Debt Consolidation Loan Alternatives

A debt consolidation loan is used to pay off high-interest debts; it replaces those debts with a new loan with a lower monthly payment and/or a lower APR. Personal loans have lower average interest rates than credit cards, which can make them a good tool for debt consolidation. Home equity loans and 0% APR credit cards are other options. But a debt consolidation loan isn't always the best solution. 

We'll look at when and why you may want to pursue other options and available alternatives.

Why a personal loan for debt consolidation may not be the best option

Whether you can't qualify for a debt consolidation loan, can only qualify at a high APR, or have access to lower-rate options, there are a number of reasons consolidating debt with a personal loan may not be your best right move.

• You can't qualify based on your credit score or income: A high amount of outstanding debt or missed payments, can negatively impact your credit score. Poor credit makes it challenging to get a debt consolidation loan with a low enough interest rate to save money (or to even qualify for a loan). Likewise, if you've incurred debt due to job loss, you may not have enough income to qualify for a debt consolidation loan.
• You can't control your spending or borrowing: "Debt consolidation loans are only a good option for people if they can cut themselves off completely from using Buy Now Pay Later programs, credit cards, and other methods of borrowing," says Jay Zagorsky, personal finance expert and senior lecturer at Boston University's Questrom School of Business. If you consistently rely on credit, taking on more debt won't solve the problem, and you should focus on alternatives that help you change your spending behavior instead.
• You can manage the debt yourself without borrowing: If you're carrying a small balance that you can repay within a few months, it may not be worth applying for a debt consolidation loan. "A consumer who has a manageable, but annoying amount of debt, and who does not have a spending problem, should consider self-management," says Michael Sullivan, personal finance consultant with Take Charge America, a nonprofit credit counseling and debt management agency. He says a credit counselor can help you choose a debt consolidation strategy, like the debt avalanche or debt snowball method.
• You have too much debt to afford the monthly payments: You can prequalify with a few debt consolidation lenders to find out the repayment terms and interest rates you're likely to qualify for. If there isn't room in your budget for the monthly payment, you shouldn't accept the loan. Instead, find expenses to cut from your budget, increase your income, or consider options that can reduce your debt balance, like credit counseling or Chapter 7 bankruptcy.
• You can benefit from a family loan or gift: If you'd prefer to keep money in the family, have a family member who has the funds to help, and are comfortable with the arrangement, a family loan could make sense. Just be aware of IRS requirements for family loans above $10,000 to avoid surprise tax consequences.

Debt consolidation loan alternatives

If any of the reasons above apply, or if you'd prefer not to take out a personal loan, consider the following.

Budget adjustment

Reevaluate your existing budget or create a new budget by adding up your total monthly income and subtracting your regular necessary expenses like rent, utilities, and insurance. Calculate your typical spending on food and other categories, and look for areas where you can trim spending. Subtract all your expenses from your total monthly income to determine how much you can devote to debt repayment each month.

Zagorsky also suggests switching to cash to control irresponsible spending. "Paper money provides benefits like helping people stick to a budget. When you are out of cash, spending stops. It also reduces the chances of splurging since paying for things with paper money causes a tiny bit of regret that doesn't happen with electronic methods," he explains.

Debt management plan

If you think you need help with budgeting and saving, make an appointment with a nonprofit credit counseling agency. This could help you address the root cause of your debt. A credit counselor can give you specific advice for your individual financial situation and, if appropriate, set up a debt management plan (DMP).

"A DMP permits the consumer to make regular payments to the credit counseling agency which in turn makes payments to creditors," explains Sullivan. "Many of these creditors will lower interest rates and/or waive fees for DMP clients, making the payments more manageable. A DMP can last for up to 48 months but will eliminate that debt."

Debt settlement

Debt settlement or debt relief companies negotiate with your creditors to settle your debt for less than you owe. But for-profit debt settlement companies can charge high fees that could wipe out your savings. Debt settlement also requires you to stop paying your credit card bills, which damages your credit and may result in legal action against you.

