Debt Consolidation Terminology
Debt consolidation is on a constant trend of becoming increasingly complicated. One one side the government attempts to regulate the industry, bringing in new, incomprehensible legal terminology. On the other side there are debt consolidation companies finding ever more ways of financing debt consolidation - the financial industry will never run out of new ways to move money about, or new terms to describe it. So, what do all these fancy words mean, and will they help you get debt consolidation? Here's an overview of some of the basics.
Debt consolidation
Let's start with the word itself. 'Consolidation' is combining things together, so 'debt consolidation' involves combining several debts into one lump. The phrase has taken on other connotations, but strictly speaking any time you replace two or more loans with a single loan, you're doing debt consolidation.
What about those other connotations? When people talk about debt consolidation, they often have a very specific idea of what that means. For instance, debt consolidation more often than not refers to replacing several unsecured loans with one secured loan (I'll explain those terms below). The term 'debt consolidation' is also typically used for consolidation of debts in cases where the borrower has hit some kind of financial trouble - in these cases the debt consolidation would form part of a debt management plan.
Neither of these conditions - being secured, or being part of a debt management plan - are necessary parts of debt consolidation. Still, it's important to understand that this is what some people mean when they talk about debt consolidation, and especially when they criticise it.
Debt Management Plan
If your income is insufficient to pay for your living costs and your debt repayments, then you have a problem. A Debt Management Plan is a plan for escaping that problem. It could be drawn up by anybody, but most typically it is written by the debtor with help either from a debt consolidation company or from a not-for-profit organisation specialising in helping people escape debt.
The debt management plan is not essential to debt consolidation, but it comes close to being essential for getting out of debt. A debt management plan will give you or your debt management company the basis to telephone your creditors and negotiate to reduce and consolidate your payments.
Secured and unsecured loans
Debt consolidation often involves replacing unsecured loans with secured loans. A secured loan is one which is tied to your assets, with the understanding that if you fail in your repayments then your assets will be seized by your creditors. The most common example is a mortgage, where your home will be repossessed if you fail to meet your payments. Like mortgages, debt consolidation loans will usually be secured on your home (if they are secured at all). If you do not have a home, it is sometimes possible (though much less common) for them to be secured on some other asset, such as your car.
Secured loans are typically cheaper than unsecured loans, especially for people with poor credit ratings. The reason for this is that unsecured loans to people seen as 'bad risks' involve a substantial risk premium. That is to say, the bank inceases the interest rate they charge you, to make up for the perceived ris that you won't pay anything at all. With a secured loan, they don't need to cover their risk in this way, because they know that they can take your house if you don't pay them their money.
You need to realise, then, that when you move from an unsecured loan to a secured loan, you're making a trade-off. You're getting lower prices, but in return you're increasing the risk that you'll lose your house. The 'secure' in a secured loan isn't security for you - it's security for the lender at the cost of reducing your security.
Bad debts
Debt consolidation companies often try to catch people with bad debt. Bad debt is money which the lender thinks he is unlikely to get back - perhaps because the borrower is bankrupt or close to bankruptcy.
Why would anybody want to deal with people who have bad debt? The reason is that a debt consolidation company can cheaply 'buy' bad debt from the original lender. What this means is that they will pay the original lender a relatively small amount of money (less than wasoriginally borrowed), in return for the right to collect the debt from the borrower. The original lender will sell the bad debt cheaply, because they do not believe that they have nay hope of retrieving any of the money. So if a debt consolidation company can buy up bad debt and then get even a little money from the original borrower, they can make a profit
Predatory lending
'Predatory lending' is one of the reasons why the debt consolidation industry has a bad reputation in some quarters. It involves companies which proactively try to sell loans (including debt consolidation loans) to people who might not benefit from them.
Why would they want to sell loans to the wrong people, you might ask. Surely that would just lead to bad debt, as their customers find that they can't make the necessary payments. Indeed this is the case - and that's part of the appeal for predatory lenders. If they persuade somebody to arrange a loan they can't afford, secured on their house, then it is liklely that they will fail in their payments, allowing the predatory lender to seize their house.
Notice how far we've come here from debt consolidation itself. People who smear the debt consolidation industry (either through malice or through ignorance) give the impression that all debt consolidation consists of predatory lending. That just isn't so. Often, it's a case of saving people from loans that they can't pay, and so making it less likely that their assets will be repossessed. So steer clear of predatory lenders, but don't let that put you off the idea of debt consolidation.
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