Debt is part of many young adults' lives. In fact, the average 25- to 34-year-olds had an average debt of $5,200, according to a 2004 Businessweek magazine report. Because the amount of debt you have accounts for 30 percent of your FICO score, paying off your debt load can have a dramatic impact on your credit score, your ability to get a future loan and the interest rate that you will have to pay on credit cards and loans.
Debt consolidation is a process that consists of compiling all of the debts that you owe into one account. This could be accomplished by rolling all of your credit card balances onto one card, for example.
Advantages of Debt Consolidation
Consolidating your debts can help you replace several credit card payments with one payment. You can often get a lower interest rate when you transfer your existing credit card balances to another card that you have or to a new card, especially if the card has an attractive promotional interest rate. This reduced interest rate can help you reduce the total amount of interest you'll pay.
Disadvantages of Debt Consolidation
Debt consolidation does not eliminate debt. It transfers the debt from several cards to another card. When you have several credit cards with no balance, you might be tempted to use these cards and increase your overall debt load. Additionally, if you use a card with a promotional rate, you might forget when the promotional interest rate ends and may wind up paying more interest than you were paying prior to the consolidation. Getting a new credit card can also decrease your FICO score -- the reading lenders use to assess a loan applicant's credit risk.
Borrowing Money to Pay Off Debt
Procuring a loan to pay off debt can come in a variety of forms. You can apply for a personal loan that is based on your credit. You can also apply for a home equity loan or line of credit. These two financial products are usually secured by your home.
Advantages of Borrowing Money to Pay Off Debt
Like debt consolidation, getting a loan could reduce the interest rate that you pay on the debt and cut all your debt payments to one monthly payment. The interest payment on a home equity loan is often tax-deductible, as long as the loan does not exceed the home's value.
Disadvantages of Borrowing Money to Pay Off Debt
If you transfer debts from credit cards to a home equity loan, you are transferring unsecured debts to secured debts. If you default on the secured debt, you can lose the asset that is used to secure it, such as your house. Indeed, 70 percent of Americans who get a home equity loan to pay off credit cards have the same amount of debt or more debt within two years, according to a 2003 Bankrate.com report. Getting a home equity loan can also come with a hefty price tag if you pay points to acquire the loan. One point equals 1 percent of the amount that you borrow, and acquiring additional points toward your mortgage can increase the amount you pay over the life of the loan. Acquiring a personal loan to pay off debt can be difficult if you do not have good credit.
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- Prime Rates: Using Debt Consolidation to Lower Your Borrowing Costs
- Bankrate: Debt Consolidation: Cure or Continued Credit Problems?
- Businessweek: Thirty and Broke
- Bank of America: Is Accessing Your Home Equity Right for You?
- My FICO: What’s in Your FICO Score
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