What You Must Know About Debt Consolidation

Debt Consolidation Explained:

Debt consolidation is a financial maneuver commenced by individuals who have incurred mounting or unsustainable debts. Debt consolidation entails taking out a large loan to pay off other debts. Debt consolidation is initiated by financial institutions and credit card companies; these entities charge a fee to consolidate a borrower’s loans. 

Debt consolidation is typically enacted to secure lower or fixed interest rates to expedite the fulfillment of repayment. As a result of this maneuver, the individual’s debts are lumped together to formulate one all-encompassing repayment plan.

By engaging in debt consolidation, a borrower will group numerous unsecured loans into one all-encompassing unsecured loan. An unsecured loan is a repayment obligation that is not backed by an individual’s asset--the creditor of an unsecured loan does not possess the right to foreclose on an individual’s asset to help relieve a portion of the loan. Common forms of unsecured debts include credit card payments or medical bills. 

The Debt Consolidation Process:

Debt consolidation can be undertaken by the borrower him or herself or through the hiring of a professional credit counseling agency. If a borrower opts to engage in debt consolidation without the inclusion of a professional the individual is required to contact their underlying creditors to initiate a balance transfer. The foal of the consolidation is to transfer all debts to the individual’s low(est)-interest credit card. If this is achieved, the all of the borrower’s debts will be placed on the borrower’s lowest APR credit card.

To engage in the consolidation process with a professional, the borrower must contact a credit counseling agency in their area. The borrower will then engage in a consultation or preliminary interview where a credit counselor will review all of the individual’s debt and determine his or her eligibility for consolidation. If deemed appropriate the counselor will provide a quote or fee to the borrower. When accepted, the counselor will contact all of the borrower’s creditors to negotiate a mitigated repayment schedule. Once all creditors are contacted, the counselor will package all debts and calculate the new monthly payment at a fixed and lower interest rate. 

A borrower, in the majority of debt consolidation initiatives, will consolidate a secured loan, such as a mortgage. In this example, the house acts as collateral for the loan—if the individual fails to meet their mortgage obligation the creditor will seize the liquidity within the home.Consolidating a secured loan typically offers the debtor a lower interest rate; by consolidating, the borrower must abide by the collateral agreement of the asset to satisfy the loan. Because of the reduced risk, the borrower is awarded a lower interest rate.

All forms of debt--from credit cards, to student loans--can be consolidated.  Although debt consolidation often lowers a borrower’s interest rate, the maneuver poses a series of long-term problems, specifically when a borrower consolidates unsecured debts into secured debts. A borrower with property or considerable assets, such as a boat or car, may consolidate debts under a secured structure with a lower interest rate. In this form of debt consolidation, the individual’s assets will act as collateral. 

Alternate solutions to collateralizing one’s debt include: credit counseling, filing for bankruptcy and engaging in debt settlements. Debt consolidation is advisable, in theory, when an individual is paying off mounting credit card debts. Because a credit cards carry a larger interest than other forms of loans—including unsecured loans from banks—debt consolidation is often initiated to pay-down or mitigate the effects associated with credit card debt. 

Consolidating Student Loans:

In the U.S., federal student loans—which are guaranteed by the United States Federal Government—may be consolidated by the Department of Education, who purchases existing loans at a fixed interest rate established by the then-current interest rate. Reconsolidating student loans; however, does not change the borrower’s interest rate. If the student combines loans of different rates and types into a new consolidation loan, a weighted average calculation establishes the new rate based on the then-current interest rates of the various loans being grouped together.

Federal loan debt consolidation is referred to as refinancing, which is technically a malapropism because the loan rates do not change. Dissimilar to private debt consolidation, federal student loan consolidation does not incur any fees for the borrower; a private company may profit on a student loan consolidation by reaping subsidies from the government. 

Concerns Involving Debt Consolidation: 

The primary concern involving debt consolidation is that many borrowers consolidate unsecured debts into secured debts, typically secured against their mortgage/home. Although this action may lower the borrower’s monthly payments, the total repayment amount is significantly higher due to the increased length of the loan. Debt consolidation may therefore treat the symptoms of repayment while ignoring the long-term obligation.