What is Debt Consolidation Loan?

Debt consolidation is the process through which a borrower refinances and combines several loans into a single one to receive the benefit of a lower interest rate or a reduced periodic payment, or maybe both. In addition, it leads to a reduction in his liability and eases the management of the loans.

We need to understand that the consolidation process does not reduce the loan obligation. However, it reduces the interest on a loan or shortens the period, leading to a quicker repayment.

Generally, debt consolidation is most popular for credit card loans and student loans. However, it may also apply to government debt or corporate debt. At times, such loans require collateral, and one of the most popular collateral is home equity.

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Process of Debt Consolidation Loan

  • Loan consolidation can be self-created such as balance transfer options of credit cards, or can be achieved by seeking the help of a financial institutionFinancial InstitutionFinancial institutions refer to those organizations which provide business services and products related to financial or monetary transactions to their clients. Some of these are banks, NBFCs, investment companies, brokerage firms, insurance companies and trust corporations. read more.As shown in the below flow diagram, the intermediary financially approaches all the lenders on behalf of the borrower and informs them of the consolidation and new terms and conditions once it is satisfied with the ability of the borrower to pay off the loan. As a result, secured loans have a better chance of getting consolidated, while unsecured loansUnsecured LoansAn unsecured loan is a loan extended without the need for any collateral. It is supported by a borrower’s strong creditworthiness and economic stabilityread more are more difficult.After consolidation, the borrower makes payments to the consolidation intermediary, paying the lenders.

A few institutions that provide debt consolidation facilities are the following:

  • LendingtreeLightstreamDiscover Debt ConsolidationMarcus by Goldman SachsWells Fargo

Examples to Calculate Debt Consolidation Loan

There can be two situations that can lead to a reduced liability through debt consolidation: –

  • Interest rates and periodic payments reduce, while the loan term remains constant.The periodic payment remains constant while the loan term and interest rate are reduced.

Let us look into a few examples to understand both of the above situations: –

Example #1

Suppose we have four loans of $250,000.00 each with an average interest rate of 20% p.a. We find out that we can consolidate it into one loan at 15% p.a. Therefore, if we are given the information 1-4 as shown below, we calculate the 5th, i.e., PMT: –

A periodic payment is calculated by solving the following equation: –

PV = PMT* (1-(1+r/frequency)-n*frequency) / (r/frequency)

We calculate the PMT under both scenarios below, followed by their respective amortization schedulesAmortization SchedulesThe amortization schedule for a mortgage is an index that provides the details of a mortgage loan repayment. It shows both the amount repaid as the principal and the sum paid as interest to date by the borrower.read more, and then draw a comparison between the two to understand the impact of debt consolidation.

Before Consolidation: –

  • = PVBefore Consolidation  = PMT (1+(1+20%/12)^(-212))/(20%/12)= 1,000,000 = PMT * (1+(1+20%/12)^(-2*12))/(20%/12)PMT = 1,000,000/196480PMT = $50,895.80

Amortization Schedule Before Consolidation: –

Amortization Schedule After Consolidation

  • PVAfter Consolidation  = PMT (1+(1+15%/12)^(-212))/(15%/12)1,000,000 = PMT * (1+(1+15%/12)^(-2*12))/(15%/12)PMT = 1,000,000/20.6242PMT = $48,486.65

Points for understanding the above calculations: –

  • Opening balance = previous year’s closing balance.Closing balance = Opening balance + Loan- Principal repaymentPMTPMTPMT function is an advanced financial function to calculate the monthly payment against the simple loan amount. You have to provide basic information, including loan amount, interest rate, and duration of payment, and the function will calculate the payment as a result.read more is calculated as per the above formulaInterest = 0.20/12 x opening balance in before consolidation scenario and 0.15/12 x opening balance in after consolidation scenarioPrincipal repayment = PMT – Interest

Comparing the two scenarios, we observe: –

  • This example is of the first type mentioned above, wherein the interest rate and periodic payments both get reduced due to a fall in the interest rate from 20% to 15%.Total interest paid before consolidation over the two years was $221,499.26, while that after the consolidation is $163,679.55; therefore, this leads to a saving of $57,819.71.The monthly payment before consolidation was $50895.80, while that after the consolidation was $48486.65, which leads to a saving of $2,409.15 per month.To pay off a loan of $1,000,000, before consolidation, we pay a total amount of $50,895.80 x 24 = $1,221,499.26 while after consolidation we pay off the same loan by paying only $48,486.65 x 24 = $1,163,679.55, which is a saving of $57,819.71, same as the difference between the total interest mentioned in the first bullet point.

