How do consolidation loans work?
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UPDATED: Feb 6, 2012
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A consolidation loan is a loan structured to help a borrower cover the balance on his or her existing loans. To achieve this goal, this type of financing awards borrowers with a single sum of money those borrowers can use to pay off their outstanding loans, thus granting them a single monthly payment. Because this is a new loan, this consolidation attempt can often be stretched over a longer period of time, resulting in lower and more manageable monthly payments.
However, depending on the type of consolidation loan obtained, borrowers should expect to pay a higher amount of interest, or a larger amount of interest by the time the financing is paid off. This interest rate is typically acceptable though since the goal of the consolidation loan is to make monthly payments manageable, which will ultimately lead to solvency and reduce the chance of a borrower being hit with late fees and default penalties.
Unlike house and car financing, interest rates on consolidation loans are not tied to a federal index, and instead rely solely on an individual’s credit score and financial history. As a result, shopping around and receiving multiple offers from different lenders is imperative to obtaining the best price. Using an online form, like the one found on our site, helps potential borrowers gather several quotes all at once, bettering their chance of receiving the most amount of money for the lowest cost.
To better illustrate how these loans work, consider a borrower who has three outstanding loans with balances of $1,000, $2,000, and $3,000, each with an interest rate of 10 percent and each scheduled to be paid off in two years. The borrower is receiving three separate checks every month, and is having difficulty making the payment on each. In the event the borrower misses payment on one, he is hit with a $35 late fee. This month, he encounters an emergency automobile problem, and diverts his money to fix his car. As a result, he misses his loan payments and gets hit with $105 in late fees.
So he decides to better his financial dilemma by taking out a consolidation loan for $6,000 at 12 percent interest and a four year term.
Granted the borrower is now stuck with the same amount of debt at a higher interest rate—but the extended term allows him to receive a lower monthly payment. He also only receives a single bill, and can devote his financial resources to managing this single payment instead of being forced to pick and choose which bills to pay and which to expect collections calls on for the next month.
Additionally, if the borrower does have to miss a payment on his consolidation loan, he will be hit with a single late fee instead of three.