Debt consolidation means grouping different loans into a single debt. When you have multiple loans at the same time it becomes difficult to manage them all and this may lead to missing a repayment that may further lead to lose of your home or low credit rating. It entails bringing together all or most of your loans as one debt so that you can have a single loan repayment each month. It is mostly used by people struggling to manage and pay off their current outstanding debts. Debt consolidation loans are a type of personal loans.
HOW DEBT CONSOLIDATION LOANS WORK
Debt consolidation can occur in two ways:
- Credit card balance transfers: Shifting credit card debts to a 0% or low interest rate balance transfer credit card. This does not require securities but you must have a good credit rating to get one.
- Personal loans. You move most or all of outstanding loans and credit card debts into one loan (consolidated loan) by borrowing enough money from a bank or credit union to pay off all your current debts and owing just one lender. You can then close down the other credit cards and loan agreements and use the consolidated loan to pay the other loans off. The new loan balance will be a summation of the other multiple loans. (Detweiler, 2014)
Consolidated loans can be secured, that is, collateralized using property which is usually houses. Secured loans have relatively low interest rates but if you miss a payment you might end up losing your home. Before taking a secured loan, you should consider the following:
- The interest rates and the annual percentage rates. The APR usually includes additional costs that you should be wary of.
- Comparing deals offered by various providers on their websites to get the best deal.
- Penalties for prepayment.
- Closing your credit cards and cancelling overdrafts to avoid the temptations of using them again and piling up more debt.
Consolidated loans can also be unsecured, that is, the lender cannot claim your home in case you are unable to keep up with the repayment. Unsecured debt consolidation loans, however, have higher interest rates charged against them.
Debt consolidation loans have various strengths and limitations.
ADVANTAGES OF DEBT CONSOLIDATION LOANS
- Managing debts is easier and more straightforward. All loans are in a single pool and thus you will have only one interest and one payment to make each month. In addition to this, you would know exactly what you owe and when your loan will be paid off.
- Closing down other credit cards and loan accounts can be an indication to lenders of your good financial management and increase your credit worthiness.
- Potential reduction in Interest rates and payments.
- Fixed payment for the loan term, usually 2-5years.
- Avoids minimum payment trap associated with other loans that keep you indebted for many years.
DISADVANTAGES OF DEBT CONSOLIDATION LOANS
- You might end up paying more interest than needed on some borrowing. Monthly repayment may be lower but the loan lasts much longer leading to a higher repayment amount.
If thinking of taking up a debt consolidation loan, you should take note of the following:
- How big a loan you will need to offset the other loans.
- The interest rate, which depends on the level of borrowing. Generally, the higher the level of amount you borrow, the lower the interest rate.
- Costs and penalties of early and late repayments. Late repayments have more interests.
You should only decide to take up a debt consolidation loan if you will end up paying less interest rates than the interest rates that you would have paid before for the multiple loans, if the overall amount you will pay will not increase and if you won’t miss on repayment of the debt consolidated loan.
Consider the following example of a person having a total of $10,200 in debts from different loans and credit card balances.
|Credit card balances||5000||16%||200|
If this person is to take up a consolidated loan, he would pay $204.39 and an interest rate of 7.5% for a 60 month loan term. It is advisable for him to take up the consolidated loan as interest rates and will be reduced. (Calculations based on Bankrate consolidated loan calculator)
STUDENT LOAN CONSOLIDATION
- United States
Federal students’ loans are guaranteed by the US government. In federal students’ loan consolidation, the department of Education purchases existing loans and then charges a fixed interest rate based on prevailing interest rates. In case of consolidating different types of loans, the fixed rate is determined by a weighted average of the prevailing rates.
- United Kingdom
Student loan entitlements are guaranteed by the students’ future income calculated using a means tested system.
Student loans normally have no prepayment penalties. Federal student loans should be consolidated as soon as possible and should be prioritized over personal loan repayments as rates increase every year and it’s better to lock in the lower current rates (DebtHelp.com, 2014).
Some of the debt consolidation loan providers include One Main Financial, Lending Club, Wells Fargo and CONSUMERCREDIT.COM. Most of these can lend up to $35,000.
Debt consolidation loans should be differentiated from debt management program (DMP) under which you make monthly payments to a credit counselling agency who then pays all your participating creditors. The agency doesn’t pay off the outstanding debts.
NOTE: A debt consolidation fund simply transfers the debt to a new lender, but you still have a debt.
Debt consolidation loans were highly marketed before the financial crisis but they are much less common now. According to media reports, many people are tempted to consolidate unsecured debts into secured debts, usually against their homes. However before making this decision you are advised to be wary of the key points mentioned afore.
There are also other solutions or ways out of struggling with debts. These include: snowballing debt, credit counselling and debt settlement.
- ConsumerCredit.com (2014). Debt consolidation. Retrieved from http://www.consumercredit.com/our-services/debt-management-program/debt-consolidation.aspx
- DebtHelp.com (2014). Student loan consolidation programs. Retrieved from http://www.debthelp.com/student-loans
- Detweiler, G. (2009) Consolidation loans. Retrieved from www.credit.com/debt-consolidation-loans