The Center For Debt Management
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“Debt Consolidation”
Do You Know the Facts?

—Article by Daniel A. Gelinas

You may have heard of the term “debt consolidation.” But are you unaware that there are several ways in which to consolidate debt? For example, a “debt consolidation loan” is very different than “debt consolidation” that is offered through a consumer credit counseling agency.

Which is the best debt consolidation option for you? It really depends on a number of factors.

This article was prepared by The Center For Debt Management to highlight the differences between a “debt consolidation loan” and “debt consolidation” through a consumer credit counseling agency or some other company offering a debt management program. If you are considering debt consolidation, it is important that you understand these differences.

Debt Consolidation Loans

For some consumers a debt consolidation loan may be their best option. This is particularly true for consumers who may have considerable debt but not enduring financial hardship. If the average interest rate on their various accounts is high, a debt consolidation loan at a low interest rate could save the consumer a significant amount of money over time. Even if there is no significant change in the interest rate, the ease of making one payment each month may be reason enough to obtain a debt consolidation loan.

Most consumers considering debt consolidation, however, are enduring financial hardship. This equation magnifies the necessity of consolidating one's debt—and may also add to the complexity of doing so.

While a consolidation loan may sound appealing, the truth is—often it does not resolve the debtor's financial hardship. In fact, it may compound it. The reality is, it's very difficult to get a low rate consolidation loan unless the would-be borrower is financially sound, has excellent credit and/or has very good collateral, typically one's equity in real estate or a motor vehicle. Lenders that accept lower standards, and therefore increase their risk, charge high interest rates—21% or higher being common. Even with excellent credit and very good collateral, often the interest rate is higher, or very near the borrower's current average interest rate of the debts being consolidated.

It is important to understand that a debt consolidation loan simply “transfers” the debt to a new lender. Furthermore, a debt consolidation loan may not lower a consumer's overall interest rate. In fact, for many consumers a debt consolidation loan increases their overall interest rate—and usually with greater consequences if the borrower defaults!

If a financially burdened consumer is able to obtain a debt consolidation loan at an overall lower interest rate it could very well prove to be the right decision. Even if the consumer's overall interest rate is somewhat increased, a debt consolidation loan could prove beneficial for consumers consolidating debt on past due accounts that are accruing late fees and other punitive charges. The higher interest rate could be off-set by the fact that the past due accounts would be paid -in-full as a condition of the loan, thus, eliminating the late fees.

In the above situations, however, it is important that the borrower is “reasonably assured” of being able to meet the conditions of the loan, making all payments as scheduled. Otherwise, as detailed below, the decision to take out the loan could prove disastrous.

A major point to consider is understanding the type of debt being consolidated; secured, unsecured or a combination of the two. An example of secured debt would be a car or boat loan. On the other hand, credit card debt or a medical bill is typically unsecured debt. Should a consumer default on a loan, whether secured or unsecured, the creditor may elect to file suit in an effort to collect the debt. In most cases, however, should a consumer default on a “secured” loan, a creditor need not file a suit, but rather may opt to repossess the secured item (the surety) under the terms of the agreement.

Debt consolidation loans are typically secured loans with the collateral being the borrower's equity in a motor vehicle, real estate or some other major asset. Should the borrower default, repossession, foreclosure or legal action often comes swiftly. Lenders who make consolidation loans understand full well their legal recourse and some will stop at nothing until the debt or a judgment is satisfied.

The important aspect to understand here is that while “unsecured” creditors can take legal action, they are typically slower to do so—and more willing to negotiate a settlement. And the fact is, consumers often consolidate “unsecured” debt in exchange for “secured” debt—which often proves detrimental to the consumer!

Another point to consider is that, by consolidating, the borrower is faced with “one large payment to one creditor” rather than “many smaller payments to many creditors.” While this can be very beneficial (in the right circumstances) the problem is—one large payment is a harder nut to crack. If the debtor is even one dollar short, the account is considered in default. While being a little short may not in itself result in foreclosure or legal action, usually late fees and/or penalty charges kick in and warning alarms sound off. These additional fees often make it more and more difficult for the borrower to catch-up, and with each successive payment the debtor falls further and further behind. Before long, the borrower is considerably past due and legal action may soon follow.

In the above scenario the perceived benefit of having only one payment becomes a nightmare. Had the borrower dismissed obtaining a consolidation loan and elected to continue making smaller payments to many creditors, running short of funds would allow for greater options. The debtor, for instance, could then be selective and direct available funds to critical creditors, and perhaps allow an account with an "unsecured" creditor with a small balance and/or one who typically does not access late fees become delinquent. As noted above, unsecured creditors, especially those with small balances, are least likely to take legal action. Lenders making large consolidation loans, however, are prone to do so and some are downright ruthless.

Another concern with consolidation loans is that borrowers are sometimes allowed to keep their credit cards. Having access to these cards, debtors often fall into the same trap—charging many of their purchases and/or expenses. Before they realize it, these charges mount. In addition to having to make their consolidated loan payment, now they must again make a credit card payment. Short of funds, eventually they take cash advances to make their payment, thus only increasing their debt. It becomes a vicious cycle, until finally bankruptcy may be the only alternative.

While a debt consolidation loan may be the right decision for some consumers, it may lead other consumers to financial ruins

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