Debt consolidation is a form of debt refinancing. With debt consolidation, consumers combine—i.e. consolidate—two or more of their debts into one, which they pay off month by month, with a fixed interest rate.
By doing so, consumers make their debt payment process easier and, ideally, eventually reach financial freedom—that is to say, freedom from debt.
What Debt Consolidation Does
Debt consolidation can streamline a consumer’s debt payment process and make it more affordable in the long run. In some cases, the total monthly cost of consolidated debt with a set or lowered interest rate is less than the combined cost of one or more individual debts and individual interest rates.
Two common ways that consumers consolidate their debt are by taking out debt consolidation loans or by enrolling in debt consolidation programs.
Both debt consolidation loans and debt consolidation programs effectively round up a consumer’s individual debts into one monthly payment.
Lending institutions that are authorized to issue debt consolidation loans in order to help consumer manage debt include credit unions, banks, and finance companies. Non-profit credit counselling agencies offer debt consolidation programs (DCPs).
To qualify for debt consolidation loans, consumers typically need to have good credit. High income and a decent debt-service ratio also helps. This poses problems for consumers who have bad credit, a bad debt-service ratio, or who struggle to follow a budget.
For these consumers, enrolling in a DCP might be the better option. To qualify for a DCP, consumers do not need to have good credit.
Secured vs Unsecured Debt
For consumers who are asking themselves, What is a debt consolidation?, it helps to know the difference between secured and unsecured debt, as DCPs and debt consolidation loans typically only cover unsecured debt.
Secured debt, unlike unsecured debt, has no collateral backing. Most, though not all, unsecured debt can be relieved by bankruptcy.
Examples of unsecured debt are student loans, outstanding balances credit cards, and personal loans.
Examples of secured debt are residential mortgage loans, bank loans, auto loans, and certain credit cards.
Debt Consolidation Loans
Debt consolidation loans are offered by credit unions, banks, and finance companies and typically cover only unsecured debt.
To determine whether a debt consolidation loan might benefit them, consumers should make sure of two things before applying: that they qualify for debt consolidation loans, and that the debt consolidation loans will have lower interest rates than the average interest rate they’re already paying on their high-interest debt.
If consumers do not qualify for debt consolidation loans, or if they would not save money by taking out debt consolidation loans, then other forms of debt consolidation, such as DCPs, might benefit them more.
Debt Consolidation Programs
DCPs are offered by non-profit credit counselling agencies and cover unsecured debt.
A DCP does not offer loans. Rather, it offers debt relief by consolidating two or more of a consumer’s unsecured debts into one, which the consumer then pays off monthly at a reduced interest rate.
More, with a DCP, consumers work one-on-one with certified credit counsellors who negotiate with the consumer’s creditors on the consumer’s behalf to lower the interest rates on the consumer’s individual debts and make the debt payment process more affordable.
Some certified credit counsellors also offer consumers advice and debt management tools. (This service can work especially well for consumers who struggle to follow a budget.)
Other benefits of a DCP may include
- fully-tracked, automatic and timely payments to creditors
- no more collection calls
- a set completion date
- monthly fund transfers by debit card, telephone banking, or money order
- consolidated debt that can be paid off between 2 to 4 years
Other Forms of Debt Consolidation
In addition to debt consolidation loans issued by banks, credit unions, and finance companies, as well as to debt consolidation programs issued by non-profit credit counselling agencies that set consumers up with certified credit counselors, there are other kinds of ways to consolidate debt:
- credit card balance transfer
- debt repayment program
- home equity loan (also known as taking out a second mortgage)
- line of credit
- low interest rate credit card
Each come with benefits, and each come with risks.
Risks of Debt Consolidation
Some consumers can benefit a great deal from consolidating their debt. But debt consolidation is not right for everyone. There are risks that can come with debt consolidation, especially from debt consolidation loans, which may appear better than they actually are.
In some cases, for example, although it may appear to consumers that debt consolidation loans will make their debt payment process easier, in reality, when debt consolidation loans pay off the balance on their credit cards, consumers may hit their credit card limits again, while they still owe money on their consolidation loans.
In other words, taking out debt consolidation loans can lead consumers into further financial trouble.
Other cons of a debt consolidation loans:
- they do not always come with lower interest rates, particularly for consumers who have lower credit scores
- longer repayment periods may entail higher overall cost
- lenders may charge loan origination, closing, or balance transfer fees
Consumers who don’t benefit from debt consolidation loans might benefit from other forms of debt consolidation, such as Debt Consolidation Programs.
