What Is Debt Consolidation?
The term debt consolidation refers to the act of taking out a new loan to pay off other liabilities and consumer debts, generally unsecured ones. Multiple debts are combined into a single, larger piece of debt, usually with more favorable payoff terms. Favorable payoff terms include a lower interest rate, lower monthly payment, or both. Consumers can use debt consolidation as a tool to deal with student loan debt, credit card debt, and other liabilities.
- Debt consolidation is the act of taking out a new loan to pay off other liabilities and consumer debts, generally unsecured ones.
- Debt consolidation loans don’t erase the original debt but transfer a consumer's loans to a different lender or type of loan.
- There are two different kinds of debt consolidation loans: secured and unsecured.
- Consumers can apply for debt consolidation loans, lower-interest credit cards, HELOCs, and special programs for student loans.
How Debt Consolidation Works
As noted above, debt consolidation is the process of using different forms of financing to pay off other debts and liabilities. So when a consumer is saddled with different kinds of debt, they can apply for a loan to consolidate those debts into a single liability and pay them off. Payments are then made to the new debt until it is paid off in full.
Most consumers apply through their bank, credit union, or credit card company about a debt consolidation loan as their first step. It's a great place to start, especially if you have a great relationship and payment history with your institution. If you’re turned down, try exploring private mortgage companies or lenders.
Creditors are willing to do this for several reasons. Debt consolidation maximizes the likelihood of collecting from a debtor. These loans are usually offered by financial institutions such as banks and credit unions, but there are other specialized debt consolidation service companies that provide these services to the general public.
An important point to note is that debt consolidation loans don’t erase the original debt. Instead, they simply transfer a consumer's loans to a different lender or type of loan. For actual debt relief or for those who don't qualify for loans, it may be best to look into a debt settlement rather than, or in conjunction with, a debt consolidation loan. Debt settlement aims to reduce a consumer's obligations rather than the number of creditors. Consumers work with debt-relief organizations or credit counseling services. These organizations do not make actual loans but try to renegotiate the borrower’s current debts with creditors.
Types of Debt Consolidation
There are two broad types of debt consolidation loans: secured and unsecured loans. Secured loans are backed by one of the borrower’s assets such as a house or a car. The asset, in turn, works as collateral for the loan.
Unsecured loans, on the other hand, are not backed by assets and can be more difficult to obtain. They also tend to have higher interest rates and lower qualifying amounts. With either type of loan, interest rates are still typically lower than the rates charged on credit cards. And in most cases, the rates are fixed, so they do not vary over the repayment period.
There are several ways you can lump your debts together by consolidating them into a single payment. Below are a few of the most common.
Debt Consolidation Loans
Many creditors—traditional banks and peer-to-peer lenders—offer debt consolidation loans as part of a payment plan to borrowers who have difficulty managing the number or size of their outstanding debts. These are designed specifically for consumers who want to pay down multiple, high-interest debt.
Another method is to consolidate all your credit card payments into a new credit card. This new card can be a good idea if it charges little or no interest for a set period of time. You may also use an existing credit card's balance transfer feature—especially if it offers a special promotion on the transaction.
Student Loan Programs
There also are several consolidation options available from the federal government for people with student loans. The federal government offers direct consolidation loans through the Federal Direct Loan Program. The new interest rate is the weighted average of the previous loans. Private loans don't qualify for this program, however.
Advantages and Disadvantages of Consolidation Loans
Debt consolidation is a great tool for people who have multiple debts with high-interest rates or monthly payments—especially for those who owe $10,000 or more. By negotiating one of these loans, you can benefit from a single monthly payment rather than juggling multiple payments, not to mention a lower interest rate. And as long as there's no additional debt taken out, you can also look forward to becoming debt-free sooner. Going through the debt consolidation process can cut down calls or letters from collection agencies, provided the new loan is kept up to date.
A consolidation loan may also help your credit score down the road. Paying off the loan's principal portion sooner can keep interest payments low, which means less money out of your pocket. This, in turn, can help boost your credit score, making you more attractive to future creditors.
You may also get a tax break, too. The Internal Revenue Service (IRS) does not allow you to deduct interest on any unsecured debt consolidation loans. But if your consolidation loan is secured with an asset, you may qualify for a tax deduction. Debt consolidation loan interest payments are often tax-deductible when home equity is involved.
Although the interest rate and monthly payment may be lower on a debt consolidation loan, it's important to pay attention to the payment schedule. Longer payment schedules mean paying more in the long run. If you who consider consolidation loans, speak to your credit card issuer(s) to find out how long it will take to pay off debts at their current interest rate and compare that to the potential new loan.
Another consideration is the potential hit to the credit score. Here's why:
- By rolling over existing loans into a brand new one, there may initially be a negative impact on the consumer's credit score. That's because credit scores favor longer-standing debts with longer, more-consistent payment histories.
- Closing out the old credit accounts and opening a single new one may reduce the total amount of credit available, raising the debt-to-credit utilization ratio.
There's also the potential loss of special provisions such as interest rate discounts and other rebates. Consolidating debt can cause these provisions to disappear. Those who default on consolidated school loans usually have their tax refunds garnished and may even have their wages attached, for example.
Finally, there's the potential for increased costs. Some debt consolidation services often charge hefty initial and monthly fees. And you may not need them. You can consolidate debt on your own for free with a new personal loan from a bank or a low-interest credit card.
Although a debt consolidation loan may reduce your payment or interest rate, you may be liable for additional fees.
Requirements for Debt Consolidation
Borrowers must have the income and creditworthiness necessary to qualify, especially if you're going to a brand new lender. Although the kind of documentation you'll need often depends on your credit history, the most common pieces of information include a letter of employment, two months' worth of statements for each credit card or loan you wish to pay off, and letters from creditors or repayment agencies.
Once you get your debt consolidation vehicle in place, you should consider who you'll pay off first. In a lot of cases, this may be decided by your lender, who may choose the order in which creditors are repaid. If not, pay off your highest-interest debt first. However, if you have a lower-interest loan that is causing you more emotional and mental stress than the higher-interest ones (such a personal loan that has strained family relations), you may want to start with that one instead.
Once you pay off one debt, move the payments to the next set in a waterfall payment process until all your bills are paid off.
Example of Debt Consolidation
Say an individual with three credit cards and a total of $20,000 owing at a 22.99% annual rate compounded monthly needs to pay $1,047.37 a month for 24 months to bring their balances down to zero. This works out to $5,136.88 paid in interest alone over time.
If the same individual consolidated those credit cards into a lower-interest loan at an 11% annual rate compounded monthly, they would need to pay $932.16 a month for 24 months to bring the balance to zero. This works out to $2,371.84 being paid in interest. This results in a monthly savings of $115.21, with $2,765.04 saved over the life of the loan.
|Loan Details||Credit Cards (3)||Consolidation Loan|
|Term||28 months||23 months|
|Principal||$15,000 ($5,000 * 3)||$15,000|
Even if the monthly payment stays the same, you can still come out ahead by streamlining your loans. Say you have three credit cards that charge a 28% annual percentage rate (APR). Your cards are maxed out at $5,000 each and you're spending $250 a month on each card's minimum payment. If you were to pay off each credit card separately, you would spend $750 each month for 28 months and you would end up paying a total of around $5,441.73 in interest.
However, if you transfer the balances of those three cards into one consolidated loan at a more reasonable 12% interest rate and you continue to repay the loan with the same $750 a month, you'll pay roughly one-third of the interest—$1,820.22—and you can retire your loan five months earlier. This amounts to a total savings of $7,371.51—$3,750 for payments and $3,621.51 in interest.