With the economic downturn still going strong, an increasing number of individuals find themselves threatened by the looming, ever-larger pressure of outstanding personal debt. Whether it’s credit card debt, student loans contracted back in the age when credit was plentiful and easily accessible, larger-than-life medical bills or any other type of loans, indebtedness is among the grizzly realities brought about by the crisis – not to mention a source of stress that is draining consumers’ optimism and confidence in a better, more stable economic future. The US Federal Reserve has made it public that in the US, at the end of 2008 revolving debt amounted to no less than USD 943 billion, most of which is generated by outstanding credit card balances. The question is – is there anything we can do to achieve at least some type of debt relief? Of course, there are extreme solutions – filing for bankruptcy, for example, is the most radical possibility out there – however, before making such a call it’s important to consider other options – such as debt settlement or else debt consolidation.
In all fairness, both debt settlement and especially debt consolidation are controversial topics. As far as debt consolidation and debt consolidation loans are concerned, financial advisors either love (and thus wholeheartedly recommend) them, or else can’t find words strong enough to warn you about the dangers to which you expose yourself by taking out a debt consolidation loan. The truth, as always, lies somewhere in the middle, and has to do with understanding the particular financial context that is valid for every individual consumer. Also, some consumers who are deep in debt may very agree to take out a secure debt consolidation loan, even if this means borrowing against personal property, such as their house or car. But before we delve further into the intricacies of debt consolidation, it’s best to ask ourselves what is the definition of debt consolidation.
In essence, debt consolidation means taking out one big loan to pay off the smaller loans which you have already contracted. Think of it this way: if you have, for example, five loans with different lenders, a debt consolidation loan will allow you to pay off the five existing loans and instead deal with a single, larger monthly payment. The main reason to take out a debt consolidation loan is to achieve a lower interest rate or else a fixed interest rate for the outstanding balance. There are several types of debt consolidation options out there, but before you effectively consider each one, there are a number of issues you should be aware of, so as to make sure you correctly understand the basic principles behind debt consolidation.
The debt consolidation
First of all, however enticingly it may be advertised to you by (usually unethical) marketing campaigns, debt consolidation is not a magic solution that will get you out of trouble with your creditors with little stress or personal involvement. As obvious as it may sound, we feel the need to state this once again: debt consolidation does not write off an individual’s outstanding debt, not does it lower it. The only measure that effectively writes off some or all of your debt is bankruptcy filed under Chapter 7, while the only means to convince a creditor to accept less money from you than originally owed is to engage in the so-called debt settlement - a debt relief strategy that involves a creditor reaching an agreement with a debtor and accepting to be paid a reduced balance (in other words, an amount lower than the rightfully owed sum) that will be considered as payment in full for the initial debt. Therefore, if your present financial standing is such that you deem yourself unable to make any type of repayments for your outstanding balances (not even smaller ones spread out over a lengthier time period, like it will be the case if you take out a debt consolidation loan) then perhaps debt consolidation is not the right path to take, and you should consider other options – such as the previously mentioned debt settlement or even filing for personal bankruptcy.
So, now that we have established that debt consolidation is not a magic trick that makes debt magically go away, we can move on to the following aspect you should be aware of in connection with debt consolidation loans: effectively, such loans don’t do much in terms of actually getting you out of debt faster, lowering your payments or saving you any money at all – except in very rare circumstances. When you consolidate debt, what basically happens is that you stack smaller, separate piles of debt into one big pile. However, all you actually do is move your debt from one lender to another, without actually making any advances towards lowering the outstanding balance. One thing a debt consolidation loan provider will promise you is lower monthly payments. But do the math: if you basically have to repay the same amount of money as before and yet you’re offered the chance to pay less on a monthly basis, this can only mean you will need a more time to complete the repayment – and therefore you’ll be in debt for months or years longer than if you’d just paid the original bills. However, if the alternative to this is bankruptcy, or else debt settlement (which also significantly trashes your credit score), being in debt longer may sound like a good alternative.
Now that we’ve covered the basics, we can move on to discussing the types of debt consolidation loans out there. One important thing you should know is that there are two basic types of debt – secured and unsecured. As such, debt consolidation loans can also be divided into the same categories – secured and unsecured debt consolidation loans. Secured debt includes loans which are backed by collaterals a house or a car. Such debt cannot be settled, as by definition the borrower has agreed to have his car or house taken away if he cannot repay the loan. Unsecured debt refers to medical bills, student loans and credit card debt. Out of these, credit card debt can be both settled and consolidated. Also remember that at all times creditors (credit card companies, banks, etc.) would prefer to reach some form of agreement, whether it’s debt consolidation or debt settlement, in order to get at least some of their money back rather than go ahead and sue the debtor or else risk the debtor filing for bankruptcy and having his debts discharged.
