The Difference Between Credit Card Refinancing and Debt Consolidation
Average credit card debt in the US changes depending on who you ask and where they get their information. In 2019, Experian estimated this to be $6,194, while a leading credit site produced a figure closer to $8,000. At the same time, data pooled from the US Census and Federal Reserve calculated a more modest $5,700, which is likely to be the most reliable figure.
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In any case, there’s one thing that researchers can agree upon: This is a growing problem and it won’t be going away any time soon.
The good news is that credit scores are improving, and debtors have never had more options for clearing their debts, including consolidation and refinancing.
In this guide, we’ll look at both of these options and more, covering cash-out refinance plans, balance transfer consolidation, and more, giving you the knowledge and tools needed to clear your credit card debt and get back into the black.
What is Credit Card Refinancing?
Credit card refinancing generally refers to a balance transfer, although it has also been used to refer to debt consolidation. In both cases, you refinance one loan or debt with another, often keeping the same balancing but adjusting the terms to something more manageable.
We’ll show you how you can properly refinance your debts in this guide as we look at both consolidation and refinancing.
How Does it Work?
A balance transfer moves all your credit card debt onto a new card provided by a new lender. These cards offer 0% APR introductory rates to tempt new customers and these rates mean you can avoid paying interest throughout that period, which typically lasts for 12 to 18 months.
If you have a $5,000 balance with a 20% APR, this switch could save you $500 in the first year. That’s $500 more towards your balance and if you continue making the monthly payments, the debt will reduce significantly by the end of the year and the 0% introductory period.
If that sounds too good to be true, it is. Sort of. These cards can help to shoulder some of your financial burdens and in certain circumstances, they are lifesavers, but there are a few downsides. Firstly, these cards typically charge a fee that can be as high as 5% of the balance. On the aforementioned $5,000 debt, that’s $250.
Secondly, at the end of the introductory period, the interest rate will kick-in and this is often charged at a premium. If you use this period to avoid paying interest and not to reduce your debt, you could end up in a worst position than when you started.
Who is Refinancing Right for?
You will need a fairly clean credit report and a respectable credit score to get a high-limit credit card. There are multiple cards with 18-month introductory periods, 3% transfer rates and APRs that go as low as 16% once the 0% period ends.
As soon as you drop below the 700s, you’ll struggle to get any of these and if you drop below 580, you’ll find it difficult to get anything at all, let alone something large enough to cover your current credit card debt.
How Does Refinancing Credit Cards Affect Credit?
If you finance your credit card debt you’ll see an instant improvement in your debt-to-income ratio, which compares your gross income to all debt payments (including student loan debt, credit card debt, mortgage debt, etc.). This figure is imperative for your financial health and needs to be considered before you shop for mortgage rates or acquire any new debt, because if it’s too high then you may struggle to make payments and could face financial ruin.
An improvement in this ratio, therefore, is always beneficial. The problem is, it doesn’t have any impact on your credit score. One of the ways that refinancing will impact your score is by initiating a hard inquiry, which follows all new loan and credit card applications. This can reduce your score by as many as 5 points.
Opening a new account will also reduce your score. If you’re consolidating several debts into one, then those debts will clear and that will improve your score in the short-term and the long-term. Generally speaking, it’s always beneficial for your long-term credit score and financial wellbeing but be prepared for a short-term reduction.
Can You do a Balance Transfer with Multiple Cards?
You can generally transfer anywhere up to five balances, providing they all remain within the specified credit limit. Balance transfer applications often include sections for multiple debts and cards. Input the details of all your credit card debt into these sections and then wait for them to finalize the decision process, being sure to keep making your payments while you do.
You cannot, however, transfer money into cards offered by the same lender. This may seem counterintuitive, but it’s important to remember that balance transfer cards and their 0% introductory rates are used to attract new customers, hopefully beginning a process that will see the customer fall into a cycle of debt. If they already have you as a customer and you’re already trapped in that cycle, they don’t have much to gain by offering you a 0% balance transfer.
Credit Card Refinancing vs Debt Consolidation
Debt consolidation is often used interchangeably with refinancing and there are many similarities and programs that provide both options. The ultimate goal of these options is also the same, but there are some key differences.
How is Credit Card Refinancing the Same as Debt Consolidation?
The goal of consolidation is to swap many large minimum payments and escalating interest rates for one manageable monthly payment and respectable interest rate. Refinancing works in a similar way and aims to achieve the same result, albeit with some key differences.
The main difference between these two concerns how the original debts are dealt with. With refinancing, you’re moving all current debt to a new credit card via a balance transfer. Your original credit card debt is repaid, and your attentions shift to your new card.
When you consolidate credit card debt, your original debt is paid off and your focus is shifted to a new debt, preferably with a lower annual percentage rate and more favorable interest terms.
Tips for Credit Card Refinancing
If you’ve decided that credit card refinancing is the best way to clear your credit card debt, then keep the following in mind to ensure you get the best deal:
Monitor Your Credit Score
Your credit score will play a massive role in determining the sort of rate you’re offered. 50 points could be the difference between a card that has a short introductory period and a high-interest rate, and one that has 0% for 18 months and provides a respectable APR. Those 50 points can be gained in as little as a month or two depending on your situation.
