With interest rates hitting new lows, now may be a good time to consider consolidating any expensive credit card debt you may have built up. But when it comes to finding a strategy that works for you, experts say it's important to calculate the costs and evaluate your habits.
Earlier this week, the Federal Reserve cut cut its benchmark short-term interest rate for the third time this year by a quarter of a point to a range of 1.5% to 1.75%. But that quarter point reduction only saves about $1 a month for someone making a minimum payment on a credit card, according to Ted Rossman, industry analyst at CreditCards.com.
Instead of just chipping away by paying each card every month, a better option may be bundling all your credit card balances into one payment with lower interest — saving you money and making life easier by just having one payment to keep track of.
Consolidating may even give your credit score a bump, according to a new report from Transunion. Nearly 70% of consumers who consolidated debt saw their credit scores improve by more than 20 points, the analysis found. Those with a VantageScore under 720 saw the biggest improvement. VantageScores range from 300 to 850.
"Consumers with credit card debt often have to juggle multiple payments on several cards. Not only does debt consolidation make paying bills more simple, but more importantly, it often results in a credit score boost for some individuals," says Liz Pagel, senior vice president and consumer lending business leader at TransUnion.
There are several ways to pay down credit card debt through consolidation. The two most common are personal loans and balance transfer credit cards. But which the best route to take? It depends on your situation, says Eric Roberge, a certified financial planner and founder of Boston-based advisory firm Beyond Your Hammock.
Here's a closer look at each method.
A personal loan is an unsecured loan from your bank, which is generally used to consolidate debt or make a big purchase. If you're using it to pay down debt, the strategy works like this: you use the loan to pay off all your credit card balances and then focus on eliminating the loan balance.
Consumers who take out personal loans pay down nearly 60% of their credit card debt on average, TransUnion finds, which brings the average balance down from $14,015 to $5,855.
But these loans don't universally offer cheaper interest rates. And like all loans, you'll need to apply and get approved. So if you have bad credit, you may risk getting declined, or approved with a high interest rate. On average, those with credit scores below 680 will be paying higher interest rates for a personal loan than the average credit card APR of 16.97%, according to an analysis by loan marketplace Credible.
For personal loans, the rate not only depends on your credit, but also on the length of the loan, as shorter loans tend to have lower APRs. If you feel that paying off your debt will take longer than three years, you may be subject to a higher rate, Credible finds.
Even if you do find a low interest rate loan, you also need to look at all the numbers, Roberge tells CNBC Make It. That's because taking out a loan could come with origination fees, and paying those expenses could cancel out any savings you might generate by having the loan be at a lower interest rate than your credit card, he adds.
These fees range from 1% to 8% of the loan amount. If you take out a $10,000 loan, you could be charged anywhere between $100 and $800 for that loan. If it's on the high end, that expense could eat up the savings you earn with the lower interest rate.
Instead of taking out a personal loan, you could apply for a credit card that allows you to transfer and combine the balances onto a single card. Look for a card that has no balance transfer fee and an interest rate of 0% for at least a year.
"In many cases, I think finding a credit card that offers an introductory 0% APR for a period of time (ideally something like 12 to 18 months) and does not charge a fee for balance transfers is a good way to go," Roberge says.
But this strategy is also not without pitfalls, he says. "The biggest thing to be careful with if you go that route is to ensure you make every single payment on time and in full," Roberge says. With most 0% APR offers, if you miss even a single payment or pay late, you nullify the 0% offer and have to pay interest on the full balance. It's important to read the fine print of the card agreement before signing up, as well as assess your own personal habits.
If you can't guarantee that you'll be able to pay the card every month, you could end up even more in the hole, Roberge says. Especially if the APR on the new balance transfer card is higher than the original cards. "Set up an automatic payment, set calendar reminders — whatever you have to do to make sure you don't miss any payments," he says.
Additionally, you may be approved for a balance transfer card, but not approved to transfer over the full balance of your outstanding debt. In that case, you may need to take out multiple cards, slightly defeating the purpose of a clean consolidation plan.
The best way to use a balance transfer card to pay off debt is to avoid using it for new purchases. "Just focus on paying off the existing balance so you don't add to the debt to repay," Roberge says.
Whichever strategy you pick to consolidate your debt, Roberge recommends separately building up an emergency fund, or a cash reserve that you can use in the future to avoid falling back into credit card debt.
"You'll want to build up cash in a savings account that you absolutely do not touch unless it's a true emergency," he says. No dipping into it to take a vacation or cover a big shopping spree.
Generally, experts recommend that you save three to six months' worth of expenses in your emergency account. But Roberge admits that's a lot of cash to save up, especially when you're just starting out. Instead, set a smaller goal of having $1,000 set aside for emergencies and work up from there.
To make the most of this money, open a high-yield savings account where you can earn at least a small amount on the cash that will be sitting there.
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