Debt Consolidation

What Is Debt Consolidation?

Debt consolidation is a process by which a person combines the number of loans he has taken out into a single, huge, long-term loan. These huge long-term loans can be outstanding credit card payments, outstanding loans, or other financial obligations.

Debt consolidation can also be viewed as a strategy that aims to simplify the repayment process and possibly lower interest rates and monthly payments.

Debt consolidation can be achieved through

1. Transfer Of Credit Card Balances
2. Acquiring Personal Loans
3. Acquiring Home Equity Loans and
4. Lines Of Credit

The crux of the strategy is to pay off any existing debt obligations by acquiring a new debt or loan. By clubbing different debt obligations, one can avail the facility/facilities to pay lower interest rates than expected, lower monthly payments, or both.

It is important to determine whether the debt consolidation technique will benefit a creditor's financial situation.

It is imperative to assess the following before opting to use debt consolidation to settle one's debt:

• One's Financial Status
• Debt Status
• Available Options for Acquiring Debt
• Interest Rates
• Fees
• Repayment Terms, and
• Any Associated Risks.

Apart from the availability of the option to pay debt at lower interest rates and/or lower monthly payments, it is of crucial importance that the debt holder make monthly payments on time.

Understanding Debt Consolidation

Debt consolidation is the act or process of reducing the number of loans by combining them into a single long-term loan. The strategy of combining multiple loans into one can prove to be beneficial in the case of individuals who can't manage their finances efficiently.

Generally, it is not easy for people to manage their multiple loans and give interest to all, as it becomes too much of a concern that people are unable to pay their debt at the due time, and because of that, interest increases which raises the burden.

It generally happens to people with inadequate money management skills or with individuals holding considerable medical, property, student loans, or sometimes credit card bills that they cannot clear due to financial issues.

By combining the debts into one, borrowers can simplify their payments since there will be fewer bills to look for, and possibly save money through lower interest rates and lower monthly payments.

Some important considerations before opting for debt consolidation include:

• The extension of debt repayment due to lower interest rates and lower monthly payments
• Possibility of paying more interest than you should
• Origination fee
• Balance transfer fee

Debt consolidation cannot be the answer to all questions since different types of debt obligations require different kinds of attention to be satisfied. The pros and cons should be weighed accordingly, and the decision should be made according to the needs and time demands.

How Debt Consolidation Works

First and first most, we need to understand that these loans can be taken from many sources like banks, credit unions, financing companies, a creditor, and family and friends, so it is not only about getting them from banks.

Secondly, we need to consider that banks are also businesses that give loans to people to earn interest. If the amount of money is big, then the interest is also big due to the duration of the loan. 

The bank does not lend to all of them; it provides loans to those who meet its criteria. The following are some of the criteria that must be fulfilled.

1. Good Credit: One of those criteria is good credit, which means people who have had good credit in the past and want to take this loan because of something wrong.
   • Moreover, sometimes people's loans reduce the stress of paying loans on the due dates. So it is more like an exit for them to reduce the number of loans into just one so that they have to pay it by one due date.
2. Size Of The Loan: Another criterion is the size of the loan, such as a health, property, or education loan. Large loans are generally taken out so that they can earn a good amount of interest in the long term.
   • So firstly, people find the right bank or source from where they can take this, considering the interest they have to pay and the duration of it so that they can find the most suitable ones.
3. Eligibility Criteria: Then, they check the eligibility criteria of the source from which they are taking this loan and whether they can meet all those terms and conditions and are ready to qualify for it.
4. Submission Of Documents: If the source is banks or NBFCs, you will submit your documents, and they will start verifying them and checking where you can meet the qualifying requirements for taking them from them.
5. Verification: You will apply for the loan, and they will come to check your profile and then tell you how much loan you are eligible to take and if it clears your needs. 
6. Acceptance Of Loan: If both agree on the same terms, then the loan is passed, and the person will know monthly payments, the duration of the loan, and the interest they are paying for getting it.
7. Payment Tenure: This loan will be consolidated into just one single loan, and you will have to pay it per the terms given by the source. You will have only one due date every once in a while as per the loan conditions, which can be monthly, half-yearly, or annually.

It sounds easy when we are just typing this, but it's not. These debts are tough to get, and most people cannot get them due to a bad credit history, but for those who do, they are an excellent chance to reduce their debt pressure if used wisely.

An Example of Debt Consolidation

To fully understand the concept, we'll go through the following example.

Suppose a person has a car and property loan, along with payments towards 4-5 credit cards, and the total principal amount payable is $50,000. The cumulative interest at the rate of 27.6% on the total debt amounts to another $13,800 in interest.

The creditor then applies for one consolidated loan of $65,000, and he has only one EMI, followed by 6-7 EMIs and bills.

Another possibility can lead to that the creditor could be eligible for lowered interest rates with lower monthly payments, which could effectively reduce the total liabilities to $52,000.

The interest rate could be reduced to 12%, with a monthly payment of $4334 and interest of $6,240 instead of $13,800.

Types of Debt Consolidation Loans

The debt consolidation loans industry boomed recently due to an unfortunate event in human history: the COVID-19 pandemic.

The sudden rise in medical emergencies, the unemployment rate, and other factors contributed to the boom. People didn't have money for medical and regular household expenses, so they started defaulting on their EMIs, credit card bills, and other bills, which made them bankrupt.

Most commonly, debt consolidation loans are divided into two types: non-secured loans and secured loans.

Non-Secure Loans

In simple words, non-secured loans are loans given by banks or Non-Bank Financial Companies (NBFC) to people without asking for any securities in return, which means people do not have any collateral or property on behalf of the loan.

These loans are generally given to those with good credit histories, and banks trust that they will pay them back without any problems. They are also small amounts.

