Consolidation Loan or Balance Transfer: How to Choose

Pros and Cons of Each Option

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Evaluate the pros and cons of each type of loan. Yuri_Arcurs / Getty Images

Paying off debt is never easy. But a lower interest rate and smaller payments can lighten your load.

When it comes to common consumer debts like credit cards and personal loans, two of the most popular ways to lower your rate include balance transfers and debt consolidation loans.

What’s the difference between those options—and which one is best? They both have advantages and disadvantages, but you can make an educated decision once you understand the fees and how your debt is currently set up.

Credit Card Balance Transfers

With a credit card balance transfer, you move debt to a new or existing credit card. To do so, your card issuer might provide promotional convenience checks or allow you to request the transfer online. Credit card balance transfers are most attractive when you know you will pay off debt quickly.

In a best-case-scenario, you can pay 0-percent interest on your debt, at least for a limited time. Eliminating interest charges helps to stop the bleeding because your loan balance stops growing, and 100 percent of each payment goes toward reducing your debt. But pay attention to the fine print.

Fees: Find out whether or not you’ll have to pay a fee to transfer balances. Costs are often around 3 percent of the amount you transfer, or a flat dollar amount—whichever is greater. Any savings you get from a lower interest rate need to more than cover the transfer fee. You might also take on new annual fees if you open a new credit card.

Interest rates: The best interest rates are available for customers with good credit. You might see tempting offers in advertisements, but you need to review what the card issuer actually offers you after reviewing your credit. Even if you get 0-percent APR, that rate might not last for long. Check to see when the rate changes and what happens after the promotional period ends.

Your credit: Balance transfer offers aren’t necessarily bad for your credit, but they can cause problems. Every time you apply for a new card, lenders look at your credit history, and those inquiries can ding up your credit scores. Having too many consumer accounts (like credit cards) open can also lower your score. If you end up using a credit card to transfer balances, be sure to use them as a debt payoff tool—not a  debt increasing tool. Avoid using the card you paid off to go deeper into debt.

Debt Consolidation

Instead of using credit cards, you can consolidate debt with a personal loan, some type of secured loan, or a P2P loan. A large loan might allow you to combine several loans and get everything in one place. Debt consolidation loans often come with a fixed rate, so they make more sense when credit card promotional periods are too short. For example, a 0-percent APR offer for three months might not be useful if you expect to take three years to pay down your debt.

Fees: You might or might not pay any upfront fees for a debt consolidation loans. With some loans, you’ll see obvious costs like processing or origination fees. With other loans, the costs will be invisible, but they’re built into the interest rate.

Compare several loans to find the combination of upfront fees and interest charges that benefits you the most.

Interest rates: The rate you pay will depend on the type of loan you use. A personal unsecured loan will have a higher rate than a secured home equity loan, for example. Still, you’ll probably pay interest at a rate that’s ​lower than standard credit card interest rates—but “teaser” or promotional credit card rates should be even lower, at least for a few months.

If you pay off debt for several years—which is longer than any credit card promotion—you might do better with a debt consolidation loan. Interest rates can be variable, meaning they’ll move up and down like credit card rates, or they might be fixed. Fixed rates make it easier to plan because you’ll know what your monthly payments are for the entire life of the loan.

But fixed rates typically start out higher than variable rates.

Your credit: Just like with credit cards, new loans cause inquiries which can impact your credit scores—at least in the short-term. Over the long-term, some debt consolidation loans could potentially be better for your credit than balance transfers.

Credit scores are higher when you use a mixture of different types of credit, and installment loans make you more attractive than a borrower who relies solely on credit cards. If you’re a heavy credit card user, it appears that you’re spending beyond your means for consumable goods and paying high interest rates—which is not sustainable.

A debt consolidation loan could suggest that you’ve made a commitment to paying down debt, and you used the right type of debt for that purpose. That means you’re a savvy borrower, so you’re likely to repay other loans in the future. As long as you make payments on time and only take on debts you can afford, your credit will strengthen.

Pledging Collateral

For some debt consolidation loans, you might have to pledge collateral. That means you give the bank permission to take your assets and sell them if you fail to repay the loan. For example, you might pledge your home as part of a home equity loan, or you might use your car as collateral.

Keep unsecured loans unsecured: Collateral can help you get approved, but pledging your assets is risky. What if things don’t work out as you planned—can you live without your home? Can you get to work and earn an income without your car? It’s best to keep unsecured loans unsecured because the only thing at risk is your credit. If you use a home equity loan to pay off unsecured credit card debt, you will dramatically increase your risk. If something unexpected happens, you could lose your home in foreclosure.

Refinancing secured loans: If you already have debt that is secured by collateral, consider refinancing those loans separately. For example, use a balance transfer or debt consolidation loan for unsecured debts, and get a different loan for your secured debts. That said, if you can pay off secured debts and turn them into unsecured debts, you will reduce your risk—just make sure it’s worth any additional costs.

Student Loans: Use Caution

If you have student loans, do some homework before consolidating those loans or paying them off with any personal loan. Government loans provide unique benefits like the potential for loan forgiveness or the ability to postpone payments. If you refinance or consolidate with a private lender, you may lose access to those borrower-friendly features.

For more details, see Advantages of Federal Student Loans.