If you are struggling with credit card debt, you are not alone. Americans’ credit card debt recently surpassed $1 trillion — a new all-time high! If you are one of them, debt consolidation could help you get out of debt and better control your finances.
Most debt consolidation loans let you keep your credit card accounts open. However, sometimes, they may close your cards. It all depends on the approach you take. But, before considering this option, you should understand the types of debt consolidation available and how they work.
- Usually, you do not need to close your credit cards if you take out a debt consolidation loan. But some debt consolidation strategies may require you to do so.
- We will go over 4 common types of debt consolidation and the pros and cons of each one.
Does Debt Consolidation Require You to Close Your Credit Cards?
The short answer is no. You typically do not need to close your accounts if you get a new loan to consolidate your credit card debt.
Traditional debt consolidation strategies involve taking out a new loan with a lower interest rate to pay off existing debts. This process makes it easier to manage your debt, allowing you to focus on only one payment instead of several.
Lenders usually issue either secured or unsecured consolidation loans. With secured loans, you would use your assets, such as your home or car, as collateral to guarantee the loan. Meanwhile, unsecured loans do not require collateral and rely on your creditworthiness instead.
If you have a high credit score, you should be able to get a better rate on your new consolidation loan while keeping your credit card accounts open. Because credit cards typically have high interest rates, this move could save you money on interest charges.
However, if you don’t have the best credit, you may not qualify for a loan with better terms and conditions. That may lead you to rack up more debt, worsening your financial situation. In this case, closing your accounts may help you better manage your money, as you will not be as tempted to overspend.
4 Types of Debt Consolidation Strategies
If you want to consolidate debt, you have a few different options. Some strategies, such as a balance transfer credit card and debt consolidation loan, do not require you to close your credit cards. But, other options, such as a debt management plan or bankruptcy, will require you to close your accounts.
1. Credit Card Balance Transfers
A balance transfer credit card allows you to move high-interest debt onto a lower-interest or zero-percent-interest credit card. Many balance transfer cards come with a 0% annual percentage rate (APR) during the promotional period, usually between 6 and 21 months from account opening.
After the introductory period ends, the interest rate on your new credit card will likely increase, meaning your balance will start accruing interest again. If you can pay off your debt before the intro period ends, you could save a lot of money.
However, if you fail to pay off your balances or make significant progress toward tackling your debt, that may negate the benefits of the balance transfer. Additionally, some of these credit cards charge a balance transfer fee of 3% to 5% and come with their own credit limits. If your current debts are higher than the limit credit card issuers give you, you will not be able to consolidate everything.
If you make on-time payments for your new credit card, you can increase your credit score and creditworthiness. Additionally, getting a new card could lower your credit utilization ratio. Your credit utilization ratio measures how much of your total available credit you use every month. The lower your credit utilization, the better you will appear to lenders. But, if you make a late payment or miss a payment, the credit card company may charge you a late fee, increase your interest rate, and report your missed payment to the credit bureaus.
2. Debt Consolidation Loans
Many banks and credit unions offer debt consolidation loans that combine your existing debt into one loan with one monthly payment. Depending on your credit score, you may also get lower interest rates and better terms, saving you money for other expenses or high-interest debts.
You are not limited only to loans branded “debt consolidation loans.” Other options you can choose from include:
- Personal Loans: These loans typically offer lower interest rates than credit cards, and amounts can range from $1,000 to $50,000, depending on your credit and the lender. Terms can vary from 2 to 7 years, though the longer your loan term, the more interest you will need to pay. Some personal loans may also charge origination fees, adding additional costs to your debt.
- Home Equity Loans: With a home equity loan, you borrow money against the equity in your home. In other words, if you miss your payments, the lender can foreclose on your house. Home equity loans tend to be fixed-rate and provide a lump sum payment you repay over a period of up to 15 years.
- Home Equity Lines of Credit (HELOCs): A HELOC functions similarly to a credit card, allowing you to borrow up to a certain limit. It is a revolving line of credit where you only pay interest on the borrowed amount. But, eventually, you need to repay the full loan amount, including the principal and interest.
- 401(k) Loans: Think of a 401(k) loan as a last resort. You should only use this option if you have bad credit and do not qualify for other refinancing options. That is because you are borrowing against your retirement fund, which could diminish your future retirement income potential and reduce the funds you have for compound growth.
The best debt consolidation loan choice depends on the amount of debt you have, your credit and payment history, and your financial situation. Compare different loan terms and interest rates to see how much you will owe overall. Pay attention to any fees, such as origination fees and late fees.
