Debt Consolidation Loan

What It Means

A debt consolidation loan is one big loan that a borrower takes out in order to pay off a number of smaller debts. It may also be referred to as refinancing one’s debt. There are three main reasons for taking out a debt consolidation loan: to lower the fee, or interest rate, of the loan; to make a person’s debt more manageable; and to reduce the size of the required monthly loan payment.

One reason people consolidate their debts under a new loan is to secure a lower interest rate (the interest rate on a loan is the percentage of extra money a borrower pays per year on top of the balance of money owed; it can be thought of as the cost of borrowing the money) or even simply to secure a fixed interest rate. Unlike a variable interest rate, which fluctuates according to changes in the economy, a fixed interest rate remains the same until the entire balance of the debt is paid off.

Some people take out debt consolidation loans in order to make their debts easier to manage. Rather than keeping track of several different payments to different creditors (or lenders), which may all be due at different times during the month, a debt consolidation loan enables the borrower to make one easy payment per month. With only one due date to remember, the borrower greatly reduces the risk of missing a payment and incurring costly late-payment penalties.

A third reason for a debt consolidation loan is that the minimum payment on such a loan is often less than the sum of several minimum payments on smaller debts. If the borrower uses less of his or her monthly income to pay off debt, it should be easier for him or her to handle basic monthly expenses for housing, food, utilities, and such. Some financial advisers say that if the borrower can live more comfortably within his means, he will be less likely to continue to build more debt.

When Did It Begin

Before the middle of the twentieth century, consumer debt was relatively unheard-of. Financial institutions (such as banks) rarely extended credit to individuals because it was difficult to assess their financial reliability, and because managing such loans was expensive and time-consuming. The concept of debt consolidation applied exclusively to matters of public (government) debt. In 1886, for example, Japan passed the drastic Consolidation of the Public Loan Act to convert the various loans that made up the national debt to a lower interest rate and a single set of terms.

The period after World War II (which ended in 1945), however, was marked by a number of economic developments in the United States, including the mass production of consumer goods, the increasing urbanization of American society, and the advent of consumer credit. By the 1960s more and more Americans were taking on consumer debt, and there was a dramatic rise in the number of personal bankruptcies. (Bankruptcy is a declaration of financial insolvency, or inability to pay off one’s debts.) Alongside these trends, independent lending companies began to offer debt consolidation loans to households in financial crisis. Many of them charged exorbitant interest rates. The practice of taking advantage of people in financial trouble by lending them money at very high interest rates or charging high fees to initiate the loan is called predatory lending.

More Detailed Information

Usually a consolidation loan is used to pay off unsecured, revolving debts, especially credit card balances. Unsecured debt is any debt that is not backed up by collateral (something, such as a house or a car, that the lender can assume ownership of if the borrower becomes unable to pay back the debt). “Revolving” means that the debt is open-ended; unlike an installment loan (as for a car), where the borrower borrows a finite sum of money and then pays it back in set installments over a fixed period of months, the balance of revolving debt continues to rise and fall (within an allowed credit limit) according to how much the borrower spends and how much he or she pays off each month. Unsecured, revolving debt is considered a more dangerous kind of debt to carry, because it is easy for consumers to get in over their heads.

If you own your home, the best way to consolidate your debt is usually with a home equity loan (also called a second mortgage). With this kind of loan, you borrow against the amount of equity you have in the home. Equity is the difference between the market value of the home (the amount you could sell it for) and the outstanding balance on your original home loan. So, for example, if your house is worth $240,000 and you owe $195,000 on your mortgage, then you may be able to borrow up to $45,000 (the difference between the two numbers) with a home equity loan. Because a home equity loan is secured (the home is your collateral), the lender regards it as a lesser risk than an unsecured loan and will usually offer you a more favorable interest rate. Also, the interest you pay on a home equity loan (as with a regular home loan) is often tax deductible, meaning it can help reduce the amount of annual income tax you have to pay.

If a person does not own a home or other property that he or she can use to take out a secured loan, it is possible to obtain an unsecured debt consolidation loan. The Federal Trade Commission (a U.S. government agency) and other consumer-protection groups caution consumers to choose carefully among the private companies that offer these loans. Many do not fully disclose the fees and other terms associated with their loans, and they may make inflated or false promises about their ability to alleviate debt.

In general, many critics warn that debt consolidation loans are not the cure-all that many people think they are. The problem with debt consolidation, they say, is that it makes you feel as though you have taken care of your debt problem, when in fact you have only rearranged the problem. Debt consolidation may get you a lower interest rate and a lower monthly payment, but it does not make the debt go away. Also, many people do not realize that a lower monthly payment often just means that the term of the loan is extended; thus, even with a lower interest rate, stretching the loan out over a longer period may ultimately cause the borrower to pay more interest.

Moreover, a debt consolidation loan does nothing to help someone change the spending habits that got him or her into debt in the first place. Indeed, according to one study, more than three-quarters of the people who consolidate their debt and clear their credit cards gradually build balances back up on those empty cards.

Recent Trends

By the end of 2003, U.S. consumer debt had topped $2 trillion. This unprecedented figure demonstrated that the level of debt carried by the average American household was escalating rapidly. Indeed, American consumer debt was far higher than that of any other country, and the $2 trillion figure represented a doubling of this debt in less than a decade.

As Americans with heavy debt loads have become increasingly anxious about their vulnerability to financial ruin, the debt consolidation industry has boomed. The Internet and television have become flooded with ads for “get-out-of-debt-quick” plans that promise financial miracles and peace of mind. Many honest loan companies do offer legitimate debt consolidation loans that can greatly facilitate the process of getting out of debt; but there are also many companies that make false claims and can potentially cause consumers more financial harm. One way to shop for a reputable loan company is through the Better Business Bureau (BBB), an independent consumer-protection organization that publishes “Reliability Reports” about all kinds of U.S. businesses.