January 13, 2017 No Comment. Posted in Financial Literacy

Debt is an amount of money borrowed by one party from another, under the condition that it is to be paid back in a specified time lines, usually with interest. This is also knows as Loan.

In today fast moving materialistic world we need money for everything, to fulfil our desires irrespective small or big. Every one of us has an easy & instant access to all types of loans such as Consumer loans to borrow any house hold items, Vehicle loan, Personal Loans to fulfil all our personal financial needs like vacations, education, marriage, Medical etc, Business loan for short term business financial requirements, Credit cards, which can fulfil any of our financial needs etc etc…

 

Though taking a loan is not a simple process but managing the repayments becomes all the more complex, hectic and nerve- racking experience for many. There are borrowers who have a tendency to borrow for every and any requirement considering that the re-payment can be made in easy instalments. But they forego to understand that this habit is leading them to a debt-trap. A situation in which a debt is difficult or impossible to repay, typically because multiple EMI for different type of loans or credit cards, high interest payments which prevent repayment of the principal, and for servicing these loans in order to avoid defaults borrower tends to borrow fresh loans.

 

 In this situation of debt trap comes a solution by way of Debt Consolidation. As the name suggest debt consolidation is a process to combine your several unsecured debts, personal loans, credit cards, consumer loans, vehicle loans etc into one loan. It should be noted that unsecured loans are usually on very high interest with shorter tenor, consolidating your entire loans into one gives you flexibility in terms of lower interest rates, extended tenors resulting into reduced EMI or monthly obligations which further results into saving and coming out of the debt traps.

If you own your home you might be able to get either a home equity loan. You would then use this loan to pay off all of your other debts. You would then have only one payment to make in month, which should be considerably less than the sum of the payments you are making on multiple loans. The reason for this is that either one of these loans would have a much lower interest rate than the average of the interest rates you’re now paying. If you’re paying an average of 19%-21% or even higher on your unsecured debts/ credit cards & were able to consolidate them into a variable rate home equity loan, your interest rate could drop to 10%-11% or less. Also the tenor of these secured loans is longer which further reduces the monthly obligation of the EMI.

In case you don’t have a home or alternative would be to get personal or unsecured loan . These are called unsecured loans because they don’t require you to use any asset as collateral to secure them. These loans typically have higher interest rates then secured loans and can be more difficult to get if you’re already having a big problem with debt repayments.

Process for Debt Consolidation

 

Although getting a consolidation loan is a fairly straightforward process just like any other loan process, The obvious things that a lender will check on in this situation are: your credit history, your loan repayment record, your income and expenditure per month etc. In short, a lender bank will go through all those variables that they check while sanctioning your home loan or any other retail loan.

In short, you can avail of such a loan only in case you have a good repayment capacity and a good credit history.

 

Example of Debt Consolidation

 

Mr Gupta has taken a business loan of Rs 800000 @16% with an EMI of Rs 28126 per month, a credit card outstanding of Rs 300000 at an interest of 36% with a monthly interest around Rs 10000 along with the entire principal outstanding, another Vehicle loan of Rs 700000 @12% with a monthly EMI of Rs 23250 and a personal loan of 400000 @19% with an EMI of Rs 16500. Mr Gupta has a total loan Rs 2200000/- (Rs Twenty Two lacs only) with a monthly outflow of EMI amounting to Rs 77876/-.

In order to do the debt consolidations, If Mr Gupta take a mortgage loan against his property or home, for 22lacs, he may get the Interest rate @11% considering his credit history and score with a tenor of 10 years, Mr Gupta will have to pay a monthly EMI of just Rs 30305/-, which enables him to reduce his monthly debt obligation by over 60% reducing the EMI by Rs 47571/-.

 

Why should you consider debt consolidation?

Consolidating debts only makes sense if:

  • You end up paying less interest than you were paying before
  • The overall amount you have to repay is not increasing.
  • You use it as an opportunity to cut your spending and get back on track by coming out of the debt trap.
  • You can keep up the repayment of the new loan until the loan is fully repaid
  • You can afford to pay off any fees or charges to your old lenders for switching your loans to a single loan.

 

Advantages of Debt Consolidation

  • Single payment: instead of paying monthly EMI for different loan on different dates, you just have to pay a single EMI on a specified date, enabling you to manage your finances effectively.
  • Interest rates: Debt consolidations helps us in reducing our total interest cost, since small unsecured loans, credit cards are priced in the rate of 19%-36%, consolidating the debt can help bring the interest cost down to 10%-11%.
  • Single creditor: You will have to manage a single creditor, who will buy over all your existing obligations, making the life & the books of account easy convenient.
  • Loan Tenor: The extended loan tenor will reduce the monthly EMI obligations, enabling you to have some additional cash flows to meet your other requirements.

Some Disadvantage

Extending the Loan Term: Debt consolidating gives you extended tenor with loan Interest rates, but one thing needs to be notes irrespective of Rate of Interest, longer the tenor means you ending up paying more Interest.

  • Hurting the Credit Score: Taking multiple loan give a negative impact on your credit scores, though after being regular in repayments of EMI the score automatically trends towards positive.
  • Jeopardising assets: The best solution for debt consolidation with better terms is by way to taking a secured loan, which means you need to mortgage your home or property till the time the loan is fully repaid.
  • Fee & Charges: In order to do debt consolidation you need to apply for the fresh loans which come with the cost of processing fee as well as administrative fees.

 

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