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How Does Debt Consolidation Work

How Does Debt Consolidation Work

In the age of plastic money, everyone lives with some form of debt or credit. In this article, we answer some of the questions concerning this malaise and the pros and cons of going in for a debt consolidation program.
Aastha Dogra
Today, we have become so used to living on a credit card that we do not even realize when the outstanding amount starts piling up. It is only when a person defaults on his credit card payment regularly, or is unable to pay his bills, that he realizes how much of a mess he is in. Inability to pay installments and bills over a period of time can add to the debt pile and put a person on the verge of bankruptcy. It is when faced with such situations that a person considers measures like debt consolidation.

Debt Consolidation Process

Debt consolidation is applicable only on unsecured loans i.e. loans which are not backed by any kind of asset or security. Credit cards, credit lines, unsecured personal loans, and student loans all fall in this category. It can make the credit rating of a person fall considerably, that is why it is considered as an option only when a person is almost nearing bankruptcy and there is no other way out.

It is a method of debt management adopted by people who have a huge borrowing, each with a different rate of interest. It works by combining all the smaller borrowings into one large loan with the lowest possible interest rate. It is a process which helps the person manage his overall debt so that he can make timely payments in a more organized way. It is also useful in terms of saving money, as it brings down the overall interest rate that a person has to pay.

To get a better understanding, let's take an example. Suppose, a person named X has five sources of borrowings and he is paying 15% interest per annum on two of them, 12% on another two, and 18% on one. Every month, he has to make individual payments to different lenders at varying interest rates, which leads to wastage of time and effort. In such a scenario, X decides to opt for a debt consolidation program. Banks, local credit unions, and consolidation companies offer such programs to people in need. Its officials will contact the individual lenders, from which X had previously taken credit, to reduce the interest rate. Also, they will offer X a single loan, on an interest rate which is much lower than what he was paying earlier i.e. at 10%. Now, X will pay the debt consolidation company on a monthly basis, and they in turn will pay the individual lenders to clear off X's loan.

Pros and Cons

The biggest advantage of debt consolidation is that it saves the person from the hassle of making a number of payments. Secondly, it helps in bringing down the monthly payment as it offers a loan at a much lower rate of interest. This way, a person can save a lot of money every month and avoid bankruptcy.

One of the major drawbacks is that it does not lead to debt elimination. All it does is to shift the debt, which has to be paid by the person at a later date. Another con is that when all the loans are shifted to a single credit card, a person who is habituated to living on cards might use the other cards whose credit limits have been freed. This might lead to another spending spree. Lastly, by consolidating the debt, the loan payments are stretched for a longer time period. There is a possibility that the total interest that one ends up paying on the loans will be much higher in the long run. Thus, in reality you could actually be paying more by opting for a debt consolidation program.

It is advised that one undertakes credit counseling services offered by different agencies as well. This will ensure that wise financial decisions are taken in the future, and a person is able to lead a happy, debt-free life.