Debt Consolidation Loan or Balance Transfer: Which is Best?

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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.

So, which option is best? They both have advantages and disadvantages, but you can make an educated decision once you look at the fees to borrow and how your debt is set up currently.

Credit Card Balance Transfers

Transferring a balance using a credit card is easy, and ideally you can pay 0% interest on your debt (at least for a limited time). That helps stop the bleeding: your interest costs disappear, and 100% of each payment goes towards reducing your loan balance. Credit card balance transfers are most attractive when you know you will pay off debt quickly.

However, you’ll need to pay attention to a few things.

Fees: in many cases, you’ll have to pay a fee (it might be roughly 3% 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 attractive offers in advertisements, but you’ll want to review what the card issuer actually offers after reviewing your credit.

Even if you get 0% APR, that rate might not last for long; check to see what happens after any promotional period.

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 will look into your credit, 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 and going deeper into debt.

Debt Consolidation

Instead of using credit cards, you can also 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, you can only get 0% APR for three months, but it will take you three years to pay down your debt).

Fees: you might or might not “pay” any 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 (they’re built into the interest rate). Compare several loans to find the combination of up-front 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 home equity loan, for example.

In any case, 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 lower – at least for a few months). If you’ll 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 might be variable (they’ll go up and down like credit card rates) or they might be fixed, depending on your loan. Fixed rates make it easier to plan (you’ll know what your monthly payments are for the entire life of the loan), but fixed rates might start out higher than variable rates.

Your credit: whenever you get a new loan, a credit inquiry will 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. For example, if you do all of your borrowing with credit cards, 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 (assuming you make payments as agreed and avoid taking on more debt than you can afford), so you’re likely to repay other loans in the future.

Pledging Collateral

For some debt consolidation loans, you might have to pledge collateral. That means you give the bank permission to take your assets (your home or your automobile, for example) and sell them if you fail to repay the loan.

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.

You might already have debt that is secured by collateral. If that’s the case, consider refinancing those loans separately (in addition to or instead of using a balance transfer or debt consolidation loan). On the other hand, 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

If you have student loans, do some homework before consolidating those loans or paying them off with any personal loan (including balance transfer checks). If you borrowed using any type of government loan, you might lose certain benefits such as the potential for loan forgiveness or the ability to postpone payments. For more details, see Advantages of Federal Student Loans.