What is Debt Consolidation?
Debt consolidation is a debt refinancing strategy that entails obtaining a new loan with a favorable term structure such as lower interest to pay off many other loans.
Debt refers to money owed by a party (the debtor) to another party (the creditor). Often, the creditor charges a reoccurring fee (interest) that the debtor is required to pay in addition to the principal amount.
Debt consolidation refers to a situation where a debtor who is overwhelmed by multiple debts, possibly with high-interest rates, takes another new loan that offers a lower interest rate to clear the other debts.
Essentially, debt consolidation merges multiple debts into a single debt. The debtor takes a new loan that is big enough to cover the multiple debts owed. That allows debtors to pay off multiple debts at once, thereby giving them room to focus on clearing a single debt.
Debt consolidation is used to finance unsecured loans – loans that are not linked to an asset. These include student loan debt, the amount owed on the credit card, and personal loans.
There are benefits to adopting this as a strategy to offset debts. These benefits include:
- It is easier to track one due date than three or more. Since missing a due date may come with a penalty such as additional interest, focusing on one is better.
- Lower interest saves the debtor money that they can channel to other things.
- Debtors have a faster chance of paying off the new loan due to savings from the lower interest rate.
It should be noted that debt consolidation may not be the best approach for everyone due to habits and motivations. For instance, an impulsive shopper is likely to still incur more debts, even with debt consolidation in place. Ideally, you should consider this only if you have a steady income which exceeds your monthly expenses.
Debt Consolidation Example
Mary has three credit cards and owes different loans with different interest rates.
- Credit card 1: $1200 at 25% APR
- Credit card 2: $3000 at 15% APR
- Credit card 3: $2500 at 17% APR
Instead of struggling to pay off each loan individually and accumulating more fees in interest over time, Mary can take a new loan of $6700 at 7% APR to pay off all the loans at once.« Back to Glossary Index