When To Consolidate Your Credit Card Debt?

When is it a good idea to consolidate your credit card debt and when is it a better idea to just pay off your credit card debt as it is? In this video, I'm going to share with you when you can actually save money consolidating your credit card debt. I'm also going to give you the rules of thumb that can help you make sure that you're making the right decision along the way. Let's get at it! For the purposes of this video, we're going to use the example of someone who has $13,000 in credit card debt across three different credit cards. And immediately, we get to the first important rule of thumb. If you will pay off your credit card debt within the next 12 months, don't consolidate. That means that you could consolidate a couple of credit cards and leave one out. Why? Well, consolidating will start a new loan with a term between two and five years. That means that even if you are getting a better interest rate, you might still pay more in overall interest because you are extending out the life of that loan and paying interest over a longer period of time. Okay, let's get at the first things that we need to do. The first thing you want to do is gather some information about your credit cards. The balances, the interest rates, and the minimum payments are essential to making good decisions. I have included the months to pay off and the principal pay down because it helps for illustration purposes. The principal pay down is the amount of your total balance that will be included in every minimum payment. You can find that number in your credit card agreement, but it only matters in understanding how they calculate your minimum payment. It's not going to make a difference in the decision that you make. $13,000 in debt with a weighted average interest rate of 23.4%. Paying the minimum payment every month without adding balances will mean that paying off the debt will take 86 months. And here's what that looks like. If you just pay the minimum payment, this is how your debt payoff schedule looks. Your payment gets gradually more manageable, sure, but that's one of the challenges actually. By the time you are a couple years into this process, your payment feels pretty manageable, which means that you can lead to adding balances through discretionary spending or just because unexpected expenses come up. Instead of looking at this by credit card, let's break down the payment by how much interest you are paying. If you just pay the minimum payment, you will end up paying over $20,000 to pay off $13,000 debt. Over the seven years, 37% of the money that you send to the credit card company will go towards interest. That interest does nothing to help you get out of debt. All right, let's take a look at how a debt consolidation loan might actually help out in this situation. Imagine that you can qualify for a credit card debt consolidation loan with an interest rate of 18%. That's a five percentage point improvement over your credit cards. That can save a lot of money, but you will notice that the loan is for more than $13,000. That's because most debt consolidation loans have an origination fee, which comes out of the proceeds for the loan. That means that if you need $13,000 to consolidate all of your debt, you will need to borrow slightly more than that. In this case, the origination fee is 5% of the loan amount. I've seen origination fees as low as 3% and as high as 9%. The other thing you should be able to see is that the payment is significantly lower than your minimum payment. That could be a good thing if you currently struggle to make your payments, but this leads me to the next rule of thumb. Don't show loyalty to your lender. If you can pay off your debt faster by getting a lower interest rate, you should do it, even if you just barely got a loan. Let's say you consolidate your credit card debt right now and it helps you avoid being late on your payments, which has happened in the past. In a few months, your credit score could go up as you make on-time payments. If in 9 months, you can earn an even lower interest rate, you should consider doing that. I call this the credit score ladder. As you climb it, you will qualify for lower interest rates, which will help you put more money towards your principal instead of paying for interest. That way, you can get out of debt faster. At The Yukon Project, we try to make shopping around easy. If you go to our marketplace page, you can pick a lender and apply for a loan, but we will check your rate with up to 40 lenders at the same time. Checking will not hurt your credit score, so you can make sure that you're getting the best deal that you can qualify for. It's a great way to periodically check to see if you are getting the best rate or whether you can qualify for a better rate than the one you have right now. So this is how credit card debt consolidation loans are different. You can see that the payment stays the same over the life of the loan. This is called amortization and it makes it easier to plan your finances. Over time, more of your payment goes towards principal. In this case, 23% of the payments were going towards the interest on the loan. When we overlay the credit card minimum payments, you can see how different the two approaches are. With the consolidation loan, the payments are better for the first year and then are higher for the