3. Debt Management Program
Debt management programs (DMP) are typically offered through a credit counseling agency to help you organize your finances. When you commit to one, you will enroll your credit cards into the program with the help of your credit counselor. Note that these plans typically only work for credit cards and may not work for other forms of unsecured debt, such as medical bills or personal loans.
Once you’ve enrolled, your credit counselor will reach out to your creditors on your behalf to try to negotiate better terms for you. Usually, lenders will agree to significantly reduce or even eliminate interest charges on your debt. If successful, you’ll start making monthly payments to the agency, which will take these payments and disburse them to your lenders.
Typically, DMPs last anywhere from 3 to 5 years. Any credit card accounts you add to the program will get closed, though you may be able to keep one for emergencies. The credit counseling agency will also charge a small monthly fee ranging from $25 to $75 for their services. If possible, choose a nonprofit credit counseling agency. You can find one on the Department of Justice’s website.
Your credit counselor will also help you create a new budget. The goal is to ensure you spend within your means instead of relying on credit you can’t afford to pay back. While that does not mean you can’t use credit anymore, it’s a way to help you create healthy and sustainable spending habits.
When you file for bankruptcy, you may be able to discharge most of your unsecured debts, including credit card balances, medical bills, and personal loans. An automatic stay will go into effect immediately, temporarily halting existing creditors from debt collection efforts against you. However, this move is risky and results in your accounts getting closed. Bankruptcy may also cause major damage to your credit score for 7 to 10 years.
The 2 main types of personal bankruptcies in the U.S. are Chapters 7 and 13. Often referred to as “liquidation” bankruptcy, in a Chapter 7 bankruptcy, a bankruptcy trustee may sell non-exempt assets to pay off creditors. To qualify for Chapter 7, you must pass a means test that evaluates your income and expenses. If your income is below the median for your state or you don’t have enough disposable income, you may qualify for Chapter 7. This process typically lasts a few months, with a relatively quick discharge of eligible debts.
Chapter 13 bankruptcy involves creating a repayment plan based on your disposable income to pay back a portion of your debts over 3 to 5 years. This form of bankruptcy allows you to catch up on missed mortgage or car payments and prevents foreclosure or repossession.
You’ll also be able to manage secured debts, such as mortgages and car loans, more effectively because Chapter 13 allows you to include missed payments in the repayment plan. You will also need to pass a means test, but this is to determine the length of your repayment and the amount you need to repay rather than for eligibility. Like Chapter 7, filing for Chapter 13 initiates an automatic stay to halt collection actions.
Other Factors to Consider
Debt consolidation does not erase your debt. It’s simply a way to make your debt more manageable and put you back in control of your finances. A lot of people won’t be able to successfully pay off their debt without making changes to their lifestyle, such as lowering spending or getting a higher-paying job.
Keep in mind that most forms of debt consolidation cost money, whether it’s fees or rising interest rates. If you don’t do research, you might end up paying more than you bargained for. And, if you have blemishes on your credit, such as late or missed payments, you may not qualify for the best rates.
You should also be wary of debt consolidation promotions that seem too good to be true. Some companies may advertise consolidation services, but they are actually for-profit debt settlement companies. These companies usually promise to settle your debts quickly if you pay them up-front, but using their services comes with risks. They often have no up-front agreements with creditors and may persuade you to stop paying your creditors while they are negotiating a debt settlement, which may hurt your credit and result in you getting sued.
Before Taking Out a Consolidation Loan…
The key to getting out of debt is to get to the bottom of why you are in debt in the first place. For example, if you are in debt because you are spending more than you are making, a debt consolidation loan will just be a band-aid for your overspending habits. In that case, you should create a realistic budget that separates your needs and wants while factoring in your monthly income.
Over the last couple of years, I started tracking all my expenses every month to get a grasp of where all my money was going. I also started evaluating what types of purchases brought me joy and what didn’t. I realized that I prefer experiences, such as traveling, trying new restaurants, and going to concerts, over shopping for new clothes or shoes. As a result, I shifted away from buying things to fill my time and instead spend more on experiences. This process enabled me to save and invest a lot more money while focusing on what makes me happy.
The Bottom Line
In general, debt consolidation will not close your credit cards. While debt consolidation loans and balance transfer cards may have more strict eligibility requirements, they don’t require you to close your other accounts to apply. Other debt relief strategies, such as debt settlement or bankruptcy, may help you get out of debt but could lead to your accounts getting closed. When weighing your options, choose the best one for your current financial situation.