Debt consolidation is the process of converting all of one’s individual debt repayments into one loan with a single repayment. It entails borrowing enough money from one lender to pay off several other existing debts. When one consolidates loans, they make only one loan repayment to the new lender which is usually less than the total amount paid to the individual loans. An individual, however, incurs more finance costs during consolidation.
Before considering consolidation, one should look at all the other options available for debt management including lowering expenses or raising income, financial counselling, or calling the creditors to discuss restructuring the loans to make the monthly repayments more manageable.
Types of debt consolidation loans
Debt consolidation loans can broadly be categorized into two; secured and unsecured. Secured loans are those that are backed up by an asset belonging to the borrower which is used as the loan collateral. The unsecured loan, which is more traditional, does not have collateral and is harder to obtain. The unsecured loans have higher interest rates and lower loan limits for borrowing.
Options available for debt consolidation
There are several options for debt consolidation including;
1. Transferring all existing loans into one credit card that has a lower interest rate. This is referred to as loan consolidation and usually has a fee, and the offered rate may only last for some time.
2. Converting existing loans into a home equity loan. With this option, an individual provides security and usually borrows up to a certain percentage of the value of the proposed security.
3. Some creditors offer loan products designed specifically for debt consolidation. These loans, however, have interest rates higher than normal home equity loans and may require collateral depending on the loan amount being sought.
4. There are debt consolidation companies that offer consolidation of the monthly loan repayments instead of loan consolidation. In this option, an individual pays the sum of all their monthly repayments to the company, and the company is responsible for making the payments to the creditors on the dates they fall due.
It is important to check the following information before choosing your lender for consolidation; the costs apart from the interest rate that you will incur, the annual percentage rate (APR), the monthly repayments, the tenure, penalties in case of default or late payment.
Advantages of debt consolidation
1. After consolidation, the monthly repayments are usually substantially lower compared to the combined payments of the different loans.
2. Consolidation loans offer lower interest rates.
3. Loan consolidation makes repayment easier and more organized.
Disadvantages of debt consolidation
1. An individual may risk foreclosure on their home following defaults in repayments on the home equity option of debt consolidation.
2. A longer tenure after debt consolidation may result in payment of higher total interest amounts over time even if the monthly repayments are less.
3. Longer tenures offered in consolidation means an individual remains in debt for a longer period.
Replacing different multiple rate loans with one loan with a single monthly repayment simplifies life. However, this should not be done only for convenience unless one is overwhelmed by several loan repayment dates.
It is important to note that debt consolidation does not erase debt, but only transfers the debt to a different lender or a different loan type. The best option, if practical, would be to consider debt settlement as it reduces one’s debt obligations instead of reducing the number of lenders.