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The collateralization of the loan allows a lower
interest rate than without it, because by collateralizing, the asset
owner agrees to allow the forced sale (foreclosure)
of the asset to pay back the loan. The
risk to the lender is reduced so the interest
rate offered is lower.
Sometimes, debt
consolidation companies can discount the amount of the loan. When
the
debtor is in danger of
bankruptcy, the debt consolidator will buy the loan at a
discount. A prudent debtor can shop around for consolidators who
will pass along some of the savings. Consolidation can affect the
ability of the debtor to discharge debts in bankruptcy, so the
decision to consolidate must be weighed carefully.
Debt
consolidation is often advisable in theory when someone is paying
credit card debt.
Credit cards can carry a much larger
interest rate than even an
unsecured loan from a bank. Debtors with property such as a home
or car may get a lower rate through a
secured loan using their property as
collateral. Then the total interest and the total cash flow paid
towards the debt is lower allowing the debt to be paid off sooner,
incurring less interest. In practice, many people are in credit card
debt because they spend more than their income. If that habit
continues, the consolidation will not benefit them much because they
will simply increase their credit card balances again.
Because of the
theoretical advantage that debt consolidation offers a consumer that
has high interest debt balances, companies can take advantage of
that benefit of refinancing to charge very high fees in the debt
consolidation loan. Sometimes these fees are near the state maximum
for mortgage fees. In addition, some unscrupulous companies will
knowingly wait until a client has backed themselves into a corner
and must
refinance in order to consolidate and pay off bills that they
are behind on the payments. If the client does not refinance they
may lose their house, so they are willing to pay any allowable fee
to complete the debt consolidation. In some cases the situation is
that the client does not have enough time to shop for another lender
with lower fees and may not even be fully aware of them. This
practice is known as
predatory lending. Certainly many, if not most, debt
consolidation transactions do not involve predatory lending.
Student loan
consolidation
In the United States,
federal
student loans are consolidated somewhat differently, as federal
student loans are guaranteed by the U.S. government. In a
federal student loan consolidation, existing loans are purchased
and closed by a loan consolidation company or by the
Department of Education (depending on what type of federal
student loan the borrower holds). Interest rates for the
consolidation are based on that year's student loan rate, which is
in turn based on the 91-day
Treasury bill rate at the last auction in May of each calendar
year.[citation
needed]
Student loan rates
can fluctuate from the current low of 4.70% to a maximum of 8.25%
for federal
Stafford loans, 9% for PLUS loans.[citation
needed] The current consolidation program allows
students to consolidate once with a private lender, and
reconsolidate again only with the Department of Education.[citation
needed] Upon consolidation, a fixed interest rate is
set based on the then-current interest rate. Reconsolidating does
not change that rate. If the student combines loans of different
types and rates into one new consolidation loan, a weighted average
calculation will establish the appropriate rate based on the
then-current interest rates of the different loans being
consolidated together.
Federal student loan
consolidation is often referred to as refinancing, which is
incorrect because the loan rates are not changed, merely locked in.
Unlike private sector debt consolidation, student loan consolidation
does not incur any fees for the borrower; private companies make
money on student loan consolidation by reaping subsidies from the
federal government.
Student loan
consolidation can be beneficial to students' credit rating, but it's
important to note that not all federal student loan consolidation
companies report their loans to all credit bureaus.[citation
needed]
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