Debt consolidation is the unification of all the credits held by an individual, even if they correspond to different entities. The procedure consists of obtaining new financing to cancel each one of the outstanding loans.
By consolidating their credits, the person commits to a single fee less than the sum of all the payments made per month. This may occur as a result of a lower interest rate or the extension of the financing term.
To explain it in another way, when the bank offers debt consolidation, it is proposing to buy the loans that the debtor owns with other institutions. Thus, a new client wins, providing better credit conditions.
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For example, suppose a person loses their job unexpectedly and can no longer meet all of their financial obligations each month. So, debt consolidation is an alternative to reduce expenses.
Also, unify the loans allows maintaining a greater order. Instead of having several installments with different maturity dates, there will now be a single disbursement that can be programmed strategically.
If I receive my salary on the 15th of each month, an ideal date to pay the bank would be, for example, every 16. In this way, I am reducing the risk of running out of funds to fulfill my obligations.
An additional advantage of debt consolidation is that some financial entities offer a grace period. That is, the individual can unify their credits in April and schedule the first installment of the new loan for July. Thus, for three months the user should not make any payment to the bank.
Disadvantages of debt consolidation
A possible disadvantage of debt consolidation is the increase in total expenses. This will depend on the term of indebtedness (which may have been extended) and the type of interest that the bank sets for the new loan.
Therefore, it is important to calculate the total disbursements until the end of the financing period.
In addition, we must take into account that it will not do anything for the borrower to consolidate his debts if he returns to acquire other credits. This would only generate financial problems.
Example of debt consolidation
Let’s look at an example of debt consolidation. Suppose that a person has a credit for US $ 15,000 in bank A at twelve installments and with an interest rate of 3% per month.
At the same time, he has a loan with bank B of US $ 20,000 to fourteen installments and with an interest rate of 3.5% per month.
In both cases we will assume that all quotas are equal, as in the French method of financial amortization . Thus, we will use the following formula:
Then, the fee is US $ 1,506.93 with bank A and US $ 1,831.41 with bank B. That is, a total periodic disbursement of US $ 3,338.35.
Let’s suppose that you need to pay 50% of both loans. Suddenly Bank C offers the consolidation of the debt with new financing for US $ 17,500. This amount will be used to cancel the outstanding loans.
If Bank C sets a monthly interest rate of 2.5% for the new loan and seven payments, all equal, the fee will be US $ 2,756.17.
Finally, although we do not consider it in the previous example, it should be noted that the early cancellation of a loan may require payment of a penalty.