The combining of several unsecured debts into a single, new loan that is more favorable. Debt consolidation involves taking out a new loan to pay off a number of other debts. The new loan may result in a lower interest rate, lower monthly payment or both. Consumers can use debt consolidation as a tool to make it easier to get out of student loan debt, credit card debt and other types of debt that aren't tied to an asset.
BREAKING DOWN 'Debt Consolidation'
There are several pitfalls consumers should consider when consolidating debt:
– Extending the loan term. Your monthly payment and interest rate might be lower, but you might pay more interest in the long run if you take longer to pay back what you owe.
– Continuing to spend beyond your means. Consolidating debt alone does not get you out of debt; improving spending and saving habits is key. Put your old credit cards in a drawer so you won't use them and don't apply for new ones to avoid getting back into debt.
– Using a home equity loan or line of credit to consolidate consumer debt. While these loans offer low interest rates and deductible interest for taxpayers who itemize their deductions, they also put your home at risk if you fail to make the required payments. Be very cautious about taking this route. It doesn't make sense to lose your house because you couldn't pay your credit card bills.
– Paying expensive fees to a debt-consolidation service. You can consolidate your debt yourself for free with a new loan or low-interest credit card.
– Consolidating debt for convenience. The simplicity of a single monthly payment is not a sufficient reason to consolidate debt.
DEFINITION of 'Direct Consolidation Loan'
A loan that combines two or more federal education loans into a single loan. A Direct Consolidation Loan allows the borrower to make a single monthly payment. The loan is facilitated by the U.S. Department of Education and does not require borrowers to pay an application fee.
BREAKING DOWN 'Direct Consolidation Loan'
A Direct Consolidation Loan allows borrowers to lower the number of loan payments they have to make each month, combining them into a single payment. Most federal loans are eligible for consolidation, but private loans are not eligible. Borrowers can consolidate once they complete school, leave school or fall below half-time student status.
Before considering a Direct Consolidation Loan, it is important to consider any benefits associated with the original loans, such as interest rate discounts and rebates. Once the loans are rolled into a new loan, those benefits are lost. Additionally, if the new loan increases the repayment period, the borrower may wind up paying more interest.