What is Debt Consolidation?
Debt consolidation is a process that allows qualified consumers to take out a new loan that pays off most or all of their outstanding debt. By aggregating all of the individual debts and paying them off, the new debt consolidation loan might become the only unsecured debt to which a consumer makes payments.
Debt Consolidation loans usually come with interest rates considerably lower than those loans that consumers are currently saddled with and are trying to pay off, usually consisting of car loans, personal loans, student loans, and high interest rate credit cards.
By taking out a debt consolidation loan, consumers can potentially save thousands of dollars over the life of the loan, since debt consolidation programs offer relatively low annual percentage rates on their loans making the savings substantial and immediate.
Debt Consolidation: Theory vs Practice
Essentially, with debt consolidation, a consumer seeks out a company that will help them get a loan large enough to pay off all their outstanding debts, effectively reducing the number of lenders to which they owe money from several to just one. This can be a formidable way for people to get a handle on their finances because the new loan amount, while obviously sizable, may come with a lower interest rate than they were paying on some or all of their outstanding balances, thus making the monthly outlay more affordable. It also has the added benefit of simplifying payments.
As an example, let’s say a consumer owes $10,000 total to five different lenders, three of which are credit cards. By consolidating that loan into one balance, they will still owe the $10,000 so the new balance is unchanged, unless there is a fee associated with the new loan. Since debt consolidation loans are generally offered with the benefit of lower interest rates than credit cards, the lower interest rate applied to the sum the same sum of $10,000 should result in reduction of the total amount that will be needed to retire the debt. So, while the total debt owed has not decreased, a lower rate of interest owed on the total sum can yield a significant savings benefit over time. Also, budgeting for the new payment is now simpler as there is only one payment to send off each month.
The pros of debt consolidation discussed above are obvious, but there are some cons as well. For example, it may be difficult to qualify for this option, especially for borrowers who are uncomfortable with the idea of collateralizing the loan. In addition, participation in this type of program will likely reflect on the borrower’s credit report and could result in the borrower looking less attractive to lenders in the future. Not only is it generally detrimental to one’s credit score to close open accounts such as credit cards, owing the majority of one’s obligations to a single creditor is perceived as an increased credit risk. This might negatively impact the borrower’s credit scores and their ability to gain access to additional lines of credit.
There is another inherent and usually overlooked challenge associated with debt consolidation loans. All too often borrowers will amass some credit card debt and as the debt balances grow, they start to feel the pinch of increasing monthly payments. Eventually, these same borrowers might respond to an attractive offer from a bank to consolidate their credit card balances for a lower rate than what they are currently paying. Good deal, right? Perhaps, but only if we’re working on the assumption that the borrowers with their new found low interest loan will curb their spending habits and credit-based spending will come to a halt. It’s so commonly the case that a borrower will find themselves feeling more at ease to continue the same spending patterns that got them into debt in the first place. Unless a borrower exercises great discipline to adjust their spending habits, the monthly savings afforded by the new loan serve to give consumers the false sense that they have reduced their debt load and can therefore spend more freely. This is how folks eventually find themselves in deep over their heads – instead of managing the debt itself, they think they need only manage the payments.
To summarize, in theory, if a consumer has good enough credit that they can qualify for a debt consolidation loan large enough to engulf all or most of the higher interest debt they carry, they can essentially save thousands in interest especially if they apply the monthly savings back to the consolidation loan to hasten the pay-off.
However, in practice, financial discipline on the part of the consumer is paramount if a method such as debt consolidation is to be an actual solution for debt riddance. When debt consolidation loans are looked upon as an easy way out, they are all too often a vehicle for expanding – not contracting – the consumer’s debt load and eventually these consumers will be looking for more serious help in the form of debt settlement and sometimes even bankruptcy.