Credit Card Consolidation: What Is It and How Does It Work?

Credit card consolidation refers to methods of combining two or more credit card balances into a single loan. Total outstanding revolving debt, which includes credit cards, has reached over $1 trillion again, topping balance totals seen during 2008’s financial crisis.

In many households, credit card debt is split amongst several credit cards, which can make it difficult to keep up with payments or pay off credit card debt altogether.

There are several methods that can be used to consolidate credit card debt, each with its advantages and disadvantages, and some that may have tax consequences as well.

Used properly, credit card consolidation can be an effective way to get credit card debt under control and ultimately become debt free. However, there are several financial considerations for each method — and as always, it’s important to read the fine print.

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Is consolidating credit cards debt a good idea?

Once credit card balances reach a certain level, the debt can become difficult to escape. For many households, as debt builds, the monthly amount paid toward credit card balances is reduced in an attempt to stay afloat.

For example, if you have a $10,000 balance at 18% APR and can only afford to make the minimum payment of 2% per month, the balance will take over 30 years to pay off and the interest charges during that time will be over $25,000.

The $10,000 balance might be from just one card or it might be from several. Assuming a similar interest rate, the math works out similarly regardless of how many cards hold the total balance.

The 18% interest rate in this example is close to the average rate for new credit cards being issued today. However, if your credit is less than perfect, it’s likely that the interest rate will be higher on at least some of the credit card balances.

Facing the prospect of paying off credit card debt for 30+ years and paying over two and a half times the balance in interest costs, credit card consolidation can be an unattractive option.

If you’re able to find a credit card debt consolidation method that provides some breathing room in the monthly budget and reduces your financial risk, it’s worth investigating further. However, not all methods are effective for all households, so you’ll want to understand the pros and cons of each strategy.

Things to consider before you start credit card debt consolidation

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Before evaluating methods to consolidate credit card debt, it’s important to understand how you reached a point where the balances or interest rates became a burden.

Emergencies happen in life and often these emergencies are paid for with credit cards. If that’s the case, you’ll want to include a plan for an emergency savings fund in your credit card debt consolidation strategy.

Without an emergency savings fund, the next emergency — of which life has many — can end up as a new credit card balance. In other cases, credit card debt can come as a result of impulse spending or large purchases, like a vacation that didn’t really fit the budget.

The debt might even be a combination of balances that came from impulse purchases — and then an emergency hit. Maybe it was medical expenses or maybe unexpected car trouble.

Even if the impulse spending balances were manageable, just one of life’s many surprises can max out your credit cards if you don’t have emergency savings you can use as a safety buffer. Also, consider strategies to pay off the credit card debt without consolidation.

One of the biggest risks of credit card consolidation is that new balances can build again alongside the consolidated balance, potentially putting you in a more difficult financial position than before and with fewer options to get the payments under control.

Before deciding on a course of action, look at simpler options, like making extra payments, working a few more hours each week, or even selling a few things to make a dent in the balances.

Balance transfer credit cards

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One of the most popular ways to consolidate credit cards is with a balance transfer to a new card. Balance transfer cards or balance transfer offers often come with low rates for up to 24 months, maybe even 0%, and then rates rise after the promotional period has expired.

It’s common for balance transfers to come with a one-time fee. This fee can range from 3% to 5% of the transferred amount and may have a fixed minimum or maximum dollar amount. 

To revisit the $10,000 balance from earlier, with a 3% fee, the balance transfer fee could add $300 to the transferred balance and interest will be charged on the entire balance (including the fee) in accordance with the transfer offer.

Balance transfer introductory rates may also apply to new purchases for a promotional duration, after which both transferred balances and purchases made at the promotional rate will be charged interest at a variable rate that may be much higher.

Balance transfer offers may be limited to those with good or excellent credit scores. To use this option, it’s best to research balance transfer lenders before debt reaches a tipping point and begins to impact your credit score or result in late payments.

Pros:

  • Low or no interest for a promotional period of up to 24 months, although promotional periods of 12 to 15 months are more common.
  • You may have a lower interest rate on balance transfer cards than on prior credit card accounts. However, this is not guaranteed. Look beyond the introductory rate to understand the potential long-term cost of the offer.

Cons:

  • The balance transfer fee can be sizeable.
  • Interest rates on the new card may be higher than the rate on the transferred balances after the promotional period has expired.
  • There is a risk of running up higher overall credit card balances if you make new credit card purchases after consolidating.
  • A late payment can result in loss of the promotional rate with some balance transfers.
  • The limit that can be transferred may be lower than the amount you wish to consolidate.

Credit card consolidation loans

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A debt consolidation loan can be used for credit card consolidation as well as some other types of debt. A credit card consolidation loan is an unsecured personal loan that can have a lower interest rate than credit cards.

Lenders may be more forgiving of a less-than-perfect credit score with a consolidation loan and those who qualify for lower rates can save money on interest. There’s no guarantee, however, that a credit card consolidation loan will save a significant amount in interest expense.

