Consolidating debt refers to eliminating a number of smaller debts by replacing them with a larger debt. This type of consolidation offers one primary benefit: simplicity. It can be much easier for a borrower mired in debt to deal with one monthly payment instead of many different payments from various loans and credit cards. However, debt consolidation does not always save money. Savings depend on the terms of the loan.
Term vs. Rate
Many people believe that if they consolidate debt into a new loan with a lower interest rate, they will be paying less. This is not necessarily true. A new loan often starts a payment term over entirely. For instance, a refinance will replace an old mortgage with a new mortgage. The new loan may have a lower interest rate that creates a lower monthly payment, but it will also restart the 30-year term of the loan. This lengthens the amount of time the borrower has to pay the debt and may lead to even greater expensive by the time the loan is finished.
When Consolidation is Cheaper
Debt consolidation is cheaper when the rate of the new loan is less that the rate of the old debt and the term is less or similar to the term of the old debt. Since consolidation often applies to several different debts, borrowers must calculate all the rates together, along with different terms, to discover if they will actually save money using the new rate of a larger loan. Fortunately, large loans tends to have lower rates than small debt lines like those associated with credit cards.
Loan Fees
Borrowers must also consider loan fees when considering consolidation. There are always new fees attached to the creation of a new loan, from origination and application fees to escrow fees if the new loan is a second mortgage. These fees can add up to thousands of dollars, an unrecoverable costs. Not only must borrowers have access to these funds, but they must compare the cost of the fees to the savings from the loan to make sure it is really cheaper.
Effects on Credit
Consolidation has a number of effects on credit, many negative. Some people only consider consolidation if they have already defaulted on loans in the past, but these defaults can drastically lower credit scores. Consolidation can improve scores if debts are getting out of hand and the borrower has not defaulted yet but wants a way to repay old debts and deal with a new loan, possibly with a more manageable payment despite the increased long-term cost.
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