Example #2

Now let us look at an example where the periodic payment remains constant while the interest rate and the term of the loan reduce: –

Point to be noted:

Before, the consolidation scenario was the same as in the previous example, and the PMT calculation was also the same. However, we keep the PMT the same as before consolidation after the consolidation scenario, but the interest rate falls. Therefore, the time taken for the loan to repay has been shortened to 23 months instead of the full two years, and the last payment will be less than $50,895.80 so that it is sufficient to pay off the loan.

Therefore, all the calculations for the before consolidation scenario remain the same while those for after consolidation are as follows: –

  • PVAfter Consolidation = PMT (1+(1+15%/12) ^(-n12))/ (15%/12)1,000,000 = 50895.80* (1+(1+15%/12) ^(-n*12))/ (15%/12)n = 1.89 years.

Amortization Schedule After Consolidation: –

We can even view the same graphically in the below chart of interest and principal payment Principal PaymentThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan’s original amount is directly reduced.read more.

  • This example is of the second type mentioned above.Total interest paid before consolidation over the two years was $221,499.26, while that after the consolidation is $154,751.62; therefore, this leads to a saving of $66,747.64.The time is taken to pay off before consolidation was 24 months, while that after the consolidation is 22 months when the PMT = $50,895.80 and the 23rd month of liquidating payment of $35,043.96.

Benefits

  • Favorable terms: If the Central Bank so desires, it reduces the policy rate, and therefore the borrowing costs for commercial banksCommercial BanksA commercial bank refers to a financial institution that provides various financial solutions to the individual customers or small business clients. It facilitates bank deposits, locker service, loans, checking accounts, and different financial products like savings accounts, bank overdrafts, and certificates of deposits.read more fall, which is transmitted in their lending rates. It leads to similar loans being available at a lower interest rate. In such an interest rate environment, refinancing or consolidating debt is rational, reducing borrowers’ interest obligations.Tax deductibility: This is country-specific; however, under certain circumstances, the debt backed by collateral is allowed tax deductions by the IRS in the US.Ease of management: Consolidation leads to only a single payment instead of several payments, reducing omission errors.Lower collection cost: From the lender’s point of view, the collection costs reduce as instead of incurring the same for several loans, they have incurred the same for only one loan.

Limitations

  • Does not provide debt relief:Debt Relief:Debt relief is defined as the process of complete or partial forgiveness of debt taken on by individuals, corporations, or nations, with the goal of stopping or slowing debt growth and providing relief to the debt taker.read more Consolidation only reduces the interest payments and not the initial obligation. Therefore, it may mitigate periodic payments to a more affordable level, but the initial loan amount ultimately remains the same.Difficult for unsecured loans: Consolidation is easier for loans that do not offer collateral. Therefore, not all borrowers can benefit from the lower interest rate environment.Strict terms and conditions: Loans backed by a home as collateral may become risky if the borrower cannot make periodic payments. That could lead to the lender claiming the collateral itself.Creditworthiness: A very high creditworthiness is required for a financial institution to refinanceRefinanceRefinancing is defined as taking a new debt obligation in exchange for an ongoing debt obligation. In other words, it is merely an act of replacing an ongoing debt obligation with a further debt obligation concerning specific terms and conditions like interest rates tenure.read more the borrower’s loan. It may be based on several conditions such as past payment history, collateral, or innovative terms such as expected future career trajectory. Without such creditworthinessCreditworthinessCreditworthiness is a measure of judging the loan repayment history of borrowers to ascertain their worth as a debtor who should be extended a future credit or not. For instance, a defaulter’s creditworthiness is not very promising, so the lenders may avoid such a debtor out of the fear of losing their money. Creditworthiness applies to people, sovereign states, securities, and other entities whereby the creditors will analyze your creditworthiness before getting a new loan.read more, debt consolidation may not be possible.

Conclusion

Debt consolidation is the process of combining multiple debts to take advantage of lower interest rates and convert multiple payment streams into a single one leading to an easier repayment structure. However, the borrower must assess the appropriateness before trying to consolidate his debt because defaulting on even a single payment can cost him dearly, unlike in the case of unconsolidated loans because the risk becomes non-diversified.

This article is a guide to Debt Consolidation and its meaning. Here, we discuss the process and calculation of the debt consolidation loan with examples. You can learn more about financing from the following articles: –

  • Debt Consolidation CalculatorHow to Invest in Gold Fund?Credit Facility TypesMortgage Calculator