What Is the Best Way to Consolidate Debt?

Debt consolidation often seems like the perfect way to conquer your debt: consolidate your balances into a single loan and make one monthly payment until you are debt-free.

While there may not be a single best way to consolidate debt, it is possible to narrow down the top options for your situation.

Personal Loan

A personal loan is often what people have in mind when they talk about consolidating debt. The ideal solution here is a loan with a low interest rate and affordable monthly payment that you can use to pay off other high-rate debt. And this can be a great strategy, provided you can find the loan you need. That can be a challenge, though, if your credit isn’t great. High levels of debt – especially credit cards with balances approaching your credit limits – can make it difficult to qualify for new credit.

When it works, though, it can work very well. In particular, if you get a personal installment loan with a fixed repayment period, you will know exactly how much you have to pay each month until you are debt-free. You won’t run the risk of falling into the trap of making minimum payments and stretching out the debt for decades. Plus, carrying a balance on an installment loan may be better for your credit scores than a credit card with a high balance.

Before you start shopping for one of these loans, though, be sure to check your credit scores to see where you stand. There’s no sense in applying for loans for which you can’t qualify. Plus, knowing your score can help you identify what loans might be within your reach. Credit.com’s Credit Report Card gives you two free credit scores updated every 14 days, plus you’ll be alerted to loans that are available through lenders who are looking for borrowers with profiles similar to yours.

When it’s best: If you can get a personal loan with a lower rate and a repayment schedule that will allow you to pay off the loan in 3-5 years, this can be an excellent option.

Credit Card Consolidation

Similar to a personal loan, you may be able to use a low-rate credit card or 0% balance transfer offer to consolidate higher rate balances. But watch out: there may be a fee for the transfer (usually 2-4% of the amount transferred) and if the offer carries an introductory (“teaser”) teaser rate, it won’t last forever. Offers with very low rates – 0% or 3.99% for example – typically last for 12-18 months. After that, the rate can jump significantly.

Another thing to keep in mind: If you use a single credit card to consolidate several other balances, you may wind up using a substantial portion of your available credit, and that can hurt your credit scores – at least until you pay it down. You will want to weigh the impact of that against the money you’ll save to decide whether it’s worth it. (You can also find out how your debt is affecting your credit scores for free by using Credit.com’s Credit Report Card.)

When it’s best: This option works best for someone who qualifies for a low-rate balance transfer offer with low transfer fee and pays off the entire debt before the teaser rate expires. It also generally works best when there is no other balance or charges on the card while the transfer is being paid off. Otherwise, multiple interest rates may make it challenging to keep track of how much you need to pay to retire the transferred balance.

Credit Counseling Consolidation

While credit counseling agencies don’t consolidate debt, a Debt Management Plan through one of these organizations is similar in many ways to getting a consolidation loan. If you enroll in a DMP, you’ll pay the counseling agency each month, and in turn the counseling agency pays each of your participating creditors. In addition, your interest rates may be reduced and your monthly payment should be lower as well.

According to Cambridge Credit Counseling Service, the average interest rate reduction for consumers enrolled in one of their DMPs during the second half of 2012 was 14.6 percentage points, from 22% down to 7.4%. The average monthly savings realized as a result of interest rate reductions was $139.26.

You don’t have to have good credit to qualify for a DMP, so it can be an ideal option for someone with less than stellar credit. Personalized budgeting advice should be part of the package, too, making this a good option for someone who needs expert advice.

When it’s best: A DMP works well for someone who is not able to successfully pay off their debt on their own, and needs the extra help and support a counseling agency can provide.

Loan From Friends or Family

A family member who is willing to loan you the money to pay off other debts may also be willing to do that at a low interest rate, and to be at least somewhat flexible with the terms. There is usually no credit check, and because these loans aren’t reported to credit reporting agencies, your credit scores might actually improve if you use one of these loans to pay off credit cards with high balances.

But if you can’t pay the loan back, you risk your relationship with the person who helped you out. Only the two of you can decide if that’s really worth it.

When it’s best: This can be an excellent option when the lender and borrower are both on the same page, and willing to put their agreement in writing to make sure there are no misunderstandings. It also helps if the lender can afford to forgive and forget the loan if the borrower can’t pay.

Retirement Account Loan

Have savings stashed away in a 401(k), 403(b) or pension plan? You may be able to borrow against those funds at a low interest rate – and you pay interest back into your own account rather than to a lender. In addition, there is no credit check for one of these loans, so it’s very easy to qualify.

While that sounds easy enough, there are plenty of drawbacks. If you can’t pay back the loan as agreed you may pay taxes, and penalties, just as if you withdrew the money from your account instead of borrowing against it. And you may jeopardize your retirement savings. After all, your money is not invested in the market where it may potentially earn higher returns.

But the biggest trap involves consumers who use retirement funds to consolidate debt but wind up in bankruptcy anyway. If you are considering a loan against retirement funds because you are struggling to pay your bills, be sure to talk with a credit counselor and bankruptcy attorney first.

When it’s best: This is the best way to consolidate debt if you can’t qualify for a low-rate consolidation loan elsewhere; you have already spoken with a credit counseling agency and bankruptcy attorney and determined those aren’t better options; and you are not at risk of being unable to pay the loan back if you leave or lose your job, for example.

As you can see, that is a pretty narrow set of circumstances – but it is intended to be. Retirement loans can be one of the cheapest ways to borrow – but can also quickly become one of the most expensive.