Interest rates for debt consolidation loans for those with average credit are often over 20% and even those with good credit may pay rates as high as 18%, which is close to the average interest rate for credit cards.

Borrowers with excellent credit may qualify for lower rates. As with all credit products, be certain to understand the interest rates; some credit card consolidation loans offer a lower rate that may only apply for a matter of months, after which interest rates can increase.

A common criticism of consolidation loans is that the loan is for a fixed term, which can be longer than the original term of the debt being consolidated.

This is less of a concern for credit card consolidation because credit cards are revolving debt and do not have a fixed number of years for repayment.

However, if considering a debt consolidation loan, you’ll want to limit the consolidation to debt that is at a higher interest rate and debt which would take longer to pay back than the length of the new loan.

Borrowing limits for debt consolidation loans may be higher than those available for balance transfers. Some lenders offer up to $50,000 for a debt consolidation loan.

While larger borrowing limits can provide more flexibility than balance transfers, it’s important to view the loan limit in relation to the term of the loan.

Many unsecured debt consolidation loans have a shorter term, such as 3 years or 5 years, which can create unwieldy monthly payments even if the interest rate is lower than the consolidated debt.

Pros:

  • Larger credit lines (if you qualify) can simplify consolidation for several credit cards.
  • A reduction in credit utilization for your credit cards because the balances are transferred can help your overall credit score.
  • Credit card consolidation loans are available for consumers with a wide range of credit scores, allowing more consumers to qualify then with competing options, such as balance transfer credit cards.

Cons:

  • Many debt consolidation loans charge an origination fee ranging from 2% up to 5% based on your credit and the length of the loan term, with longer-term loans often subject to a higher fee as a percentage.
  • Interest rates may not be appreciably lower than credit card interest rates.
  • Fixed term loans can create higher monthly payments even at a lower interest rate and may leave less flexibility in the event of a change in income, a job loss, or if you need cash for another reason.

Home equity loans

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Often available at a much lower interest rate than credit cards, home equity loans are another popular way to consolidate credit card debt.

Alternatively, mortgage refinancing loans can play a similar role in debt consolidation and also have lower interest rates than revolving debt.

The primary reason interest rates are lower with these types of loans is that the loan is secured by your home. The obvious risk, in this case, is that if you’re unable to continue making payments, you can lose your home.

Until recently, interest on home loans was tax deductible for many households regardless of how the loan proceeds were used. Recent changes in tax rules limit deductible interest to loan balances used to purchase the property or to improve the property.

Additionally, many taxpayers can no longer use the mortgage interest deduction a recently increased standard deduction eliminates the benefit of itemized deductions, like interest on home loans, for many households. In the short term, don’t count on tax benefits from home loans.

Home equity loans come in two forms: a traditional home equity loan which provides a lump sum loan with a fixed payment term ranging from 5 to 20 years, or a home equity line of credit which has a fixed amount of time that you can access funds, often about 10 years.

Home equity loans are fixed-rate loans whereas home equity lines of credit are variable rate loans, which means your payment amount can change over time if you are using a home equity line of credit to consolidate credit card balances.

Pros:

  • A lower interest rate can make debt payments more manageable and potentially save thousands of dollars in interest.
  • A home equity loan with a longer term can also reduce monthly payment amounts.

Cons:

  • Expect to pay an origination fee or related fees, such as home appraisals or other underwriting costs.
  • A home equity loan of any type uses your home as collateral, which puts your home at risk if you cannot make loan payments.
  • If property prices drop in your area or your home loses value for another reason, you may find that you owe more for your home than it is worth, which can make buying another home difficult if you need to move.
  • Depending on the type of loan and its term, you may be paying off debt for a longer period of time.

401k loans

401k plan
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Depending on how your 401k plan is structured, you may be able to take a loan against your 401k to consolidate credit card debt. Not all 401k plans support this option but if your 401k plan does, the loan is a loan you pay back to your own 401k account — with interest.

401k loans that are not used for the purchase of your primary home have a maximum 5-year loan limit, which can create some risk and using this type of loan, primarily related to potential tax liability.

Typically, loan payments are handled as an automatic payroll deduction with 401k loans, which virtually guarantees repayment. However, if you lose your job or need to change jobs, it’s possible that you’ll have to pay the loan immediately or face tax consequences.

Unpaid 401k loan balances may be treated as an early distribution by the IRS, making the unpaid balance subject to early withdrawal penalties of 10% as well as making the unpaid balance taxable as income at your current tax rate.

These two factors can easily negate any cost savings you realize by choosing to consolidate credit card debt with a 401k loan. You may also be limited in the amount that you can borrow.

The maximum amount for a loan against your 401k is either (1) $50,000, or (2) the greater of $10,000 or 50% of your vested balance, whichever of the two options is lower. For many households, this creates a cap on 401k loan limits that may be insufficient to cover credit card debt consolidation goals.

