What is Debt Consolidation? Definition of Debt Consolidation, Debt Consolidation Meaning and Concept
Debt consolidation is the unification of all the credits that an individual maintains, even if they correspond to different entities. The procedure consists of obtaining a new financing to cancel each one of the pending loans with it.
When consolidating their credits, the person agrees with a single installment less than the sum of all the payments made per month. This can occur as a result of a lower interest rate or the extension of the financing term.
To put it another way, when the bank offers debt consolidation it is proposing to buy the loans that the debtor owns with other institutions. Thus, you win a new customer, providing you with better credit conditions.
Advantages of debt consolidation
There are several advantages of debt consolidation. First of all, it is useful in the face of short-term liquidity problems.
For example, let's say a person unexpectedly loses his job and can no longer meet all of his financial obligations each month. So, debt consolidation is an alternative to reduce expenses.
Likewise, unifying the loans allows to maintain a greater order. Instead of having multiple installments with different due dates there will now be a single disbursement that can be strategically scheduled.
If I receive my salary on the 15th of each month, an ideal date to pay the bank would be, for example, every 16. In this way, I am reducing the risk of running out of funds to meet my obligations.
An additional advantage of debt consolidation is that some financial institutions offer a grace period. That is, the individual can unify their credits in April and schedule the first installment of the new loan for July. Thus, for three months the user will not have to make any payment to the bank.
Disadvantages of debt consolidation
One possible downside to debt consolidation is the increase in total expenses. This will depend on the term of indebtedness (which may have been extended) and the interest rate set by the bank for the new loan.
Therefore, it is important to calculate the total disbursements until the end of the financing period.
In addition, we must take into account that it will not help the borrower to consolidate his debts if he reacquires other credits. This would only lead to financial problems again.
Debt Consolidation Example
Let's look at an example of debt consolidation. Suppose that a person has a loan for US $ 15,000 in bank A with twelve installments and an interest rate of 3% per month.
At the same time, he has a loan with bank B of US $ 20,000 in fourteen installments and with an interest of 3.5% per month.
In both cases we will assume that all the installments are equal, as in the French method of financial amortization.
So, the fee is US $ 1,506.93 with bank A and US $ 1,831.41 with bank B. That is, a total periodic disbursement of US $ 3,338.35.
Suppose you have to pay 50% of both loans. Suddenly, bank C offers debt consolidation with new financing for US $ 17,500. This amount will be used to cancel outstanding credits.
If bank C sets a monthly interest rate of 2.5% for the new loan and seven payments, all the same, the fee will be US $ 2,756.17.
Finally, although we did not consider it in the previous example, it should be noted that the early cancellation of a credit may require the payment of a penalty.