According to the Federal Reserve Bank of New York’s Center for Microeconomic Data, the total household debt in the United States hit an all-time high of $17.69 trillion in the first quarter of 2024. Even worse, delinquency rates continued to skyrocket across all debt types and all age groups.
Among all, the transition rates of credit card balances and auto loans continued to increase, approximately 8.9% and 7.9%, respectively. Similarly, mortgage delinquency transition rates also rose by 0.3%. Although this increase is low by historical standards, it’s still alarming considering the $12.44 trillion mortgage balances reported as of Q1 2024.
These high U.S. household debt and delinquency transition rates are a concern not only for financial institutions but also for borrowers. It’s particularly true for those who don’t run away from debt but are struggling financially. It could lead them to a question: is paying debt with another loan advisable? Let’s figure it out here.
Debt Consolidation is Key
It’s possible to pay your existing debt with another loan. It’s typically done through a credit product called debt consolidation. As its name implies, it’s a type of loan wherein all your existing loans, typically high-interest ones, will be rolled over into one payment. That means your interest rate and, in turn, your total debt will be lower.
There are two main methods of consolidating debt: 0% APR balance-transfer credit cards and fixed-rate debt consolidation loans:
- 0% APR balance-transfer credit cards: These allow you to transfer your existing debt at a 0% annual percentage rate (APR) but only during a promotional period, typically six to 21 months. Besides interest-rate breaks, you can also enjoy rewards points or cash back based on each dollar you spend.
- Fixed-rate debt consolidation loan: Traditional financial institutions and alternative lenders offer these loans. You can use the disbursed funds to pay off your existing debt and repay the consolidation loan in installments over a set term. It’s particularly beneficial for those with high credit scores, who will likely qualify for the lowest interest rates.
Apart from lower interest rates, debt consolidation can streamline your monthly payment since you’ll only pay one payment. If you’re a busy person who has no time to manage multiple debts or is not good at managing your finances, this will greatly improve your debt management.
Lastly, debt consolidation can also build and improve your credit. Although lenders run a hard credit inquiry for every new form of credit, the net effect of consolidating debt and then paying it on and in full outweighs the temporary ding in your credit report. Note that your credit score takes into account your credit utilization ratio (CTR) by 30%. In other words, the lower your debt, especially in revolving accounts like credit cards, the better your credit score.
Personal Loans are The Bandwagon
One of the most well-accepted ways to consolidate debt nowadays is through personal loans. These are offered by various financial institutions, including traditional organizations like banks and credit unions and alternative lenders like CreditNinjaand peer-to-peer (also called marketplace) lenders.
What makes personal loans better than other forms of debt consolidation loans is that they can have better terms. As their name implies, personal loans can be used for different loan purposes, unlike debt consolidation loans, which can only be used to consolidate loans. This means that they may have different and sometimes better underwriting requirements, including credit score, debt-to-income ratio, and interest rates, than debt-consolidation loans.
For example, online personal loan lenders may offer personal loans to borrowers with low to no credit scores. In contrast, banks that offer fixed-rate debt consolidation loans, as stated, may require high credit scores. It makes personal loans a borrower’s go-to debt consolidation method compared to other forms.
When Should You Not Pay Debt with Another Loan
While consolidating debt is a good idea to manage multiple loans, it’s not always ideal. In some cases, borrowing again could put you at risk of a debt spiral, where you continuously fall deeper and deeper into debt. It’s particularly true if you fall into one (or many) of the following situations:
- Your outstanding balances are so high that consolidating them will only increase your total debt rather than decrease it.
- The interest rate on a debt consolidation loan is higher than the interest rate on your current debts. While this is rare, it can happen when dealing with predatory lenders.
- The debt consolidation loan requires a guarantor or a cosigner.
- The collateral required for the debt consolidation loan is too high.
In such cases, it’s highly recommended to keep a cool head and look into other options. These may include cash-out refinance, home equity line of credit (HELOC), and filing for a consumer proposal or bankruptcy. If you’re familiar with these, consider seeking professional advice for a more effective and personalized financial strategy.
Final Thoughts
Paying debt with debt can be a strategic financial move, but it’s not suitable for everyone. However, it’s not recommended for everyone. It’s crucial to thoroughly understand your financial situation before taking out another loan. If you’re unsure where to start, consulting a financial advisor is a wise investment.