What are Credit Consolidation Loans?

Debt consolidation is the process of combining several smaller debts into one larger debt. Consider this simple example: if you owed one friend $5 for buying you coffee, a second friend $10 for a movie ticket, and a third friend $10 from losing a game of poker, you would have three small debts. "Debt consolidation" would be like borrowing $25 from a fourth person, using it to pay off the three small debts, and then owing the fourth person $25 plus a small amount of interest.

In practice, debt consolidation is a bit more complicated, but the underlying principle is the same: combining smaller debts into one larger debt. One of the more popular debt consolidation practices is taking out a debt consolidation loan. To do this, you take out one loan that covers the total amount owed on several smaller debts. You use the proceeds from the new loan to pay off the smaller debts, and then have one monthly payment for the consolidated loan.

Types of Credit Consolidation Loans

Generally, there are two types of debt consolidation loans – secured and unsecured. A secured consolidation loan requires use to put up collateral, and in the event you stop making payments, the lender has the right to seize the property. The most common secured debt consolidation loans are home equity loans, mortgage refinancing, and home equity lines of credit. Unsecured debt consolidation loans do not require collateral, but the interest rates you pay are generally much higher.

Advantages of Cebt Consolidation Loans

Debt consolidation loans bring several advantages to those trying to pay off debts, including:

• Lower interest rates than most credit cards
• Simplicity of one monthly payment versus several
• Potential for raising credit scores if the loan is paid off on time in full

Disadvantages of Cebt Consolidation Loans

Debt consolidation loans really only address the symptoms of the underlying financial problem, so it is easy to fall back into debt. For example, if a person takes out a debt consolidation loan to pay off credit card debt, but doesn't stop using the credit cards, financial problems can escalate again very quickly.

Alternatives to Cebt Consolidation Loans

Two alternatives to debt consolidation loans are 0% balance transfer credit cards and home equity loans. Balance transfer cards with generous 0% balance transfer periods are generally only offered to people with good credit. Balance transfers usually charge a fee of 2 to 3% of the amount transferred, but if the debt is paid off before the 0% period ends, that fee is minimal compared to the interest that would otherwise accrue during that time. Home equity loans can be used to pay down debt, and the interest rates are often lower than the rates on unsecured loans.

Advantages to Consolidation Loan Alternatives

• Balance transfers to 0% credit cards can be done online or by phone quickly and easily
• If a balance transfer is paid off on time, it's cheaper than a debt consolidation loan
• Home equity loans are available to people who do not have excellent credit

Disadvantages of Consolidation Loan Alternatives

• Not paying the debt before the 0% period ends on a 0% balance transfer card results in a huge jump in interest rate
• Any new credit card can be a source of temptation for overspending
• Home equity loans that aren't paid off can result in foreclosure

Debt consolidation loans are not for everyone, but they can be useful in a concerted plan to erase debt. Consumers should consider other options and compare at least three lenders before taking out a debt consolidation loan to make sure they are getting the best deal possible.

Sources:

http://forexa.org/understanding-the-various-risks-of-debt-consolidation-loans.html
http://www.bankrate.com/brm/news/cc/20031007a1.asp
http://www.thinkmoney.com/debt/debt-consolidation/what-is-a-debt-consolidation-loan-0-5050.htm