Home Equity Loan
Debt Consolidation
Debt consolidation entails taking out one loan to pay off many others.
This is often done to secure a lower interest rate, secure a fixed interest rate
or for the convenience of servicing only one loan.
Debt consolidation can simply be from a number of unsecured loans into another
unsecured loan, but more often it involves a secured loan against an asset that
serves as collateral, which is most commonly a house (in this case a mortgage is
secured against the house.) The collateralization of the loan allows a lower
interest rate than without it, because by collateralizing, the asset owner
agrees to allow the forced sale (foreclosure) of the asset in order to pay back
the loan. The risk to the lender is reduced so the interest rate offered is
lower.
Sometimes, debt consolidation companies can discount the amount of the loan.
When the debtor is in danger of bankruptcy, the debt consolidator will buy the
loan at a discount. A prudent debtor can shop around for consolidators who will
pass along some of the savings. Consolidation can affect the ability of the
debtor to discharge debts in bankruptcy, so the decision to consolidate must be
weighed carefully.
Debt consolidation is often advisable in theory when someone is paying credit
card debt. Credit cards can carry a much larger interest rate than even an
unsecured loan from a bank. Debtors with property such as a home or car may get
a lower rate through a secured loan using their property as collateral. Then the
total interest and the total cash flow paid towards the debt is lower allowing
the debt to be paid off sooner, incurring less interest. In practice, many
people are in credit card debt because they spend more than their income. If
that habit continues, the consolidation will not benefit them much because they
will simply increase their credit card balances again.
Because of the theoretical advantage that debt consolidation offers a consumer
that has high interest debt balances, companies can take advantage of that
benefit of refinancing to charge very high fees in the debt consolidation loan.
Sometimes these fees are near the state maximum for mortgage fees. In addition,
some unscrupulous companies will knowingly wait until a client has backed
themselves into a corner and must refinance in order to consolidate and pay off
bills that they are behind on the payments. If the client does not refinance
they may lose their house, so they are willing to pay any allowable fee to
complete the debt consolidation. In some cases the situation is that the client
does not have enough time to shop for another lender with lower fees and may not
even be fully aware of them. This practice is known as predatory lending.
Certainly many, if not most, debt consolidation transactions do not involve
predatory lending.
Student loan consolidation
In the United States, federal student loans are consolidated somewhat
differently, as federal student loans are guaranteed by the U.S. government. In
a federal student loan consolidation, existing loans are purchased and closed by
a loan consolidation company or by the Department of Education (depending on
what type of federal student loan the borrower holds). Interest rates for the
consolidation are based on that year's student loan rate, which is in turn based
on the 91-day Treasury bill rate at the last auction in May of each calendar
year.
Student loan rates can fluctuate from the current low of 2.77% to a maximum of
8.25% for federal Stafford loans, 9% for PLUS loans. The current consolidation
program allows students to consolidate once with a private lender, and
reconsolidate again only with the Department of Education. Once the student has
consolidated their loans, the loans are set to a fixed rate based on the year
they consolidated; reconsolidating does not change that rate.
Federal student loan consolidation is often referred to as refinancing, which is
incorrect because the loan rates are not changed, merely locked in. Unlike
private secton debt consolidation, student loan consolidation does not incur any
fees for the borrower; private companies make money on student loan
consolidation by reaping subsidies from the federal government.
Student loan consolidation can be beneficial to students' credit rating, but
it's important to note that not all federal student loan consolidation companies
report their loans to all credit bureaus; SLM Corporation (formerly Sallie Mae)
does not report to Experian or Transunion, which means that students will have
differing credit scores at Equifax, Transunion, and Experian.