Should you consolidate credit card debt? (The do’s and don’ts)
THE STACK #50Trying to pay off debt can feel overwhelming, especially when juggling multiple credit cards with high balances. It seems like, no matter how many extra payments you make, your balance isn’t budging because you’re being decimated by the high interest rate.
Many people prefer to consolidate all their debts into a single loan to simplify their repayment process. By focusing on paying off just one loan instead of multiple ones, it can make managing debts easier. However, it's important to be cautious when considering a consolidated loan, as it's possible to end up in a worse financial situation if not done carefully.
In today's newsletter, we will discuss the dos and don'ts of debt consolidation.
THE STACK
What is Debt Consolidation?
Debt consolidation is a financial strategy that involves combining multiple debts into a single, larger debt. This can be done to secure a lower interest rate, simplify the repayment process, or reduce the total amount of monthly payments.
DO NOT consolidate debt using revolving credit
Revolving credit is a type of credit that allows you to borrow up to a specific limit and repay the borrowed amount over time. With revolving credit, you can borrow, repay, and borrow again up to the established credit limit. Examples of revolving credit include credit cards and lines of credit.
It is not advisable to consolidate your debt using a credit card or line of credit. When you transfer a balance to your credit card, it will not receive the interest-free grace period that you typically get when making new purchases. This means that interest will start accruing from the day you transfer your balance, resulting in high-interest payments. Additionally, credit cards and lines of credit often have high interest rates, so your payments mainly go towards paying off the interest accrued, potentially prolonging the time it takes to pay off the debt.
Consolidating debt with revolving credit is also risky because there's a chance you could end up spending part of the balance that you had already paid off, which could increase your debt further.
The only exception is if the balance transfer to a credit card has a 0% interest rate.
DO consolidate debt using a fixed loan
The best way to consolidate your debt is by using a fixed loan. With a fixed loan, you borrow a specific amount and make consistent payments over a set period. Your payments go towards paying off both the principal and interest. Fixed loans usually have a fixed interest rate, and you have a specific end date for when your loan will be fully paid off. This can keep you motivated to continue making payments because the end is in sight. Unlike revolving credit, where you could be stuck in a debt loop for many years without making progress.
Most fixed loans also come with a lower interest rate than revolving loans, which means that you will pay less interest over time. With a fixed loan, once you pay off a portion of the loan, you no longer have access to the amount that you paid off, so this reduces your chances of accumulating more debt. This is unlike revolving credit, where you can end up in more debt than when you started.
DO NOT consolidate debt if you do not have a clear plan to pay it off
Make sure you have a clear plan in place to pay off the loan before consolidating your debt. First, take a look at your budget to figure out how much extra you can afford to pay each month. Also, ensure that your monthly payments will allow you to pay off the debt within a reasonable timeframe without paying more in interest.
If you get a 0% balance transfer, make sure you can pay off the entire balance before the promotional period ends because most credit cards that offer a 0% balance transfer switch to a high interest rate after the promotion ends.
DO NOT use the credit cards you paid off with the consolidated loan
One common mistake I notice when people consolidate their loans is that they end up using the credit cards they paid off with the consolidated loan. This puts them further in debt. It's important to remember that consolidating your loans doesn't make you debt-free; it simply means you've combined all your debt into one place. If you start using the cards that you paid off, you will be increasing your overall debt balance, which will leave you in a worse position than when you started.
To resist the urge to use the cards you paid off, you can lock them, cut them up, or store them in a place that is not easily accessible. Avoid using these cards for your everyday purchases to prevent carrying a balance.
DO ensure that the interest rate on your consolidated loan is low
Make sure that the interest rate on the consolidated loan is lower than the average interest rate of all your existing loans. By doing this, you will pay a lower interest rate, allowing you to pay off the consolidated loan faster rather than most of your payments going towards interest.
Let's say you have three existing loans with interest rates of 6%, 8%, and 10%. The average interest rate for the three loans is 8%. If you consolidate these loans into one with an interest rate of 5%, you will be paying a lower interest rate overall, which can help you pay off the loan faster.
Remember that consolidated loans, like balance transfers, often come with an initial transfer fee. Be sure to include this fee in your calculations and ensure that even after paying the fees, you'll still be saving on interest.
THE TOOL
Debt-consolidation calculator
This debt consolidation calculator helps you compare the interest rates on your credit card with those on a consolidated loan to see if consolidating your loans is worthwhile.
THE ACCOUNTABILITY
If you are considering a consolidated loan, make sure you shop around for the lowest fixed loan that you qualify for and use the debt consolidation calculator to ensure that you’re getting a good deal.
THE COURAGE
THE KNOWLEDGE
APR
APR stands for Annual Percentage Rate. It is a measure of the cost of borrowing, expressed as a yearly interest rate. The APR includes not only the interest on the loan but also certain other fees and charges associated with the loan, which can make it a more accurate measure of the true cost of borrowing.
Consumer Proposal
A consumer proposal is a formal arrangement between an individual and their creditors that is facilitated by a licensed insolvency trustee. It is a legally binding process that allows individuals to make a formal proposal to their creditors to settle their debts, often by paying back a portion of what is owed over a specified period of time. This option provides an alternative to filing for bankruptcy and can help individuals manage their debt while avoiding some of the consequences associated with bankruptcy.
Most consumer proposals are often advertised as debt consolidation, please note that the two are not the same. A consumer proposal will have a negative effect on your credit score and typically stays on your credit report for three years from the date it is paid off or six years from the date it is filed, whichever comes first.
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