How Does Debt Consolidation Work?
Debt consolidation means taking out one big loan to pay off all the other
debts. Often this is done to secure a lower interest rate, or obtain a
fixed interest rate or for the simplicity of having only one loan instead
of multiple loans. Debt consolidation can simply be moving several
unsecured loans into another unsecured loan, but it can often mean making
a secured loan against an asset that will serve as collateral. Often, the
collateral is a home and a mortgage is secured against it. By securing the
loan with an asset, it allows for a lower interest rate than without it.
In case of default on the loan, the asset owner agrees to allow the
mandatory sale of the asset to pay back the loan balance. The risk to the
lender is less, so the available interest rate is lower.
Debt consolidation companies can discount the amount of the loan at
their own discretion. If the debtor is facing bankruptcy, a debt
consolidator will purchase the loan at a discount. A sharp debtor can look
for a consolidator who will pass along some of the savings. Consolidation
can affect the ability of the debtor to discharge debts in bankruptcy, so
the decision to consolidate must be weighed carefully.
Debt Consolidation is often advisable in theory when someone is paying
credit card debt. Credit cards can carry a much larger interest rate than
even an unsecured loan from a bank. Debtors with property such as a home
or car may get a lower rate through a secured loan using their property as
collateral. Then the total interest and the total cash flow paid towards
the debt is lower, allowing the debt to be paid off sooner, thus incurring
less interest. In practice, many people are in credit card debt because
they spend more than their income. If that habit continues, the
consolidation will not benefit them much because they will simply increase
their credit card balances again.
Sometimes companies will take advantage of the debt consolidation
process by refinancing to charge very high interest fees in the debt
consolidation loan. These fees can be near the maximum for mortgage fees.
Other unethical companies will wait until clients are desperate and have
to refinance in order to pay off bills (i.e. when they are behind on their
payments). If the client fails to refinance they can lose their home, so
they are basically forced to pay any allowable fee to complete the debt
consolidation. This highlights the need for consumers to find a reliable
company they can trust, with a good reputation for debt consolidation.
