Debt Consolidation Loans Decoded

The idea of discharging all your debts by taking out one big debt consolidation loan and paying off everyone at once can sound tempting.  It’s a big decision, though, and one in which you should carefully consider all aspects of the operation.

How Personal Debt Consolidation Loans Work

You might be able to take out an “unsecured” debt consolidation loan, depending on your personal circumstances and on how big of a lump sum you need to settle everything.  Chances are, though, if you’re already delinquent on several debts or have collectors after you, your credit scores have taken a beating.  You’d be considered a poor risk, and if you’re able to get the loan at all in this tight credit market, it might be at an interest rate that isn’t much better than your credit cards.

That’s where the “secured loan” comes in; you’re actually borrowing against the equity in your house.  Lenders are much more comfortable making lower-interest debt consolidation loans when they’re secured against real property.  Sounds like a home equity loan, doesn’t it?  That’s because, essentially, that’s exactly what it is.  The danger here, of course, is that if you default on that loan you could see your house go into foreclosure.

Debt Consolidation for Student Loans

This is a different ballgame.  “Debt consolidation” for student loans is when you have multiple student loans at varying interest rates (which can run from 4.25% to 9%).  A private lender buys your loans and then uses a weighted average to set one interest rate and one lump payment for all of them.  The loans can be re-consolidated again (only once) with the Department of Education, depending on circumstances.

Federal student loan consolidation is referred to sometimes as “refinancing,” which isn’t quite accurate; at this point, the interest rates are locked in.  The big difference is that the D of E doesn’t incur fees on the part of the borrower.  When private lenders buy student loans, they make their money from interest, fees and federal subsidies; a D of E re-consolidation avoids some of those charges.

Debt consolidation loans can be used to pay off credit cards, personal debt or car loans.   What they don’t do, however, is address the root cause of the problem.  If you’re deciding to take this route, it’s best to rethink your spending habits at the same time (and probably cut your credit cards in two and be done with them).