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Debt Consolidation Explained


Consolidation of debt into a single monthly payment is ideal for those with multiple credit lines. Debt consolidation is a great solution to consider because this solution comes with many benefits. However, not all debt consolidation solutions work in favor of the customer. It mainly depends on the platform that a customer uses. 

What is Debt Consolidation? 

Debt Consolidation is the act of taking out a new loan to pay off existing loans and liabilities. The solution brings all or some of the debts into one loan. Loans that can be consolidated may include vehicle loans, home loans, retail loans, medical debt, payday loans, etc. A consolidation loan is larger since it covers the overall debt that a customer has.

Taking a debt consolidation loan will make it easier and less expensive to pay off existing debt. Customers can negotiate for low-interest rates and in the process saving money, as compared to holding multiple loans from different lenders. Furthermore, only one debit order payment will be made instead of initiating many or making multiple payments which may result in one forgetting to make other payments or having other loans being in arrears. 

How debt consolidation works

Debt consolidation requires one to take out a new loan to finance existing loans or buy them off. The consolidation loan will only require one monthly installment to repay it. Getting a debt consolidation loan is simple. Banks, financial services providers, and debt management companies can be used to acquire the loan. 

Debt consolidation loans will require a customer to have a good credit score, therefore, you need to be up to date with overall loan repayments. Having a bad credit score may cause your debt consolidation loan to be rejected. If it gets rejected, the use of a debt counselor may be necessary to restore your credit score. 

Types of Debt Consolidation 

Debt consolidation has two types of loans. These include the secured loan and the unsecured loan. 

Secured loan

A secured debt consolidation loan is a loan that is issued to the borrower and requires the borrower to put assets on the line as security against the loan issued to them. The assets that are put on the line will work as collateral of the loan. Should a borrower fail to meet the consolidation loan obligations, the lender will sell the asset that is put up as collateral. The sale of the borrower’s assets will be done so as to recuperate the money owed to the lender. 

Secure debt consolidation loans bear low interest rates because of the risk that the lender has to incur should a borrower default. Since the loan has a lower interest rate as compared to the unsecured loan, the borrower accepts much of the risk than the lender. 

Unsecured loan

Unsecured debt consolidation loans are not backed by assets and can be difficult to obtain. Borrowers don’t risk much since they don’t have to put up collateral to secure this loan. Lenders are the ones that bear the most risk as the loan is unsecured and money cannot be recuperated through assets seizure. 

Unsecured loans are hard to option because of the risk that is involved to the lender. Those that get this type of loan are usually those that have a solid credit score and credit history. Even after getting the unsecured loan, you will pay a higher interest rate because the loan is unsecured. The qualifying loan amount is normally lower than a secured debt consolidation loan. 

Benefits of Debt Consolidation 

  • Customers pay less total interest when compared to having multiple credit lines from different credit providers. 
  • The repayment process is simplified since customers can now make one payment for their loan instead of making multiple payments. There are no different repayment dates attached to the consolidation loan, only one date of repayment is given. 
  • Debt consolidation boosts credit score since one credit line will be on the customer credit record instead of multiple credit lines. 
  • You won’t have to deal with many lenders, you will only deal with one lender. 
  • Clients may ask for extended payment periods on the new loan meaning that the new installment on the new loan will be lower. 

Risks of Debt Consolidation

  • Should you use a secured loan, you run the risk of your collateral being seized should you fall behind on payments. 
  • As much as you might save on interest rates, you may incur costs when taking out a consolidation loan. You will incur Initiation fees and there might be other fees such as balance transfer fees or closing costs. 
  • If the duration of the loan is lower than the average duration of the loans held with other credit providers, you stand a chance of getting increased installments. 
  • Choosing a longer period to repay the consolidation loan may mean that you will incur more interest over time. 

Impact of Debt Consolidation on credit

When taking out a debt consolidation loan an inquiry will be registered on your credit report and this will affect your credit score. However, your credit score won’t be much affected. If you have a good credit score, there won’t be much change. If you are using one of the major credit bureaus, you can expect 10 points or less in a shift on your credit score. 

Furthermore, it will take around 6 months to make a recovery from the inquiry. Inquiries will stop appearing from your credit report in 24 months’ time. Therefore, before making an inquiry check your credit score and find out what credit bureaus think of you. You can then make an application if the credit bureau that you use advises that you have a good credit score, if not get your credit score in order before starting an application. 

Conclusion

Debt consolidation is a great tool to put your debt into one solution that makes repayment a lot easier. Not everyone needs this solution. Those that are paying high-interest rates and are failing to manage their debt are most likely to benefit from this solution. However, before getting this solution, you need to make considerations by drawing a cost-benefit analysis to evaluate if this is the best option for you.

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Lethabo Ntsoane

Lethabo Ntsoane holds a Bachelors Degree in Accounting from the University of South Africa. He is a Financial Product commentator at Rateweb. He is an expect financial product analyst with years of experience in reviewing products and offering commentary. Lethabo majors in financial news, reviews and financial tips. He can be contacted at [email protected]

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