Introduction To Debt Consolidation
When a new loan is taken out to pay off other liabilities and consumer debts this act is referred to as debt consolidation.
Multiple debts are fused together into a single, larger debt, like a loan, that has more favorable payoff terms in the form of a lower interest rate, lower monthly payment, or both.
Debt consolidation can be used to deal with student loan debt, credit card debt, or other liabilities.
How Does Debt Consolidation Work?
When different forms of financing are used to pay off other debts and liabilities that process is debt consolidation.
If a customer is weighed down with different kinds of debt, they can apply for a loan to consolidate those debts into one single liability and pay them off.
Money then goes towards the payment of the new debt until it is paid off in full.
As their first step for a debt consolidation loan most people apply through their bank, credit union, or credit card companies.
If the borrower has a good relationship and payment history with their institution then the process would be easier. If they’re turned down, they can try with private mortgage companies or lenders.
Many creditors are ready to go ahead and do this because debt consolidation maximizes the possibility of payment from a debtor.
Financial institutions such as banks and credit unions usually offer these loans, but these services are also provided by other specialized debt consolidation service companies to the general public.
The Difference Between Debt Consolidation And Debt Settlement
One should understand that debt consolidation loans don’t erase the original debt. They merely transfer a consumer’s loans to a different lender or type of loan.
For actual debt relief or for those who are not eligible for loans, it is wise to look into a debt settlement instead of, or in conjunction with, a debt consolidation loan.
A debt settlement aim is to reduce a consumer’s obligations rather than the number of creditors.
Here the borrowers can work with debt-relief organizations or credit counseling services.
These organizations try to renegotiate the borrower’s current debts with creditors because they do not make actual loans themselves.
The Pros And Cons Of Debt Consolidation Loans
If a borrower is considering a debt consolidation loan there are a few advantages and disadvantages they need to consider.
Pros:
- Debt consolidation is ideal for people who have multiple debts with high-interest rates or monthly payments especially debt worth $10,000 or more. When they negotiate with one of these loans, they can benefit from a single monthly payment in place of multiple payments, and that too with a lower interest rate.
- And if the borrower doesn’t take additional debt, they can become debt-free soon. When they go through the debt consolidation process and are up to date with their payments they can cut down calls or letters from collection agencies.
Cons:
- Even if the interest rate and monthly payment could be lower the borrower needs to pay attention to the payment schedule. Because it would mean they would be paying more in the long run. When taking into account consolidating loans, a borrower should have a word with their credit card issuer and find out how long it will take to pay off the debts with their current interest rate and compare that to the potential new loan.
- They may also lose out on the special provisions on school debt, such as interest rate discounts and other rebates because these provisions disappear when a borrower consolidates their debt.
The Different Types Of Debt Consolidations
Basically, there are two types of debt consolidation loans which are — secured and unsecured loans.
Secured loans are backed by one of the borrower’s assets, like their house or a car, these asset, in turn, works as collateral for the loan.
On the other hand, unsecured loans, are not backed by assets and can be more difficult to obtain.
Their interest rates are also higher and the qualifying amounts are lower. With either type of loan, interest rates are usually lower than the rates charged on credit cards.
And most of the time, their rates are fixed, so they do not vary over the repayment period.
Ways to Consolidate the Debts
There are many ways that a borrower can combine their debts together and consolidate them into a single payment.
1. Debt Consolidation Loans
As part of a payment plan, many lenders — traditional banks and other lenders offer debt consolidation loans to borrowers who are unable to manage the number or size of their outstanding debts.
These loans are specially designed for consumers who want to pay down multiple, high-interest debts.
2. Credit Cards
Borrowers can also consolidate all their credit card payments into one single new credit card.
This idea of a new card can be ideal if it charges little or no interest for a set period of time.
The borrowers may also use the balance transfer feature of an existing credit card if it offers a special promotion on the transaction.
3. HELOCs
Another option for debt consolidation is home equity loans or home equity lines of credit (HELOCs).
4. Student Loan Programs
Several consolidation options are offered to people with student loans, including direct consolidation loans through the Federal Direct Loan Program by the federal government, where the new interest rate is the weighted average of the previous loans. However private loans don’t qualify for this program.
Conclusion
When a single loan is taken out to pay off multiple debts it is called debt consolidation.
With debt consolidation, the borrower pays a single monthly payment in place of multiple payments and a lower interest rate.
When a borrower closes out old credit accounts and opens a single new one, they may reduce the total amount of credit available, thereby raising their debt-to-credit utilization ratio.
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