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How big a balance is too big? There's no cut-and-dried answer, other than "the wider the gap between the limit and the balance, the better."
In general, I advise people not to use more than 30% or so of their credit card limits at any given time, and to get balances below 10% if they want to see significant improvements in their credit scores. If you really want to consolidate your debt onto one or two cards, ask your card issuers for higher limits if the transferred debt will eat up a sizable chunk of your available credit.
If you're really concerned about your credit scores, though, or you'll be in the market for a major loan soon, you might want to consider other options:
Home-equity borrowing. If you have plenty of equity in your home, you may be able to tap it by transferring your debt to a home-equity loan or line of credit. You may get a lower rate, and your interest payments are typically tax-deductible. But this approach also has significant risks, including:
- You're pledging your home as collateral. If you can't make the payments, you could lose your house.
- You're securing the debt. Unsecured debt on credit cards typically can be erased in bankruptcy, while secured debt, including home-equity borrowing, typically can't. If your finances are so shaky that bankruptcy may be in your future, you should avoid this option.
- You may need all the equity you can get. Falling home prices could make it tough for you to sell your home and net enough to pay off your mortgage. Draining your equity now could be a bad move, particularly if you need to move before you get the loan paid off.
- You could find yourself deeper in debt. If you don't fix the problem that caused the overspending in the first place, you're likely to run up more credit card debt. Also, home-equity lines of credit allow you to pay just the interest for the first decade or so, which means you aren't making any progress paying down the principal. Home-equity loans, by contrast, typically require principal payments, but you could be making payments on this debt for decades if you're not disciplined enough to pay more than the minimum required.
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The effects on your credit depend on what type of loan you get. A home-equity line of credit is typically treated as a revolving debt, like a credit card. Maxing it out could have negative consequences for your credit. By contrast, a home-equity loan is typically treated as an installment loan, which generally has beneficial effects on your credit scores (as long as you make the payments on time).
A 401(k) loan. Most employers allow you to borrow up to half of your retirement account balance and pay back the loan at a relatively low interest rate over five years. You're essentially paying yourself interest, rather than a lender, and the loan doesn't even show up on your credit reports, which could be good for your scores (all that debt disappears from your credit cards). But there are serious potential disadvantages:
- Losing your job could be a disaster. If you leave your employer, it's likely you will be required to repay any 401(k) loan in a short period of time. Any unpaid balance would be turned into a withdrawal, which means you'd pay taxes and penalties and lose all the future tax-deferred returns the money could have earned.
- Your money isn't working for you. Your retirement account funds would probably earn more over time invested in the stock and bond markets than what you're saving on interest.
- Once again, you could wind up deeper in debt. As with home-equity borrowing, tapping your retirement fund might be just another way to paper over a serious spending problem that will just continue if not addressed.
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Unsecured loan from a credit union. Finally, you should check out the options at your local credit union before considering a for-profit debt consolidator.
Credit unions, as I explained in "Ditch your bank for a credit union," are member-owned organizations that typically offer lower rates and better terms than other lenders. Ideally, you could get a fixed-rate loan with payments that will allow you to pay off the debt in a reasonable length of time. If you don't already belong to a credit union, you can find a list of possibilities by using the tool at JoinACU.org.
Installment-debt-consolidation loans typically have a positive effect on your credit. But your lender may ask you to close your credit cards or other accounts, which can have a negative effect on your scores. If that's the case, you'll have to weigh the potential hit against the advantage of a one-payment loan solution.
Liz Pulliam Weston's new book, "Easy Money: How to Simplify Your Finances and Get What You Want Out of Life," is now available. Columns by Weston, the Web's most-read personal-finance writer and winner of the 2007 Clarion Award for online journalism, appear every Monday and Thursday, exclusively on MSN Money. She also answers reader questions on the Your Money message board.
Published Jan. 21, 2008
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