next two years. But then you are completely out of debt. You are trading the orange striped portion for the blue striped portion. So if you're struggling to make your current minimum payments, debt consolidation can provide you some relief. It will meaningfully drop your bill as you get on top of things. But of course, in year two and three, your payment is actually higher than it otherwise would have been. But that shouldn't be a problem because the goal is to get out of debt. And as you can see from the minimum payment line, it is really hard to get out of debt if you never pay more than the minimum. So the obvious rule of thumb is that if you struggle to make payments, debt consolidation can help provide a little relief. But just because your payment is a little lower during that first year, it doesn't mean that you're avoiding the debt. This graph shows what percentage of your monthly payment is actually going towards paying off the principal. Because of the amortization, consolidation loans increase the amount you are paying off the loan. Credit cards are designed to only pay a percentage of the current balance. So it really only increases when you hit that $35 minimum payment requirement. This leads to one of the most important rules of thumb. Extra principal payments early in your loan will save you significantly more interest than the same extra payments later in your loan. In practical terms, this means that as soon as you have stabilized your finances with a new loan, you should try as hard as you can to make extra payments. Making an extra payment in the first year can save you two or three times as much interest as making that same extra payment in the third year. Okay, but how much interest are we really talking about? Even when your consolidation loan payment is lower than the credit card payment, you are still paying less per payment on interest. And the savings isn't insignificant either. In this instance, going with a debt consolidation loan will allow you to spend $2,600 less in interest and get out of debt faster. Part of the savings you get from a debt consolidation loan is the lower interest rate. This graph shows the cumulative interest you pay on your debts. That yellow consolidation loan curve is not as steep as the orange credit card curve because the interest rate is lower. The other part of this is that the consolidation loan, you're not paying interest as long. So is it good to consolidate even if you don't get a better interest rate? After all, you would pay off the loan faster, right? Well, yes, but if you're not actually getting a better interest rate, you would be better off just paying extra on your current credit cards. So how much better should your interest rates be to make it worthwhile? That's our next rule of thumb. The longer you are in debt, the more important small improvements to your interest rate will be. Small interest rate improvements aren't as important in shorter time periods. So let me show you what that credit card payoff would look like if you locked in your current payment and paid that much until you were out of debt instead of just making the minimum payment. That looks pretty familiar, doesn't it? The blue part of the graph is the minimum payment required and the gray is the extra amount you would pay in order to maintain your payment amount. By locking in your payment amount, you are effectively amortizing your credit card debt. This is why consolidating doesn't make any sense if you're not getting a better interest rate. You can pay off the debt as if you were consolidating just by making consistent payments. So if you can handle your current minimum payment, keep paying that amount and you can be out of debt in just over two years. When we look at the split by how much of the payment is going towards principal versus interest, you can see how aggressively we are making principal payments. That means you are spending a lot less on interest. More of your payment is going to paying off the debt. And when we compare that approach to the debt consolidation loan, we can see that the payment is much higher, but we get out of debt significantly faster. When we make the same monthly payment, the graphs look really similar. The consolidation loan does get paid off slightly sooner. Why? Well, because of the lower interest rate. The blue portions of this graph are the interest we would pay under each scenario. The gray is the origination fee that we had to pay for with the debt consolidation loan. So we would want to make sure that we are accounting for it in the cost of the loan. Even still, with the lower interest rate, we pay off faster and pay less in interest with the debt consolidation loan, but not a lot. The final rule of thumb is probably the most important one. Don't take a debt consolidation loan and clear off your credit card balances if it just means you're going to run up new balances. The idea is to get out of debt. So if you struggle to control your spending, close the cards or put them aside. But if you don't have a spending problem, pay off the debt as fast as you can because those unexpected expenses are going to come sooner or later. We hope this video gave you the information that you need to know when to consolidate your credit card debt and when not to. If you found this video useful or helpful, please consider subscribing to our channel. Thanks for watching.