Debt Consolidation Loan

How Does It Work?

The term “consolidation” simply means combining separate items into one unit. A consolidation loan, then, helps consumers combine many small debts into one larger loan. If done properly, a consolidation loan can help savings-challenged individuals cut their payments and reduce their debt drastically.

Consolidation loans work because the lender effectively pays off all the small loans and rolls that lump sum payment into one large loan for the consumer, typically with a lower interest rate than multiple credit cards, car loans, medical bills, or other financing. Rather than needing to manage many different bills, the consumer can make a single payment, thereby saving time and frustration as well as potentially significant fees.

A consolidation loan isn’t without cost, however. In order to secure the loan – guaranteeing to the lender that you will not default on the loan payments – you typically need to offer substantial collateral, usually a house. Home equity loans and second mortgages are types of consolidation loans, though some consumers may be able to offer an expensive car or other property as collateral.

If, however, they are unable to meet their loan payments, the lender has the right to seize that collateral. Borrowers should also carefully investigate fees and late payment or prepayment penalties before signing up for a loan.

Benefits of a Consolidation Loan

There are many benefits to securing a debt consolidation loan, including:

• Lower payments because the overall interest rate of the loan is lower than the combined rates of many different payments.
• Less hassle from creditors because the lender paid them off when the loan was secured.
• Easier money management by making a single payment instead of many small ones.
• Locking in a low fixed interest rate with consolidation can be a much better deal than variable interest rates on different bills, particularly if interest rates are rising. This is especially true for student consolidation loans, which are offered by the federal government to help graduates combine all their variable loans into one fixed rate.
• Paying off many small accounts can help consumers close those accounts and begin to build a better credit record even as they continue to pay on the loan.

At the same time, consolidation loans are not right for everyone.

Should I Get a Consolidation Loan?

Deciding to get a debt consolidation loan is not as simple as counting up payments and deciding that it would be easier to write one check instead of several. Before getting a consolidation loan, consumers should first add up the balances and interest rates on their current debts and compare them to the cost of a new loan, including administrative fees and initiation fees. A new loan may end up costing more than paying off accounts independently.

Furthermore, because having many debts lowers an individual’s credit rating, most consumers will not qualify for the lowest rates on consolidation loans, whereas their existing debts may have lower interest rates already.

Consumers who are close to paying off at least some of their debts should avoid a consolidation loan – the initial fees to set up the loan will likely cost more than the potential savings, and taking on a new loan will penalize their credit history. In many cases, responsible budgeting and conscientiously working toward a debt-free lifestyle will be a better option.

Beyond a Debt Consolidation Loan

While a consolidation loan can indeed help consumers manage their payments, the extra loan will prove worthless if they keep the same spendthrift habits that led them to acquire multiple debts in the first place. Once you have obtained one debt consolidation loan, you will find it far more difficult to acquire another in the future if the same situation arises: you will already have used your collateral for the first loan.

Changing poor money management habits is the key to working with a consolidation loan to ensure a more budget-conscious future. Once you are paying on your consolidation loan, it is time to:

• Cancel unnecessary accounts for store credit cards, gas cards, or other credit lines that only serve as temptation for more spending.
• Develop a budget to track necessary spending and luxuries so you know where to trim expenses.
• Investigate cheaper service providers for Internet access, cell phones, cable television, car insurance, and other bills.
• Avoid racking up new debt with other credit cards or unnecessary purchases.
• Develop a savings plan to grow a cash reserve for unexpected expenses or large purchases.

By learning new frugal habits in addition to securing a debt consolidation loan, consumers can greatly reduce their debt both today and tomorrow. A consolidation loan may not be the sole solution to a financial crisis, but it can be a tool to help avert more crises in the future.

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