Debt consolidation loans are ideal when a borrower has taken loans from one source too many.
Payments on several small debts are difficult to monitor, especially when the amounts are payable on different dates of the month. This means the borrower may unintentionally fail to pay an installment, which may eventually damage his or her credit report. This is especially true of smaller debts, as larger debts are somehow difficult to forget.
By consolidating debts, the borrower brings all such borrowings into fewer but larger debts. Apart from keeping a firm control on payments, debt consolidation loans may also enable the borrower to get a better deal. Interest rates and repayment term are two aspects of any debt.
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In debt consolidation loans, the borrower negotiates on these two factors. It is obvious that if a borrower can get a debt consolidation loan with interest rate that is lower than the weighted average of interest on all his or her borrowings as of date, then the deal is favorable.
But at times, even if the interest rate is a bit higher than or equal to weighted average interest rate on existing debts, the deal may still be worthwhile. This can happen if the repayment term is extended considerably. When repayment term gets extended, the equal installment that is payable every month comes down, improving the cash flows of the borrower, i.e., leaving the borrower in a more comfortable cash position.
From here, inflation does its bit for the borrower. Inflation has the effect of reducing the value of money. Since the borrower would be repaying the loan in equal installments well into future, the value or purchasing power of monies paid in later years would be much lower than what it is in early part of the loan. But the borrower is not required to compensate for that loss in purchasing power of money. Instead, he or she is left with surplus monies on hand today, and this money has more value. This is good for the borrower any day.
So the first step is to check the interest rates applicable on the debt consolidation loan vis-a-vis the weighted average interest rate on all the existing debts. Secondly the borrower needs to check the repayment term, and guess estimate how much advantage he or she would have by discounting for inflation.
A third expense which borrowers generally forget is the loan processing and closing charges. Debt consolidation loans may be taken from existing lender, or any new lender. Existing lenders know the borrower's credit profile, sources of income, etc. Therefore, they can assess how much interest borrower will be able to pay and how financially disciplined a borrower is. Loan processing and closing charges in such case will be less, as borrower's credit profile is already known.
Unlike them, any new lender has to investigate and learn about the borrower's financial behavior and credit scores. Such investigations cost money, and therefore, the loan processing and closing charges imposed by any new lender would be marginally higher.
If debt consolidation loans are being taken on security of any real estate asset, then costs of other expenses such as finding out if there are any liens, confirming the rights of the borrower on the property, getting a valuation of the property are also to be incurred by the borrower.
In any event, it is up to the borrower to negotiate and bargain. Even though loan processing and closing costs are only one-time charges, they have an effect that is equivalent to an increase in interest rates. The borrower could also face some early payment penalty charges when he or she chooses to pay-off an existing loan, as no lender likes to lose a reliable customer.
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