Consolidation Loans 101
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UPDATED: Aug 28, 2012
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The current economy has pushed many Americans to their financial breaking points. Once the economy began to nosedive, Americans borrowed money in order to keep their heads above water. With income streams reduced, Americans used credit cards and financing to pay for everything from utility bills and rent to groceries and car payments. Adding another log to the proverbial fire is the fact that many Americans have debt, be it in the form of mortgages, student loans, or car payments. As one can imagine, having a multitude of monthly payments and then having to borrow more money in order to get from one month to the next can be taxing to say the least.
Fortunately for borrowers, who may be either financially uncomfortable or financially desperate, there is an option for combining all of their monthly payments into a single payment. That option is a consolidation loan.
The way consolidation loans work is by taking all of a borrower’s outstanding debts and combining them into a single monthly payment.
Naturally, having to only worry about a single payment each month can be a lifesaver. Instead of juggling due dates, repayment forms, checks, and envelopes, borrowers can combine their debt into one monthly payment made to a single lender.
There are a few telltale signs borrowers should look for that may prompt them to consider combining debt.
The Time to Consolidate
When a borrower has multiple credit cards, medical bills, personal financing, or other bills to pay, it may be wise to look into getting a consolidation loan. Borrowers can do this by viewing quotes for consolidation loans, speaking with lenders, and researching their options online.
Other “red flags” include:
- Late payments piling up
- Falling so far behind on payments that they are approaching default
- Contemplating filing for bankruptcy
- Feeling financially and emotionally overwhelmed by monthly payments
- Realizing that the bulk of a borrower’s financing has high interest rates and a borrower desires a “blanket refinance.”
If any of those red flags are present in a borrower’s personal situation, a consolidation loan may be a prudent choice.
Once borrowers decide to merge all of their debts into one, then it is time to review the lenders they could approach for financing.
A Look at Consolidation Lenders
Banks and debt consolidation agencies are the two most conventional lenders for merging debts. Customers who have longstanding relationships with their banks may find that their banks will offer consolidation loans at generous interest rates.
After borrowing from a bank, the lent money is given to borrowers who then write checks or wire funds to creditors. Borrowers are then able to focus on repaying just one lender and just one loan.
Another type of consolidation lender is debt consolidation agencies. Borrowers often choose to work with these agencies when they don’t qualify for traditional consolidation programs from banks.
Agencies help borrowers through one of two ways. First, an agency may work with creditors on behalf of a borrower and work out an agreement with those creditors. After coming to terms, the agency would cut a check to each creditor and issue a consolidation loan to a borrower of the amount the agency needed to spend. After this, a borrower simply makes monthly payments to the agency that paid off their debt.
The second way debt consolidation agencies work is to request a lump sum from the borrower each month and then divide those funds to pay off each of the borrower’s creditors. This method essentially turns an agency into a borrower’s personal assistant who manages all of their payments for them.
Finally, peer-to-peer lenders are another resource for borrowers to seek. Peer-to-peer lenders allow borrowers to obtain financing from a collection of individual lenders that have pooled their funds together in order to lend money. These lenders may be more accepting in their lending process, but usually at a cost of offering higher-than-average interest rates.
Consolidation Loan Requirements
Lenders are highly selective of borrowers. Borrowers must keep in mind their number of debts, the amount of money owed, and their credit histories will all likely impact the interest rate and terms that lenders offer.
Most lenders require applicants to have a monthly income of a certain amount. They’ll then compare that monthly cash flow to an applicant’s outstanding debt in order to formulate that applicant’s debt-to-income ratio. This helps lenders see if an applying borrower is even capable of repaying debt.
Lenders will also consider a borrower’s credit history. By looking at an applicant’s payment and credit history, a lender can see if lending to a potential borrower would be a wise investment. A history of late payments may prompt lenders to disqualify applicants or only offer financing with high interest rates.
Another common requirement is home equity. Since a consolidation loan is typically for a large amount of money, lenders prefer applicants who have a large amount of collateral. While there are many types of collateral, security of substantial size often comes in the form of home equity. While lenders do lend money to non-homeowners, renters rarely get lent the same amount of funds that homeowners do.
Collateral makes lending money less risky for lenders, which in turn makes them more prone to approve of an applicant. Should a borrower default, lenders would have cause to repossess the offered collateral. In the event that collateral is home equity, lenders may be permitted to foreclose the home and sell it for profit. Liquidating collateral allows lenders to recover the cost of their lost money.
While borrowers aren’t usually expected to fully own their home without debt, they typically must have a sizable amount of equity in their home if they hope to offer it up as collateral. For example, if a borrower has $50,000 of equity in their home the lender will probably be more than happy to offer financing of $40,000 or less.
It is important for borrowers to remember that all lenders have different requirements, standards, and practices. Speaking to a representative of each lender, reviewing websites, and comparing options are wise actions for prospective borrowers to take when looking for a consolidation loan. However, even before speaking to lenders, borrowers must remember that there is risk involved in consolidating debts.
The Pitfalls of Consolidation Loans
Just as is the case with other types of financing, consolidation loans carry interest. This interest accrues and increases the amount of money that a borrower owes. Borrowers must pay off the interest and principal by paying more money. Only by paying off owed money would a borrower become free of debt.
Consolidation loans also last a long time. Borrowers achieve lower monthly payments through consolidating debt by stretching out existing loan durations. This means borrowers will make payments for longer periods of time. This also means that more interest will accrue (even if at lower rates) because a borrower will carry these debts for longer periods of time than they otherwise would if they just repaid their existing debts.
Finally, collateral is always at risk of being seized or repossessed in the event that a borrower fails to make payments. Relying on the forgiveness and mercy of lenders is unwise, even if some lenders are willing to accept delayed payments due to unforeseen circumstances. For these reasons, borrowers should only pursue consolidation loans after determining if these financing tools are the right choice for them.