How Does Debt Consolidation Work

Today, we have become so used to spending and living on a credit card that we do not even realize when the credit card debt starts piling. It is only when a person defaults on his credit card payments regularly, or is unable to pay his bills, that he realizes how much of a debt he is in. Inability to pay interests on loans can add to more interests and a person is almost on the verge of bankruptcy. It is when faced with such situations that a person considers measures like credit card debt consolidation. Given below is some useful information on the same.

Debt Consolidation Process

Debt consolidation is applicable only on unsecured loans, that is, loans which are not backed by any kind of asset or security. Credit cards, credit lines, unsecured personal loans and student loans all fall in the unsecured loans category. Debt consolidation can make the credit rating of a person fall considerably, that is why it is considered as an option only when a person is almost nearing bankruptcy and there is no other way out.

Debt consolidation is a method of debt management adopted by people who have a number of debts, each with a different rate of interest. It works by combining all the smaller debts into one large loan with the lowest possible interest rate. It is a process which helps the person manage his different debts properly so that he can make timely payments in a more organized way. It is also useful in terms of money, as it brings down the overall interest rate that a person has to pay. To have a better understanding of debt consolidation, let's take an example.

Suppose a person named X has five debts and he is paying 15% interest per annum on two of them, 12% interest on another two and 18% interest on one. Every month, he has to make five different payments to five different banks at different interest rates, which leads to lots of wastage of time, not to add how much confusion it can add to with regards to the payments. In such a scenario, X decides to opt for a debt management program. Banks, local credit unions and consolidation companies offer such programs to people who are knee deep in debt. Suppose, he chooses to take a program from a debt consolidation company, then in such a case, its officials will contact the individual companies from which X has previously taken loan to reduce the interest amounts. Also, they will offer X a single loan on an interest rate which is much lower than what he was paying earlier. Now, X will pay the company and they in turn will pay the five individual companies to clear off X's loan.

Debt Consolidation Pros and Cons

The biggest advantage of debt consolidation is that it saves the person from the hassle of making a number of payments. Secondly, it helps in bringing down the monthly payments as it offers loans at a much lower rate of interest. This way, a person can save hundreds of dollars every month and can maintain a good lifestyle.

One of the main drawbacks of debt consolidation is that it does not lead to debt elimination. All it does is to shift the debt, which has to be paid by the person at a later date. Another con is that when all the loans are shifted to a single credit card, a person who is habitual to living on credit cards might see that now most of his credit cards have huge available amounts. This might lead to another spending spree and some more debt. Lastly, by consolidating the debt, the loan payments are stretched for a longer time period. There is a possibility that the total interest that one ends up paying on the loans will be much higher due to this. Thus, a person in reality could be actually paying more by opting for a debt consolidation program.

Besides going in for debt consolidation to clear out the loans, it is advised that one undertakes credit counseling services offered by debt consolidation agencies as well. This will ensure that wise financial decisions are taken in the future and a person is able to lead a happy, debt free life.