Pros:

  • The loan is a loan to yourself, with interest paid back to your own 401k account.
  • Lower interest rates may provide welcome relief from higher interest rate revolving debt.

Cons:

  • Money borrowed from your 401k cannot grow at market rates, possibly affecting longer-term growth and retirement goals.
  • 401k loans that you are unable to pay due to a change of job or a job loss can be subject to tax penalties and taxable as income.
  • Short-duration loans limited to 5 years maximum can lead to higher payments.
  • You can only have one 401k loan at a time, which can impact your ability to use your 401k to help purchase a house or prohibit 401k loans for any other purpose.

Debt management programs

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A debt management plan (DMP) is another option for credit card consolidation but works quite differently than other options because it involves a third party whom you pay monthly and who then pays your creditors on your behalf.

Debt management plans are usually affiliated with credit counseling agencies and are designed for people who are unable to pay their debts. When enrolled in a debt management program, you deposit money each month into the plan.

Typically in a debt management plan, the plan attempts to get concessions from creditors, such as lower interest rates or waiving late fees and penalties. To gain leverage with creditors, often the plan requires that you stop making payments on your credit cards.

In many cases, you’ll also be required to close existing credit accounts and agree not to open new credit accounts.

Because of the way many debt management plans are structured, participating in a debt management plan can have ongoing negative effects on your credit report, which can then affect you in a number of ways, including your ability to borrow in the future, employment opportunities, and the cost of everyday expenses, like insurance.

Pros:

  • A debt management plan may be a viable alternative to bankruptcy and won’t require that you liquidate your assets.
  • Your overall cost for debt enrolled in the plan may be lower than paying creditors directly.

Cons:

  • The structure of many debt management plans will cause negative information on your credit report, which may stay on your credit report for up to 7 years.
  • There is no guarantee that your creditors will make any concessions or that the concessions will be as great as those promised by the plan.
  • You’ll be required to close your existing credit accounts and may have to agree not to open new credit accounts, which can reduce your financial flexibility.

What is the best way to consolidate your credit card debt?

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There is no single best credit card consolidation solution that fits the needs of all consumers. If you’re able to qualify for a credit card balance transfer, this option is often the safest route for consumers who wish to consolidate credit card debt.

With a credit card balance transfer, you aren’t swapping unsecured debt for debt secured by your home, nor are you exposing yourself to potential tax liability or long term negative effects on your credit report.

With careful shopping and by keeping payments current, it’s possible that you can continue to benefit from a lower interest rate on the transferred credit card balance even after the promotional period ends.

Some consumers have also been successful in transferring balances multiple times, continuing to save on interest. However, when considering this strategy, it’s also important to evaluate the balance transfer fee, which can be as high as 5% of the transferred balance.

Is consolidating credit cards bad for your credit?

The extent of the effect on your credit by consolidating credit card debt depends on the method of consolidation you choose. For example, if you use a 401k loan, the effect on your credit will be positive because the credit card balances have been paid off.

By comparison, using a balance transfer to consolidate credit card debt can have short-term effects on your credit because you are applying for new credit.

The average age of your credit accounts, as well as the percentage of your available credit limit that you’ve used, are also factors in your credit score that can be affected by balance transfers, although the short-term effects are less damaging than late payments, which are likely to result from other consolidation strategies like debt management plans.

Can you still use credit cards after consolidation?

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If you choose to use a debt management plan to consolidate credit card debt, it’s likely the plan will require that you close your credit card accounts and agree not to apply for new credit until the plan is complete.

If you choose another credit card consolidation strategy, your ability to use your credit cards after consolidation won’t be affected.

However, you’ll want to carefully consider whether using credit is a good option after you’ve invested time and money in finding a way to reduce credit card debt with a goal of eventually paying off your debt.

Stay out of debt after credit card debt consolidation

If the amount of credit card debt you’ve accumulated leads you to consider debt consolidation in any of its forms, take the opportunity to analyze your spending habits and gain a better understanding of how the debt reached a level of concern.

In most cases, you’ll be able to identify the reasons the debt continued to grow and may have to make some changes in behavior, reduce living expenses, or increase your income. Credit card debt is usually related to impulse purchases or emergency expenses.

By building a realistic budget and establishing saving habits, you’ll be better prepared for emergencies, reducing your need for credit, and can set savings goals for discretionary purchases.

Getting out of debt and staying out of debt requires some belt-tightening, but the long-term gains in the form of saved interest and overall financial security are worth the short-term sacrifice.

Credit card consolidation can have long term effects on your credit

Choosing a credit card debt consolidation strategy is a decision that shouldn’t be taken lightly. In all cases, you’re making a financial choice that can have long-term effects on your credit and monthly finances.

Many debt consolidation solutions aren’t as healthy for your finances as they might seem at a quick glance.

Study your options carefully and start with building a budget that will help you understand what you can afford to pay, which can help prevent a difficult debt situation from becoming worse if you aren’t able to keep up with payments after consolidation.

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