are not, to liquidate the non-exempt assets, and pay the debtor’s creditors from the money that’s realized. The process takes about six months, but at the end most types of your unsecured debts will be legally discharged. However, child support obligations, tax debts, student loans, and liabilities incurred as a result of any criminal or malicious acts will remain.
What happens to your secured debts, such as a mortgage or an auto loan, will depend on whether you’re current on your payments and how much equity you have in those assets. If you have substantial equity in a car or a house, the court may order it to be sold to satisfy your creditors. However, if you don’t have much equity in a house or car and you’re current on your payments, you can usually keep your property so long as you continue to make payments on it.
Chapter 13 bankruptcy is commonly referred to as a reorganization. It’s better suited for people who have stable, regular income and moderately substantial assets, but who are unable to meet their financial obligations. People who file under Chapter 13 are allowed to keep all their property, but must pay back some or all of their debts through a monthly payment to the trustee, who then distributes the money among the creditors. The process can take from three to five years. In a process known as a cramdown, the trustee may be able to force creditors to modify the terms of their loans or to take less than what they claim is owed in satisfaction of the debt.
Both Chapter 7 and Chapter 13 bankruptcy will have a negative impact on your credit rating. By law, the negative impact of bankruptcy from a credit report must be expunged within ten years. In practice, most credit bureaus drop bankruptcies from your credit report after seven years. However, not declaring bankruptcy when your debts are clearly beyond your ability to pay will also harm your credit history. The advantage of bankruptcy, though, is that it immediately gets your creditors off your back and promises a fresh debt-free start.
As with the real nuclear option, bankruptcy may work better as a threat than as an actual course of action. In some cases, lawyers can use the threat of a bankruptcy filing to convince creditors to agree to more reasonable repayment terms. However, for people who are so far in debt that no repayment whatsoever is possible, bankruptcy, although painful, may be the best remedy.