Debt consolidation
Encyclopedia
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
, 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 card
s 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.
s are consolidated somewhat differently than in the UK, as federal student loans are guaranteed by the U.S. government.
, 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.
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.
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 in Bankruptcy
, 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
The level of personal debt in the UK has also risen astonishingly in recent years:
"Total UK personal debt at the end of February 2008 stood at £1,421bn. The growth rate increased to 8.9% for the previous 12 months which equates to an increase of £111bn.
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.
, debt settlement
and personal bankruptcy
. Some consolidation lenders will renegotiate with the creditors on the debtor's behalf, as a credit counselor does.
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
to pay off many others. This is often done to secure a lower interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
, secure a fixed interest
Fixed interest
A fixed interest rate loan is a loan where the interest rate doesn't fluctuate during the fixed rate period of the loan. This allows the borrower to accurately predict their future payments...
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
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
, most commonly a house. In this case, a mortgage
Mortgage loan
A mortgage loan is a loan secured by real property through the use of a mortgage note which evidences the existence of the loan and the encumbrance of that realty through the granting of a mortgage which secures the loan...
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
Foreclosure
Foreclosure is the legal process by which a mortgage lender , or other lien holder, obtains a termination of a mortgage borrower 's equitable right of redemption, either by court order or by operation of law...
) of the asset to pay back the loan. The risk
Risk
Risk is the potential that a chosen action or activity will lead to a loss . The notion implies that a choice having an influence on the outcome exists . Potential losses themselves may also be called "risks"...
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
Debtor
A debtor is an entity that owes a debt to someone else. The entity may be an individual, a firm, a government, a company or other legal person. The counterparty is called a creditor...
is in danger of bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
, 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 card debt
Credit card debt is an example of unsecured consumer debt, accessed through credit cards.Debt results when a client of a credit card company purchases an item or service through the card system...
. Credit card
Credit card
A credit card is a small plastic card issued to users as a system of payment. It allows its holder to buy goods and services based on the holder's promise to pay for these goods and services...
s can carry a much larger interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
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
Secured loan
A secured loan is a loan in which the borrower pledges some asset as collateral for the loan, which then becomes a secured debt owed to the creditor who gives the loan...
using their property as collateral
Collateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
. 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 loanStudent loan
A student loan is designed to help students pay for university tuition, books, and living expenses. It may differ from other types of loans in that the interest rate may be substantially lower and the repayment schedule may be deferred while the student is still in education...
s are consolidated somewhat differently than in the UK, as federal student loans are guaranteed by the U.S. government.
United States
In a federal student loan consolidationFederal student loan consolidation
In the United States the Federal Direct Student Loan Program include consolidation loans that allow students to consolidate Stafford Loans, PLUS Loans, and Federal Perkins Loans into one single debt. This results in reduced monthly repayments and a longer term for the loan...
, existing loans are purchased by the Department of Education
United States Department of Education
The United States Department of Education, also referred to as ED or the ED for Education Department, is a Cabinet-level department of the United States government...
. 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.
United Kingdom
In the UK Student LoanStudent loan
A student loan is designed to help students pay for university tuition, books, and living expenses. It may differ from other types of loans in that the interest rate may be substantially lower and the repayment schedule may be deferred while the student is still in education...
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 in Bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
, 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
Income tax
An income tax is a tax levied on the income of individuals or businesses . Various income tax systems exist, with varying degrees of tax incidence. Income taxation can be progressive, proportional, or regressive. When the tax is levied on the income of companies, it is often called a corporate...
and National Insurance
National Insurance
National Insurance in the United Kingdom was initially a contributory system of insurance against illness and unemployment, and later also provided retirement pensions and other benefits...
contributions. Many students however, are struggling with debt
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
well after their courses have finished
The level of personal debt in the UK has also risen astonishingly in recent years:
"Total UK personal debt at the end of February 2008 stood at £1,421bn. The growth rate increased to 8.9% for the previous 12 months which equates to an increase of £111bn.
Concerns
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 debtUnsecured debt
In finance, unsecured debt refers to any type of debt or general obligation that is not collateralised by a lien on specific assets of the borrower in the case of a bankruptcy or liquidation or failure to meet the terms for repayment....
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
Debt-snowball method
The debt-snowball method is a debt reduction strategy, whereby one who owes on more than one account pays off the accounts starting with the smallest balances first while paying the minimum on larger debts...
may be a better solution.
Alternatives
Other options available to overburdened debtors include credit counselingCredit counseling
Credit counseling is a process that involves offering education to consumers about how to avoid incurring debts that cannot be repaid through establishing an effective Debt Management Plan and Budget...
, debt settlement
Debt settlement
Debt settlement, also known as debt arbitration, debt negotiation or credit settlement, is an approach to debt reduction in which the debtor and creditor agree on a reduced balance that will be regarded as payment in full....
and personal bankruptcy
Personal bankruptcy
Personal bankruptcy is a procedure which, in certain jurisdictions, allows an individual to declare bankruptcy. In other jurisdictions, bankruptcies are reserved for corporations.-Canada:...
. Some consolidation lenders will renegotiate with the creditors on the debtor's behalf, as a credit counselor does.
External links
- Federal Direct Consolidation Loans Information Center of the U.S. Government
- William D. Ford Federal Direct Loan Program
- Federal Trade Commission - Debt Consolidation
- UK Financial Services Authority impartial information about extending your borrowing
- Debt Settlement Advice from Consumer Reports magazine