In debt consolidation, one way to go is to move from having several unsecured loans to taking out yet another unsecured loan. Such unsecured loans usually carry high interest rates, due to the fact that no guarantee is offered by the debtor. Usually, getting a debt consolidation loan without owning a home might prove problematic, as lenders will want some form of guarantee that they will get their money back in case you default. Therefore, the most common types of debt consolidation loans involve moving from several unsecured loans to a secured debt consolidation loan backed with assets serving as collateral – usually the borrower’s house. Via the so-called “collateralization”, debtors have a chance to be offered a lower interest rate for the new loan. The reasoning is simple: once they have backed the loan with their home, borrowers’ level of creditworthiness in the eyes of the lender has increased, as the latter knows that in case of default, it can repossess the property in question, sell it and recover the amount of the loan. The risk to the lender is lowered so the offered interest rate is lower, however the risks undertaken by the borrowers increase exponentially.
The debt consolidation
On very rare occasions, debt consolidation services providers can discount the amount of the loan they offer the borrower. This only occurs when the latter is facing the very real danger of filing for bankruptcy. The reasoning is simple here as well: despite appearances, a lender is always willing to make some level of compromise in order to recover at least part of the amounts it is owed, rather than take the debtor to court and pay significant legal expenses. If however the debtor decides to file for bankruptcy, debt consolidation is a bad idea: consolidation can potentially affect the ability of the debtor to discharge his debts in case of bankruptcy, therefore the decision to consolidate must be carefully considered.
Yet another type of debt consolidation is the so-called credit card debt consolidation. This essentially consists of a credit card balance transfer – with the sole exception that instead of transferring your outstanding balance from one credit card account to a 0% APR card, you transfer all your credit card balances onto one card for which lower interest rates are charged. However, the decision to opt for credit card debt consolidation must also be carefully considered. Keep in mind that most credit card issuers will only offer a discounted APR for a strictly pre-defined interval, usually anything between 6 and 15 months, after which they revert to a much higher interest rate, perhaps higher than the one charged on your original credit card balances (prior to the consolidation). Debtors who own a car or a can get discounted interest rates for their cards as well via a secured loan backed by their property (which serves as collateral).
Despite some of its less rosy sides, consumers continue to regard debt consolidation as some type of “miraculous last resort”, which can help them avoid financial ruin by allowing them to “escape” their high interest debt balances with lower-interest ones. This attitude, which we have tried to correct via the information provided in this article, places debt consolidation services providers in a very favorable position with consumers, a position which some of them sometimes abuse by taking advantage of individuals’ distress and hitting them with very high fees for the “privilege” of refinancing their existing loans. Also, some debt consolidation companies sometimes knowingly wait until a client is in a very delicate financial position (usually in danger of losing his home unless he takes out a debt consolidation loan), and would pay any amount (even an outrageously high one) to avoid foreclosure. This kind of practice is referred to as predatory lending and is punishable by law. However, consumers should be aware that such practices are normally the exception, not the rule: the majority of debt consolidation agreements are carried out legally, with consumers being granted enough time to weigh their options and chose a lender that best suits their needs.
One question that frequently occurs in connection with debt consolidation practices is – are debt consolidation loans a better options that straight-out loans? One thing we should remember is that going for debt consolidation will most likely enroll you in a debt repayment program, in which the debt consolidation company to which you have signed will get in touch with your creditors and attempt to negotiate more advantageous repayment terms on your behalf, possibly arguing in favor of lowering your late fees and even your interest rates. The monthly payments made by the debtor to the debt consolidation company are dispersed by the latter to the former’s creditors.
As mentioned above, debt consolidation loans are a form of lending that raises numerous concerns. Some experts argue that such loans are essentially useless, as they do not contribute towards effectively lowering a debtor’s outstanding balance but rather shift the debts around, allowing lenders to draw more fees and commissions. The much-praised lower interest rates and lower monthly payments that (sometimes) come with debt consolidation loans are also a double-edged issue, as repaying smaller monthly amounts will only keep consumers indebted for longer time periods. Yet another reason for concern is that an increasing number of consumers show themselves willing to consolidate unsecured debt into secured debt and back debt consolidation loans with their homes without actually being aware that there is a good chance they will lose their property if anything goes bad – and so many things can go bad. Losing one’s job or else an unexpected serious illness can prove disastrous under such circumstances. Debt consolidation is thus seen by some as treating the symptoms of debt rather than the cause of the problem.
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