Debt consolidation

Helene Mueller
eCollect support team

To consolidate debt means to merge multiple liabilities into one single amount to be paid and also to unify multitude creditors into one lender. Such debts are usually credit card loans, which have descended from purchase of different services or goods. The aim of debt consolidation is to unite all defaults so that the debtor will have to make only one payment per month on the new monetary obligation. To consolidate debt using secured loan is more convenient for creditors, but more dangerous for debtors. When using secured debt, a consumer might lose his home, if he falls behind with the regular payments, therefore a foreclosure process may take place. This means his property, or another material object pointed as a collateral in the contract, might become repossessed. When a real estate is pledged, the loan is known as a mortgage.

Consolidate debt & debt-to-income ratios

Sometimes it is not convenient for a debtor to use debt management plans or different kinds of additional debt agreements, e.g. Individual and Company Voluntary Arrangements (for UK and Wales). If a consumer decides to unite all his debts into one single payment, consolidate debt is an appropriate option, as it not only unites debt payments, but also lowers the total interest rate.

When a debtor secures his property or another material object, he has to take into consideration his monthly income and conform with the total debt payments per month. This is possible by using the formula for personal debt-to-income (personal) ratio, also known as DTI ratio. This method is used to calculate debtor’s gross income and is divided into two main types: front-end ratio and back-end ratio. The first determines what percentage of consumer’s income (wage) goes for expenditures like PITI, if the consumer is the property owner (including mortgage, house insurance, etc.); rent, if the consumer is a renter; general monthly consumption, household bills, etc. The second debt-to-income ratio describes the income percentage, which defrays all debt obligations, such as credit card debts, education loans, child support payments, etc.

Consolidate debt programs are bound up with longer repayment period. Generally this means increase of the total debt amount. As a whole, the consumer will have to pay more (regarding the full default monetary sum) but his monthly taxes will be affordable and conformable to his gross income. If the debtor estimates that he will be financially capable of covering the monthly amounts of the consolidated debt, secured debt borrowing will be more appropriate, as when a secured loan is consolidated, the interest per month is perceptibly lower. Such loan is known as home equity loan and the interest rates are often lower than with other types of consolidation loans. But when the consumer is in a bad financial state, the more convenient option for him will be consolidating unsecured debt, which is not bound by an asset. Here the interest is higher, but the debtor will be in no danger of losing his property. Unfortunately, when a consumer has bad credit history, the new lender will request a debt-to-income ratio percentage. In order the debtor to be classified for a mortgage, he has to perform as low DTI as possible. As every creditor has a different policy for how low should the debt-to-income ratio be, there are no exact numbers, but it is usually between 26-36%. If debtor’s monthly income is high, some lenders might agree on a higher percentage.

Consolidate debt clauses & circumstances

When consolidating loans, a consumer has to be aware of the conditions of using such debt clear option. First of all consolidate debt contracts have to consist of full and thorough information about the interest rates. Their percentage has to be fixed and not to vary between the months for disbursement. The contract has to include how much will the interest increase, if the consumer falls behind with one or several monthly payments. When the debtor has a bad credit rating, consolidate debt may not be a good option for him, as such poor credit score exerts influence on the monthly interest rate and can significantly increase it. However, there are creditors who will agree to grant the consumer a secured loan despite his bad credit history.

If a consumer decides to use consolidate debt, especially if his defaults have derived from bad credit card payments or if he has consolidated unsecured loan, he should try to stop using his credit cards or at least restrict their utilisation until he is debt free again. The same is valid for the secured debt option. If the debtor uses a mortgage or a home equity loan, he has to avoid falling into debt again, as this can cost him his property or home.

Interest rates vary depending on the type of lender. If the creditor is a bank, the debtor will be typically charged somewhere between 7-12%, but if it is a private finance company, the rates start from 14% for secured debt payments, to 30% or more for unsecured debts.

Used literature & external links