How Do Consolidation Loans Work?

The Facts

As of the year 2007, consumer debt amounted to $2.5 trillion. This amount was derived from credit cards, student loans and automobile loans. Many consumers have turned to consolidation loans to get a handle on accumulated debt.

In a nutshell, a consolidation loan is made up of several smaller loans, or debts, all rolled up into one lump sum. There are benefits to consolidating your debts, as well as disadvantages. This article will address what to expect when consolidating your debt.

Types of

There are a couple variations on consolidation loan types. The type of loan depends on the type of debt you have, and if you'll be putting up collateral.

Secured loans are collateral loans where typically houses or cars are held by the lending agency in exchange for the money loaned. These types of loans generally carry lower interest rates because of the collateral's value.

Unsecured loans are used to cover credit card loans, student loans, or any loan where there's no collateral exchange. Interest rates on these loans are higher due to the "unsecure" status of the loan.

Benefits

What makes consolidation loans so appealing are the lower interest rates and the easy payment schedule that replaces the multiple payments paid out to different creditors. If done right, you can even end up paying off your debt in a shorter amount of time than before.

In some cases, a consolidation loan can be used to free up monies needed for an unexpected expense. By paying on a single loan at a lower interest rate, you can use money that otherwise wouldn't be available before.

Risk Factors

There are several routes you can take when consolidating debt. Some harbor less reputable practices and should be avoided if at all possible. Here is a partial list of available debt consolidation agency types:

Debt settlement: These agencies work on your behalf with creditors to settle on a repayment amount, usually less than what was originally owed. Use caution when considering a debt settlement agency, especially if they charge large, upfront fees. Also, any settlement offers arranged by these agencies on your behalf may not be acceptable to a particular creditor. A worse case scenario would be your creditor ends up suing you, rather than settling with the agency.

Debt consolidation: A simple bank loan can act as a consolidation loan. You can put up collateral to lower your payment and interest rate or you can apply for an unsecured loan with a good credit rating. Do keep in mind that any collateral used can be confiscated by the bank if you are unable to payback on the loan.

There are also debt consolidation agencies. Those that charge large, upfront fees are the ones to avoid. Always do a background check before committing to a debt consolidation agency contract.

Credit counseling: These agencies work with you to develop repayment plans, assist with budgeting and some offer workshops on money and debt management. A number of these agencies are non-profit entities but not all of them live up to this claim. High fees or hidden fees are possible. Always ask.

Debt management plan: This is a plan set up by a credit counseling agency. Money gets deposited into an account with the agency and is used to make payments to your creditors. This option generally takes anywhere from 3-5 years to pay off your debt. The credit counselor negotiates the payback terms with your creditors.