Debt consolidation is a form of debt refinancing, which involves obtaining one loan to repay many others. This usually refers to individuals who are faced with the problem of consumer debt, but sometimes this may also apply to a country’s fiscal approach to consolidating corporate debt or public debt. The consolidation process can provide a lower overall interest rate for the entire debt burden and provide the convenience of servicing only one loan or debt.
Debt is money owed by one side (debtor) to the other side (creditor). As a rule, the borrower pays off the principal and interest. Interest is the fee charged by the creditor to the debtor, which is usually calculated as a percentage of the principal amount per year, known as the interest rate, and is usually paid periodically at intervals (usually every month). Debt may be secured or unsecured.
Although there are differences in different countries and even in states within a country, consumer debt mainly consists of housing loans, credit card debt and car loans. Household debt is the consumer debt of adult family members plus a mortgage, if applicable. In many countries, especially in the USA and the UK, student loans can make up a significant portion of the debt, but they are usually regulated differently than other debts. Total debt can reach a level at which the debtor faces bankruptcy, insolvency or other emergency financial situation. Options available to overly burdened debtors include credit counseling and personal bankruptcy.
Other consumer options include:
- debt settlement, when the debt of an individual is agreed with creditors with a lower interest rate or principal, in order to reduce the total burden;
- debt relief when part or all of individual debt is forgiven;
- debt consolidation, when an individual can pay off current debts by taking a new loan.
Sometimes a solution may include several of the options above.
Debt consolidation process
The bulk of consumer debt, especially with a high interest rate, is paid off with a new loan. Most loans for debt consolidation are offered by credit institutions and are secured by a second home mortgage. It is required that a person put up a house as collateral, and that the loan is less than the available capital.
An overall lower interest rate is an advantage that offers consumers a debt consolidation loan. Lenders have fixed costs for processing payments, and repayment may extend over a longer period. However, such consolidation loans have their costs: commissions, and interest. In some countries, these loans may provide certain tax benefits. Since they are secured, the lender may try to seize the property if the borrower defaults.
Personal loans are another form of debt consolidation loan. An individual can give a debtor a personal loan that will cover the outstanding debt and create a new one on his or her own terms. These loans, often unsecured, are based on personal relationships rather than collateral.
There are certain companies and private law firms in the US that are considered debt relief companies and / or debt consolidation companies. They provide professional debt consolidation services. The consumer can address them for help on debts and make only one monthly payment. This payment will then be paid by these companies to various creditors.
Pros and cons of consolidation
Pros of consolidation:
- The ability to pay one debt instead of several. Accordingly, several monthly payments with different amounts and dates are replaced by one. If the client does not pay via online methods, then he or she will have to visit one bank office (or ATM) instead of several. Of course, this is convenient. This is also an advantage for the bank. A significant part of overdue debts with a short payment delay period arises due to the absent-mindedness and forgetfulness of the client. And if it’s easier for the client to control one payment than five, then the probability of timely payment of each next payment increases;
- The possibility of changing the loan term. If the financial burden turned out to be overwhelming, one way to regulate it is to increase the maturity. This allows you to reduce the size of each payment. True, the extension of the term is accompanied by an increase in the total overpayment in favor of the bank. But it’s easier to pay a smaller amount. In any case, this question needs to be carefully thought out and calculated before drawing up a new contract;
- The possibility of reducing the overpayment by reducing the price of the loan. As a rule, the combined loan rate is lower. In addition, if the loan had, in addition to interest, other additional payments in favor of the bank, they can also be canceled. For example, the funds were transferred on a card. This, by the way, is the most expensive loan option. In addition to interest, there may be a service charge, SMS banking, etc.
Cons of consolidation:
- In order for consolidation to really be profitable, you need to be able to count all possible options and take into account all the nuances. As practice shows, not all ordinary people do it. Some consumers believe the bank. Others simply do not know how to count;
- Before approving a new loan, the bank carefully examines the borrower. It is possible that the bank will refuse the client if at least one of the available loans had late payments. Well, only a borrower with a good credit history can count on low cost;
- The bank will not give out the funds to the client but will transfer it to the account of the creditors to pay off the previous debts. This feature of the association is related to the minuses since the client does not receive money personally. But in fact, this is more a plus than a minus. After all, if the client gets the money, he or she may not pay off previous debts. This will increase the debt burden and aggravate the situation;
- The need for negotiations with previous creditors and the preparation of relevant documents;
- In some cases, you will have to pay a fine for early repayment of the loan;
- Additional costs of time and money associated with the collection of all the documents for a new loan.
Tips & tricks
- Choose credit debt consolidation, and see what monthly payments you previously paid, this reduces the risk of spending money for other purposes and you can pay off debt faster;
- Do not apply for new credit cards and other loans for at least 6 months after applying for debt consolidation;
- Try to pay more than the minimum monthly payment to reduce your debt as quickly as possible;
- Do not miss a single payment on a consolidation loan, this may negatively be reflected in the credit report, while the interest rate will increase;
- Make sure that the credit report does not contain errors or omissions before applying;
- Find out if there is any monthly fee for maintaining a debt consolidation, as most banks hide this information and indicate it in small print or as an addendum to the loan agreement.