"A debt settlement process comes with a lot of risk," says Ashley Morgan, attorney at Ashley F Morgan Law, PC. That's because there's no guarantee that your creditors will negotiate with the debt settlement company. "When one creditor doesn't work with the program, the entire program falls apart," explains Morgan. Some of her clients tried debt settlement but saw little progress with reducing their debt. "Unfortunately, I have had many clients who have had to file bankruptcy because their debt settlement plan failed," she says.

Bankruptcy

Bankruptcy is a legal process to discharge debt. Filing bankruptcy provides an automatic stay, which stops collection attempts and lawsuits. The bankruptcy court then oversees a liquidation process or repayment plan to pay your creditors and discharge most remaining debt. Individuals usually file either Chapter 7 or Chapter 13 bankruptcy.

Bankruptcy remains on your credit report and negatively impacts your credit score for up to 10 years. But Morgan says bankruptcy may not be as destructive to your credit score as some people think. "A common misconception is that debt settlement is better for your credit than bankruptcy. But when you do debt settlement you are behind on your debt and do not see improvement on your credit till the majority of your debt is resolved," says Morgan. "With a Chapter 7, your credit can start improving immediately after your debt is discharged, sometimes sooner."

Other types of debt consolidation loans

If you like the idea of debt consolidation, but aren't sold on using a personal loan, consider these alternatives.

Balance transfer credit card

Many credit card issuers offer promotions for new and existing cardholders that allow you to avoid paying interest for up to 21 months on balance transfers. You can move balances from other credit cards to the new card with the 0% APR offer. A balance transfer card can save you money if you're able to pay off the full balance during the introductory period. But you'll typically need to pay 3% to 5% of the transferred amount in balance transfer fees. And if you need more time for repayment, you could get stuck with a high interest rate.

What's more, if you're late making your monthly payment, the credit card company might charge a penalty interest rate on the transferred balance and end the promotional period early.

Home equity loan or HELOC

A home equity loan allows you to borrow a lump sum of cash from the equity you've built in your home. Home equity loans offer lower interest rates than personal loans and may give you more time to repay, but they typically come with higher upfront fees, more requirements, and take longer to fund.

Because a home equity loan is secured by your home, there's also a risk of foreclosure if you fail to repay. A home equity line of credit or HELOC is similar, but it provides ongoing access to a credit line rather than a lump sum of cash, so you can borrow from your home equity as needed.

Cash-out refinance

A cash-out refinance involves taking out a new, larger mortgage to pay off your existing mortgage, and keeping the extra money to pay off debt. Depending on the interest rate for the new mortgage and the repayment term, your new monthly mortgage payment and total borrowing costs may either be higher or lower than your existing mortgage.

You can use this cash-out refinance calculator to estimate the change. Like home equity loans and HELOCs, a cash-out refinance is secured by your home. Make sure you can afford your new mortgage payment, or you'll risk foreclosure.

Tips on improving your debt consolidation loan application

• Pay off some debt first: If a high debt balance is dragging down your credit score, pay off accounts with small balances in full or pay down balances that are close to maxed out. Paying down debt improves your credit score, which can help you qualify for a debt consolidation loan.
• Show proof of income: Steady and sufficient income may help compensate for a less-than-perfect credit score on a debt consolidation loan application.
• Try a credit improvement tool: If you pay your rent, utilities, and other bills on time, a tool like Experian Boost may instantly improve your credit score, which could help you qualify for more debt consolidation loan options.
• Apply with a cosigner or co-borrower: Some lenders allow joint applications. Applying with a co-applicant who has good credit and income may improve your chances of approval, since the co-applicant agrees to be responsible for the loan if you fail to repay. Few lenders allow you to apply with a cosigner, which is someone who guarantees the loan but doesn't have access to the funds.
• Secure the loan with collateral: Offering a valuable asset like your vehicle as collateral reduces the lender's risk since the lender can take your property if you fail to repay. This collateral may help you qualify if you have a low credit score.
• Ask for credit line increases: Card issuers may let you request a credit line increase online or in your credit card's app. If approved, it's a quick and easy way to reduce your credit utilization and potentially increase your credit score.