Understanding the world of finance can often be a daunting task, with a seemingly insurmountable mountain of jargon and techniques needed to navigate successfully. One such financial construct that often confounds people is that of consolidation loans. This guide is designed to demystify the concept and help you understand if this financial tool fits you.
What are Consolidation Loans?
To begin with, we need to address the fundamental question: what exactly is a consolidation loan? Simply put, a consolidation loan is a type of financing that allows you to combine multiple loans into one single loan. Essentially, you are taking out a new, larger loan to pay off existing smaller loans.
The reasons why people opt for a consolidation loan vary, and in many situations, more than one factor is important.
A few examples of why people decide to get a consolidation loan:
- They have small, expensive debts with high interest rates and/or high fees, and have the opportunity to take out a bigger loan with better conditions to replace them.
- Managing many small loans and credits have become overly complicated. Payments are being missed, resulting in late fees and similar costs that makes the burden of debt even bigger.
- They have realised that they have one or more loans where they will not be able to keep up with the repayment schedules. Instead of incurring late fees and risk a lowered credit worthiness score, they replace them with a consolidation loan – with a longer loan term – to make the monthly payment more manageable.
- They took out loans in an emergency situation where they did not have time to compare terms and conditions, and now they want to replace these loans with a loan that comes with better conditions.
Types of Consolidation Loans
Now that we have established a basic understanding of consolidation loans, let’s delve a little deeper into the different types available.
1. Secured Consolidation Loans: These are loans that are secured by an asset such as your home (home equity loan) or car (auto loan). Should you fail to repay the loan, the lender will take possession of the asset to recover their money.
2. Unsecured Consolidation Loans: These loans do not require an asset as collateral. Typically, they come with a higher interest rate due to the increased risk for the lender. You may also find that it is more difficult to be approved for a big consolidation loan if you do not have an asset to put up as collateral.
3. Student Loan Consolidation: This is a specialized loan designed to combine multiple student loans into one.
4. Balance Transfer Cards: These are essentially credit cards with a low introductory interest rate, often used to consolidate high-interest credit card debts. Make sure you understand what happens when the introductory period is over – you do not want to end up in a situation that is even worse than before.
The Pros and Cons of Consolidation Loans
Pros:
1. Simplicity: Instead of managing several loans with different interest rates and due dates, you only have to manage one. For many, this is very important not just practically but also psychologically. If you have felt anxious and stressed about having so many different loans, consolidation can bring a lot of relief and free up mental space and energy that can be used more productively in your life.
- Lower Interest Rate: If you have high-interest debts like credit cards, consolidation loans can potentially offer a lower overall interest rate. Of course, this will depend on the exact terms and conditions of the consolidation loan.
- Fewer Fees: Having many small debts can involve paying a lot of fixed fees, e.g. monthly billing fees, transaction costs for each repayment, late fees (when applicable), and more. Switching many small debts for one larger consolidation loan can eliminate this annoying cluster of costs.
- Avoid Defaulting: If you are close to defaulting on one or more loans, a consolidation loan with a more realistic repayment plan can be the solution.
- Improve Your Credit Worthiness: Having a big bunch of small debts can make your economy look more messy in the eyes of potential future loan givers. They might wonder why you are juggling four different credit cards and various consumer credits. Of course, owing money to collection agencies will be extra detrimental. If you for instance are planning to apply for a house mortage loan in the future, it can be beneficial to clean up your credit report by getting a consolidation loan (if possible). Note: How lenders view you having many small debts tend to vary between different countries. Make sure you understand the system you are in.
Cons:
1. Security Risk: If you opt for a secured consolidation loan and fail to meet your repayments, you will lose the collateral.
2. Longer Repayment Period: Consolidation loans can extend the lifespan of your debt, meaning you could end up paying more in the long run, since you will be paying interest for a longer period. Make sure you get a consolidation loan where you are allowed to repay the loan in advance if you want to. Also remember, that paying a bit more over time is still better than trying to manage short-term loans, failing, and ending upp paying a myriad of late fees and having debts go to collection agencies.
3. Potential Extra Costs: Getting the consolidation loan may cost you, adding additional stress to your budget. Some lenders will for instance charge origination fees and annual fees. Make sure you compare offers from many lenders before you make your choice.