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.[1]
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, 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.[2] Credit cards can carry a much larger interest rate than even anunsecured 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.[2] 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.
Student loan consolidation
In the United States, federal student loans are consolidated somewhat differently than in the UK, as federal student loans are guaranteed by the U.S. government.
[edit]United States
In a federal student loan consolidation, existing loans are purchased by 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.[3]
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.[citation needed]
[edit]United Kingdom
In the UK Student Loan entitlements are guaranteed, and are recovered using a means-tested system from the students future income. Student Loans in the UK can not be included inBankruptcy, but do not affect a persons credit rating because the repayments are recovered from the students future salary at source by the employer before any income is paid, similar to Income Tax and National Insurance contributions. Many students however, are struggling with debt well after their courses have finished
As of June 2011, total personal debt in the UK stood at £1,451bn. The annual growth rate remained at 0.8%.[4]
[edit]Concerns
In recent years, reports in the media have raised concerns about the use of consolidation loans.[5] 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. Debt consolidation sometimes only treats the symptoms of debt and does not address the root problem. In some circumstances, snowballing debt may be a better solution.
[edit]Alternatives
Other options available to overburdened debtors include credit counseling, debt settlement and personal bankruptcy. Some consolidation lenders will renegotiate with the creditors on the debtor's behalf, as a credit counselor does.
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