We have a complete guide on How to Improve Your Credit Score Quickly that you can read to better understand what your options are, but here are a few quick tips to help:
- Pay More: If you have extra cash at the end of the month then use it to pay towards the debt with the highest interest rate. This will reduce the compounded interest, which in turn will reduce the term and the total amount you pay. Both of these will improve your score long-tern, but the greater balance reduction will also help the next time your score is calculated.
- Increase Limits: You can increase limits of active credit cards to give your credit utilization a boost. This accounts for 30% of your total score, so it makes a big difference.
- Look for Mistakes: If you notice any mistakes on your credit report, dispute them. These are much more common than you might think and by disputing them you can remove them and improve your score.
- Be Careful with Hard Inquiries: Credit scoring systems allow something known as “rate-shopping” whereby all applications for the same type of loan are included in one hard inquiry providing they take place in a fixed period. However, this is not true for credit cards, and all applications will count as a separate inquiry. Be very careful when comparing balance transfer cards and make sure you don’t agree to any hard inquiries unless they are absolutely essential.
Look for an Introductory Period
You need a 0% introductory period of at least 12 months, but there are many cards that extend this to 18 months. Anything less may not give you the time you need to get your finances in order and start making those crucial payments.
Check the Transfer Rate
The transfer rate is displayed as a percentage and can vary considerably. Even a difference of 2% (between the lowest average of 3% and the highest average of 5%) can account for $400 on a debt of $20,000.
Don’t Neglect Rates and Penalties
If a card is offering terms that seem too good to be true, you need to do a little digging. Look at the terms and conditions to discover what the APR will be when the introductory period ends and what sort of penalties they charge. The 0% introductory period is a massive positive, so it’s okay if the other terms are a little worse than what you have now. But there’s a line, and you don’t want to go from 16% interest to 26%, for instance.
The purpose of these cards is not to give you a break from interest payments so that you can pump more money into your vacation fund or buy that new games console you’ve had your eye on. That might be what the lender (secretly) wants, but to get the maximum benefit out of balance transfers you need to repay all or most of your debt during the introductory period.
Use this opportunity to reduce the debt by as much as you can because every cent you pay is one less cent for future interest to be calculated against.
Keep it Open
Don’t be tempted to cancel the card as soon as your debt has been repaid as this will greatly reduce your credit utilization ratio, which will impact your credit score. Instead, keep the card active, but try not to use it except for in emergencies and when you’re 100% confident you can clear the balance at the end of the month.
Tips for Acquiring a Consolidation Loan
There are companies that specialize in providing consolidation loans, both in the form of student loans and personal loans. These companies work by repaying your debts with a single, large consolidation loan—leaving you with just one payment to make every month and one debt to worry about.
But much like refinancing, consolidation is not without its issues. To make sure you get the best deal and are mot burdened with more debt than you can afford, remember to:
Check the Total Interest
Many consolidation loans work by reducing the interest rate and minimum payment but increasing the term. On the surface, it looks like you’re getting a great deal, but in reality, you could be paying two or three times as much during the lifetime of the loan.
Use a loan calculator to determine how much the consolidation loan will cost you over the term. A lower interest rate and monthly payment is great and in the short-term, it can provide a huge boost to your finances, but you don’t want to be stuck with a loan that requires you to pay more in interest than the principal.
Understand the Impact on your Credit Report
Some consolidation loan companies, particularly those in the debt management sector, will insist that you close all but one credit account. This removes temptation, but once those old accounts close and are replaced by a brand new one, it will also remove a sizeable chunk of your credit score.
This is not true if you do it yourself using a personal loan, but this can be a risky option and isn’t suitable for anyone with a less-than exceptional credit score.
Don’t Miss a Payment
It should go without saying, but it’s crucial that you never miss a payment on your new loan. Doing so could drastically reduce your credit score and reduce your chances of acquiring a loan or line of credit in the future.
If you’re on a debt management plan, missing a payment could result in the lenders scrapping their agreement and demanding that you return to your original terms. Even if you have a personal loan it’s important to keep meeting those payments on time as each late payment will appear on your credit report and reduce your credit score.
Look at Other Options
When you have taken the above into consideration, you need to ask yourself if a consolidation loan is the best option for you. Is it the cheapest, easiest, and most hassle-free way for you to escape debt? Are there other debt relief options that are more suitable?
There are other ways to consolidate credit card debt. Refinancing might be a more viable alternative, but you can also look into debt settlement. We have written about debt settlement extensively already and while it’s not perfect and can make your situation worse, it’s also ideal for people who feel like they are at the end of the line and are being rejected by lenders despite having access to a steady income.
Choosing Between a Debt Consolidation Loan and Credit Card Refinancing
Refinancing is a great option if you have a lot of credit card debt and a high credit score, as that way you’re almost guaranteed a prolonged introductory period and a high fixed rate of interest. However, if your score is low, your options are a little more limited. There is no origination fee to worry about, but there is a balance transfer fee, there may be high penalties, and the interest rate you’re offered at the end of the introductory period will be high.
In such cases, you should look into debt management or a fixed-rate loan, both of which will seek to clear all of your credit card debt and leave you with more manageable payments. Your credit score may take a significant hit in the short-term, but you’ll be much better off a few months later and can look forward to a brighter financial future.