Generally, banks do not give this type of consolidation loans because there is a huge chance of these loans becoming NPA (non-performing assets), so they are only offered to highly trusted people.

Secured Loans

Banks' loans are secured by collateral, so if a person cannot pay the loan in the future and becomes an NPA, the banks can recover their money from the collateral.

Generally, the amount given as a law is 50 to 60% of the collateral offered by the person to the bank while taking these loans so that the bank can earn money from it and not lose money.

Usually, banks give this type of loan because it is more secure for banks to provide them with this instant of non-secured loans. Moreover, the bank can recover money in the worst scenario.

These loans are categorized based on collateral, but depending on the individual taking them, they can be used for many purposes, such as student loans, mortgage loans, or credit card loans.

Other Types Of Loans

Apart from secured and unsecured loans available to the general public, there are few more options available to which people can resort to:

1. Personal Loans: These types of loans can be mentioned under unsecured loans. Banks provide a lump sum amount to the borrower, which can be utilized for any purpose the borrower wishes for. Payments are made monthly with interest.
2. Credit Cards: Credit cards can also help greatly reduce overall debt when the interest on them is low. However, great care should be taken when using a credit card to set off loans since they can carry expensive fees.
3. Home Equity Loans: Also known as HEL, this is the type of loan where you can utilize the equity in your home as collateral to borrow money. Equity here can be defined as the worth the property currently holds minus any mortgage payable.
4. Student Loans: The Federal Direct Loan Program includes direct loan consolidation for people with student loans. The interest rates here are the weighted average of all the interest rates and can encourage monthly payments.

Debt Consolidation Advantages

There are some advantages that a person can consider if they are thinking of taking it and why it benefits them. To answer that, some points of support are given below:

Repay Debt Early

One of the biggest advantages of this type of loan is that it helps pay the already-taken debt early by consolidating different debts into one, huge long-term debt. By taking this, you will be able to pay your debt more early than in the maturity period.

Also, lower interest rates provided by the bank or any other lender can also prove to be beneficial in terms of paying debts early (especially, if the interest and interest rates on all the debts were particularly high). 

Once you have taken up consolidation, it will cover all of your previous loans, including your house loans, mortgages, any credit card payments, student loans, and even any other outstanding financial obligations.

Simplify Finance

It has been simplifying finance for normal people. It helps them manage their liabilities by decreasing the number of loans to a single loan with a single due date at a particular time, as per the instructions. 

It allows people to reduce their tension regarding the frequent due date payments for each loan and makes it easier to manage their loans by combining them into one long-term loan.

People prefer this because it gives them flexibility and convenience and releases all the tension about the inability to pay payments.

Having A Fixed Repayment

Every loan a person takes has repayment policies, EMIs, and ways to pay their loan. But by taking this type of loan, if the repayment of the loan is fixed, you do not need to track many but one.

It means that by taking these types of loans, you will have to pay for one loan, not all the loans you have taken, which reduces the person's time and effort and is also peaceful for the person's mind.

It becomes much easier to track it when you need to track only one loan instead of many loans, which is stressful as you need to remember all the due dates of the loans taken respectively.

Boost Credit

Being able to pay loans and debts are the right time can help in the increment of your credit score, increasing your creditworthiness and credibility in front of banks.

It increases a person's credibility and goodwill as a borrower in front of the banks, which increases the person's credit score as they are taking the long-term loan and paying the installment before or on the due date.

It contributes to this by assessing the ability to pay all outstanding debts and increasing the debt-to-income ratio.

Debt Consolidation Disadvantages

After knowing all about it, including what this process is, how it works, its advantages, and the many types of these loans, you will ask me why most people do not take it or apply for it.

Some of the reasons why people do not consider taking this and the disadvantages of it are below so that you will know both sides of the coin:

Debt Isn't Gone

One of the primary considerations under debt consolidation is the existence of debt. It would be wrong to assume there will be no debt for them to clear, but people need to understand that there is a difference between clearing the debt and consolidating the debt.

Taking up a debt consolidation loan does not amount to the elimination of debt, rather the reality is that all of your debt from different sources has been transferred to a single long-term loan, and you have to pay this to eliminate all debt.

The person will be responsible to only one person or source from which the person has taken the loan.

High-Interest Rate

Sometimes, a person who takes these types of loans because of his bad credit history and lack of credibility ends up getting a loan with higher interest, which is a bigger concern for them.

This generally happens to people with a credit history and those currently unable to pay their loans due to financial issues. There is a higher risk, so the bank charges more interest.

Long Duration Of Payments

As we all know, these loans are long-term loans mentioned earlier in this article only, meaning the duration of these loans is mostly 10 to 20 years, which is a lot of time.

It also means that you need to pay them their EMIs regularly with interest, so if you calculate wisely, you will find out that the interest you are giving them is more when it comes to the amount.

The high interest you pay on these types of loans, combined with the long payment tenures, can generally be considered exploitative. Whether the interest rate is higher or lower. Still, due to the duration of the loan, you will end up paying more interest.

Collateral Requirements

Some of these loans are secured loans, which means you need to give some collateral before taking this loan. This is a more significant concern because most people do not possess that much collateral to offer as security.

It is understood that debt consolidation loans are huge, and most commoners do not hold huge amounts of assets that can be used as collateral. When only a few assets are used as collateral, the accessibility of the consolidating debt loan also becomes limited.

It is challenging to get the required amount because of the secured loan policy followed by the bank to make these loans feel secure while giving you the loans.

This results in fewer people taking these loans because they could not satisfy the collateral demand for getting a loan from a bank for the required amount the people want.

Free Resources

To continue learning and advancing your career, check out these additional helpful WSO resources:

• Calculating Yield on Debt

• Cost of Debt

• Debt Refinancing

• Market Value of Debt

• Venture Debt