How to Consolidate
There are several ways consumers can lump debts into a single payment. One method is to consolidate all their credit card payments into one, new credit card—which can be a good idea if the card charges little or no interest for a period. They may also utilize an existing credit card's balance transfer feature (especially if it offers a special promotion on the transaction).
Home equity loans or home equity lines of credit (HELOC) are another form of consolidation sought by some people. Usually, the interest for this type of loan is deductible for taxpayers who itemize their deductions.
There also are several consolidation options available from the federal government for people with student loans.
Understanding Consolidation
Theoretically, debt consolidation is any use of one form of financing to pay off other debts. However, there are specific instruments called debt consolidation loans, offered by creditors as part of a payment plan to borrowers who have difficulty in managing the number or size of their outstanding debts.
Creditors are willing to do this for several reasons, including that it maximizes the likelihood of collecting from a debtor. These loans usually are offered by financial institutions, such as banks and credit unions, but there also are specialized debt-consolidation service companies.
There are two broad types of debt consolidation loans:
1. Secured loans are backed by an asset of the borrower’s, such as a house or a car, that works as collateral for the loan.
2. Unsecured loans such as debt consolidation loans are not backed by assets and can be more difficult to obtain. They also tend to have higher interest rates and lower qualifying amounts.
With either type of loan, the interest rates are still typically lower than the rates charged on credit cards. Also, in most cases, the rates are fixed—meaning they do not vary over the repayment period.
These types of loans don’t erase the original debt; they simply transfer all your loans to a different lender or type of loan. If you need actual debt relief or don't qualify for loans, it may be best to look into a debt settlement rather than, or in conjunction with, a debt consolidation loan. Debt settlement aims to reduce your obligations rather than just reducing the number of creditors. You usually work with a debt-relief organization or credit-counseling service. These organizations do not make actual loans; instead, they try to renegotiate the borrower’s current debts with creditors.
Advantages of Consolidation Loans
Once in place, a debt consolidation plan will stop the collection agencies from calling (assuming the loans they're calling about have been paid off).
There may be a tax break, too. The Internal Revenue Service (IRS) does not allow you to deduct interest on any unsecured debt consolidation loans. If your consolidation loan is secured with an asset, however, you may qualify for a tax deduction. Debt consolidation loan interest payments are often tax-deductible when home equity is involved.
How Debt Consolidation Works
For example, say an individual with three credit cards and a total of $20,000 owing at a 22.99% annual rate compounded monthly needs to pay $1,047.37 a month for 24 months to bring the balances to zero. This works out to $5,136.88 being paid in interest alone over time. If the same individual were to consolidate those credit cards into a lower-interest loan at an 11% annual rate compounded monthly, he or she would need to pay $932.16 a month for 24 months to bring the balance to zero. This works out to $2,371.84 being paid in interest. The monthly savings is $115.21, and over the life of the loan, the amount of savings is $2,765.04.
Even if the monthly payment stays the same, you can still come out ahead by streamlining your loans. Say that you have three credit cards that charge a 28% APR; they are maxed out at $5,000 each and you're spending $250 a month on each card's minimum payment. If you were to pay off each credit card separately, you would be spending $750 per month for 28 months and you would end up paying a total of around $5,441.73 in interest.
However, if you transfer the balances of those three cards into one consolidated loan at a more reasonable 12% interest rate and you continue to repay the loan with the same $750 a month, you'll pay roughly one-third of the interest ($1,820.22), and you will be able to retire your loan five months earlier. This amounts to a total savings of $7,371.51 ($3,750 for payments and $3,621.51 in interest).
| Loan Details | Credit Cards (3) | Consolidation Loan |
|---|---|---|
| Interest Rate | 28% | 12% |
| Payments | $750 | $750 |
| Term | 28 months | 23 months |
| Bills Paid/Month | 3 | 1 |
| Principal | $15,000 ($5,000 * 3) | $15,000 |
| Interest | $5,441.73 ($1,813.91 * 3) | $1,820.22 ($606.74 * 3) |
| Total | $20,441.73 | $16,820.22 |
Of course, borrowers must have the income and creditworthiness necessary to qualify with a new lender, which can offer them at a lower rate. Although each lender will probably require different documentation depending on your credit history, the most commonly required pieces of information include a letter of employment, two months' worth of statements for each credit card or loan you wish to pay off, and letters from creditors or repayment agencies.
Debt Resolution Centers can help you with your debt consolidation. Speak to one of our Certified Debt Specialists today to find out how much you could save with debt consolidation.