Debt consolidation loan
A debt consolidation loan is a loan used to pay off other loans. The idea is to get a single loan at a lower interest rate instead of multiple loans at a higher interest rate. Many times the length of the consolidation is much longer than the length of the loans it replaces. While this may result in lower payments per month, it can also mean that the total amount paid can be much much greater.
In some cases a debt consolidation loan means you will be paying for purchases long after they are no longer useful. For example, if one of the loans you work into your debt consolidation loan is a car payment, you will be paying on the car for the life of the consolidation loan. This means your car which lasts 5 years may require payments for the next 30 years. When you consider the interest you may end up paying many times the cost of the car.
Some people look for debt consolidation loans as a step on their path toward living debt free. Others see them as a way to increase their spending power by paying their existing obligations over a longer period of time or using the lower interest rate of the consolidated loan to give them more current spending power. Ideally consolidation loans should be used to allow you to apply more of your monthly payment toward the principle and less toward the interest.
Debt consolidation refinance
One way of creating a debt consolidation loan is to refinance your house and take cash out. You can use the cash to pay off other loans which effectively rolls these loans into your mortgage payment. If you take a credit card debt of $15,000 where you own 21% interest and move it into a mortgage where you only pay 6% interest, you have drastically cut down the amount you are paying in interest. However, you've also turned unsecured debt (your credit card bill) into secured debt (the mortgage secured with your house as collateral). You've also stretched the payment on your credit card out for 30 years with a typical mortgage so even if you are at a lower interest rate, you'll pay a lot more over the longer period.
Another option would be to take out a home equity loan with a shorter term. For example, you may be able to get a home equity loan for 10 years at a rate comparable to a mortgage. This can be the best option because you get the low rate along with an accelerated payoff period. This type of setup will minimize your interest payment.
Debt consolidation dangers
While there are some significant benefits to debt consolidation, there are some very serious pitfalls for the financially illiterate consumer. Consolidation may offer some level of financial relief, but for individuals with poor financial self control this may be a curse in disguise. If you consolidate your debt before learning to control your spending it may lead to even deeper debt.
If someone gets into financial trouble and then takes out a new loan that lets them get a lower interest rate on their balances and spread it over a 30 year period, they may be tempted to spend more money on credit. Within a few years they can end up back in trouble again except now the situation is far worse. Any equity they tapped in the beginning is now gone and it is unlikely that there are any consolidation options available for them.
Debt consolidation is usually only beneficial when it is part of an overall change in financial lifestyle and a move toward operating in a debt free manner.
Free Debt Consolidation Loans
While most people find someone else to put together a debt consolidation loan, there are some ways to do a free debt consolidation loan yourself. If you have 3 credit cards and one has a much lower interest rate than the others, you can sometimes create your own debt consolidation loan for free by moving the balances from the higher rate credit cards to the card with the lower rate. It is also possible to take out a home equity loan in order to consolidate your higher interest loans or even take out a second mortgage on your home in order to accomplish the same thing. You may be able to do a cash out refinance in order to use the equity in your house as a consolidation loan. These types of "free debt consolidation loans" will require you to pay interest, but you don't have the added fees that someone might charge you to put together a traditional debt consolidation refinancing for you.