Loans description
Debt consolidation entails taking
out one loan to pay off many others. This is often done
to secure a lower interest rate, secure a fixed interest
rate or for the convenience of servicing only one loan.
Debt consolidation can simply be from a number of
unsecured loans into another unsecured loan, but more
often it involves a secured loan against an asset that
serves as collateral, which is most commonly a house (in
this case a mortgage is secured against the house.) The
collateralization of the loan allows a lower interest
rate than without it, because by collateralizing, the
asset owner agrees to allow the forced sale
(foreclosure) of the asset to pay back the loan. The
risk to the lender is reduced so the interest rate
offered is lower.
Sometimes, debt consolidation companies can discount the
amount of the loan. When the debtor is in danger of
bankruptcy, the debt consolidator will buy the loan at a
discount. A prudent debtor can shop around for
consolidators 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, 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.
Because of the theoretical advantage that debt
consolidation offers a consumer that has high interest
debt balances, companies can take advantage of that
benefit of refinancing to charge very high fees in the
debt consolidation loan. Sometimes these fees are near
the state maximum for mortgage fees. In addition, some
unscrupulous companies will knowingly wait until a
client has backed themselves into a corner and must
refinance in order to consolidate and pay off bills that
they are behind on the payments. If the client does not
refinance they may lose their house, so they are willing
to pay any allowable fee to complete the debt
consolidation. In some cases the situation is that the
client does not have enough time to shop for another
lender with lower fees and may not even be fully aware
of them. This practice is known as predatory lending.
Certainly many, if not most, debt consolidation
transactions do not involve predatory lending.
Student loan consolidation
In the United States, federal student loans are
consolidated somewhat differently, as federal student
loans are guaranteed by the U.S. government. In a
federal student loan consolidation, existing loans are
purchased and closed by a loan consolidation company or
by the Department of Education (depending on what type
of federal student loan the borrower holds). Interest
rates for the consolidation are based on that year's
student loan rate, which is in turn based on the 91-day
Treasury bill rate at the last auction in May of each
calendar year.
Student loan rates can fluctuate from the current low of
4.70% to a maximum of 8.25% for federal Stafford loans,
9% for PLUS loans. The current consolidation program
allows students to consolidate once with a private
lender, and reconsolidate again only with the Department
of Education. Upon consolidation, a fixed interest rate
is set based on the then-current interest rate.
Reconsolidating does not change that rate. If the
student combines loans of different types and rates into
one new consolidation loan, a weighted average
calculation will establish the appropriate rate based on
the then-current interest rates of the different loans
being consolidated together.
Federal student loan consolidation is often referred to
as refinancing, which is incorrect because the loan
rates are not changed, merely locked in. Unlike private
sector debt consolidation, student loan consolidation
does not incur any fees for the borrower; private
companies make money on student loan consolidation by
reaping subsidies from the federal government.
Student loan consolidation can be beneficial to
students' credit rating, but it's important to note that
not all federal student loan consolidation companies
report their loans to all credit bureaus; SLM
Corporation (formerly Sallie Mae) does not report to
Experian or Transunion, which means that students will
have differing credit scores at Equifax, Transunion, and
Experian.
Concerns of consolidation
In recent years, reports in the media have raised
concerns about the use of consolidation loans. The worry
is that many people are tempted to consolidate unsecured
debt into secured debt, usually secured against their
home. Although the monthly payments can often be lower,
the total amount repaid is often significantly higher
due to the long period of the loan. In some
circumstances, snowballing debt may be a better
solution.
There are other alternatives to a debt consolidation
loan, where unsecured debt is not "shifted" to secured
debt, but is eliminated through a settlement or payment
plan. Debt consolidation can be confusing for many
people, so it is helpful to learn about all of your
options, and sometimes with the help of an advisor. |
