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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.
