Debt consolidation is a form of debt management which consists of taking out one loan to pay off others. In some cases, this may entail taking out one unsecured loan in order to pay off other unsecured loans (such as credit cards).
Another option is a home equity loan whereby a borrower refinances his or her home and uses the proceeds to pay off other debts. Since the home equity loan is a secured mortgage, the interest rate is much lower than that of an unsecured loan.
Instead of making several monthly payments at a higher interest rate, the borrower is then able to make one smaller monthly payment and repay the loan over a longer period of time. While the original debt still exists, a debt consolidation loan typically results in a lower overall monthly expense, allowing the borrower to make payments more easily.
A third choice is to transfer debt from several credit cards to one credit card with a lower interest rate. Credit card companies continuously send out offers for credit cards with low initial interest rates (sometimes even 0% for the first several months), encouraging potential customers to transfer their other credit card balances to the new card.
Finding a debt consolidation loan
Most banks and credit unions offer options for debt consolidation, either as unsecured loans, home equity loans or lines of credit. Other types of lenders are also taking advantage of the current credit situation and offering debt consolidation loans. These companies use widespread advertising to attract customers looking for lower monthly payments; their offers arrive constantly via mail, email, or television and radio commercials.
When searching for a debt consolidation loan, it is wise to shop around for the best interest rate and repayment terms. Particularly in the case of unsecured loans, borrowers must calculate the total monthly payments on their current debt to be sure that the new loan does, in fact, put them in a better position. Likewise, it is important to read all loan terms carefully; some loans offer a low interest rate initially which increases over time.
Advantages of debt consolidation
One advantage of debt consolidation is, as stated before, that the new loan or line of credit typically has a lower interest rate and requires a smaller monthly payment. Disciplined borrowers who have budgeted their monthly expenses and who adhere strictly to a plan of repaying their debt may find that this is the right solution for them.
Another plus is that interest on home equity loans is tax deductible, resulting in additional savings for homeowners.
Disadvantages of debt consolidation
There are a number of disadvantages to debt consolidation, as well. When using one loan (or credit card or line of credit) to pay off other loans, the original debt is simply being moved, not erased. While the lowered monthly payment may initially ease some of the borrower's expenses, there are dangers to this method.
With an unsecured loan or credit card, the interest rate typically increases after a grace period. If payments are not made on time, the interest rate is likely to skyrocket, putting borrowers in the same position, or worse, than when they took out the loan.
In the case of a home equity loan, all outstanding debts are tied to the mortgage. Borrowers then stand the chance of losing their homes should they fall behind on their payments.
Unfortunately, statistics have shown that most borrowers who enter into debt consolidation loans end up deeper in debt within two years. With lower monthly expenses, borrowers often feel confident incurring even more debt, rather than following the original plan of paying off their existing obligations.
Other options
While debt consolidation may work well for certain consumers, there are other options available for debt management. Credit counseling companies mediate between borrowers and creditors to reduce monthly payment amounts without incurring further loans. In some cases, consumers may work directly with creditors to settle their debts at a lower rate rather than defaulting; some borrowers may find that their only option is bankruptcy.
Borrowers looking into debt management should investigate all the possibilities carefully to find the solution that works best for their circumstances.
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