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What is Debt Consolidation?

Debt-Consolidation

Personal Finance

What is Debt Consolidation?

Debt consolidation involves obtaining a new loan to repay various consumer debts and liabilities, which are usually unsecured. In other words, the process combines multiple debts into a single, larger loan, typically with better repayment terms and conditions which usually include a lower rate of interest, reduced monthly payments or a combination of both. Debt consolidation is a useful tool for consumers to better manage their student loans, credit card liabilities, bills, overdraft balances and various kinds of debt.

In strict technical terms, it is actually not possible to merge loans and combine them into one. This is because every loan has its own unique repayment terms and interest rates. Each loan is basically a binding agreement where a customer borrows money and then agrees to repay it over a span of time with specific payments. So when you consolidate or combine loans, you actually take out a new, larger loan and use its proceeds to repay all the different smaller debts you intend to consolidate or bring together. It is also important to keep in mind that debt consolidation does not erase your loans; rather they are simply transferred to another lender.

In theory, whenever you use one form of finance to repay other loans you are practicing debt or loan consolidation. However, there are numerous specialized instruments available in the markets which are known as debt consolidation loans. These instruments are provided by creditors to borrowers who are facing difficulty in handling the size or number of their outstanding loans. Creditors have several motivations for offering debt consolidation instruments; one is that they enhance the chances of collection from a debtor. These instruments are typically issued by financial institutions, like commercial and investment banks and credit unions. Moreover, in today’s economy there is no dearth of special debt-consolidation service entities.

Types of Debt Consolidation Loans

Debt consolidation loans usually fall into 2 broad categories which are secured and non-secured. Secured loans tend to be backed by a borrower’s asset; these assets can include items like a car, a house that are used as collateral for the debt. On the other hand, more conventional, non-secured debt consolidation loans that do not require an asset as collateral are difficult to secure. These non-secured loans also have lower qualifying amounts and higher rates of interest. Still, the rates of interest on these loans are usually less compared to the interest rates on credit cards. Their interest rate is fixed too.

Methods of Consolidating Debts

Consumers have numerous ways that they can use to lump debts or loans into a single payment. One method is to combine all your credit card related payments into a single credit card, which can be very useful if your card charges no or little interest for a time period.  Or as a borrower you can also use your current credit card’s balance transfer which is valuable feature (especially if you are getting a special promotion on your transaction).

Similarly, home equity line of credit or home equity loans are also a form of debt consolidation which borrowers seek, because the interest expense on this loan type is deductible for tax purposes for borrowers  who tend to itemize their deductions. There are a slew of consolidation options that are offered by the federal government for people with significant student loans.

Why Opt for Debt Consolidation Loans

Borrowers go for debt consolidation loans for a variety of different reasons, some are listed below:

  • Debt consolidation does a great job of simplifying borrowers’ finances. Rather than having to keep track of a bunch of debt payments and paying on a timely basis every month, they now have to cope with only one payment.
  • The process can save borrowers considerable amount of money by slashing their rate of interest. It achieves this by repaying higher interest loans with a lower interest rate that is available on debt consolidation loans (provided you get approval for a lower interest rate consolidation loan).
  • It can make a borrower’s life easier and stress free with lower monthly payments. This is true if a borrower consolidates at a lower rate of interest or has a longer time period (also called amortization period) to pay off the loan.
  • Debt consolidation can work in your favor by letting you repay debts quicker. However, this is only applicable if you manage to get a lower rate of interest and maintain your existing monthly debt payments at a stable level. This enables you to apply a higher proportion of your monthly payment to repay your principal as less of your money is used in paying the interest expense.
  • You may qualify for a tax break, as well. TheIRS prohibits you from deducting interest expense on your non-secured debt consolidation loans. However, in case your consolidation loan is collateralized using an asset, you may be eligible for a tax deduction. Interest payments on debt consolidation loans are usually tax deductible in case of home equity.
  • Debt consolidation loans may also enhance your credit score down the road. If you repay the principal faster, the balance is repaid sooner, which helps in boosting your credit score.

Mechanism of Debt Consolidation

Let’s assume, you have 3 credit cards and owe a total sum of $20,000 with interest charged at a rate of 22.99% (this is a yearly rate which is compounded monthly). As per calculations you will have to pay $1047.37 per month for 24 complete months to drive your balance to nil. This comes out to be $5136.88 in interest expense alone.

If instead you were to consolidate or combine your credit cards into a reduced-interest loan which charges 11% on an annual basis and this rate is compounded monthly, you will have to pay only $932.16 per month for 24 months to drive the balance down to nil. This comes out to be $2,371.84 in interest alone. Your monthly saving would be $115.21, and over the period of your loan the total savings would be $2,765.04.

Obviously, the above calculations assume that the borrower will have the credit worthiness and income necessary to permit a new lender to provide them a lower rate of interest. Lenders usually require extensive documentation before they agree to this kind of arrangement.

Potential Pitfalls

There are numerous pitfalls that you should consider when opting for debt consolidation.

Extension of Loan Term

You may pay lower monthly payments and enjoy a reduced interest rate, thanks to the new loan. But give due attention to your repayment schedule. If your new schedule is considerably longer compared to your previous one, you may end up paying more money in the long term. Lenders who engage in debt consolidation tend to make money by stretching the duration of your loan and earn a handsome profit even if they charge a lower interest rate.

Deterioration of Credit Score

When you roll over your current loans into a new and bigger loan, you will probably notice a modest negative effect on your credit score initially. Credit scores are usually healthier if you have long-standing loans with more consistent and longer payment histories. Swapping out debts prematurely is viewed negatively. You also have a larger, newer debt, which elevates your risk profile.

Jeopardizing Assets

It is generally easy to get a secured consolidation debt compared to a non-secured one, which implies that you will consolidate numerous non-secured debts (such as credit card balances) into a bigger secured debt. To achieve this you will have to pledge your property as collateral against a larger amount compared to your prior debt .For instance, using a home equity loan puts your house at risk if you do not make the requisite payments on a timely basis.

Loss of Special Terms

Student loans tend to have special terms or provisions (like interest rate rebates and discounts) that will be revoked in case you consolidate them with other loans. But things can get even worse if you default on consolidated students loans; you will have your tax refunds garnished and in some cases may even have your wages attached.

The Bottom Line

Swapping out numerous multiple-rate loans with single, fixed-rate monthly payments definitely simplifies life, and we are not questioning that. However, do not consolidate your loans just for the purpose of convenience. Unless you find yourself absolutely overwhelmed and stressed because of several payment dates, the ease offered by a single monthly payment alone is not considered a good enough reason in favor of debt consolidation, in the light of  the pitfalls we have discussed above.

And never forget that debt consolidation alone will not make you debt free; this is where improving your spending and saving habits come in the picture. And if you do consolidate your debts, fight the temptation to rack up huge balances on your credit card again. If you do not do this you will be saddled with repaying them along with the new and higher consolidated loan.

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