Debt Consolidation

What is Debt Consolidation Loan?

Debt consolidation is the process through which a borrower refinances and combines several loans into a single one to receive the benefit of a lower interest rate or a reduced periodic payment or maybe both, this leads to a reduction in his liability and brings in an ease in the management of the loans.

We need to understand that the consolidation process doesn’t reduce the loan obligation itself, however, it reduces the interest on a loan or shortens the time period, leading to a quicker repayment.

Generally, debt consolidation is most popular for credit card loans and student loans, it may also apply to government debt or corporate debt. At times, such loans require collateral and one of the most popular collateral is home equity.

Debt-Consolidation

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Process of Debt Consolidation Loan

Process of debt Consolidation

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A few institutions that provide debt consolidation facilities are the following:

  • Lendingtree
  • Lightstream
  • Discover Debt Consolidation
  • Marcus by Goldman Sachs
  • Wells Fargo

Examples to Calculate Debt Consolidation Loan

There can be two situations which can lead to a reduced liability through Debt consolidation:

  1. Interest rate and periodic payment reduce, while the term of the loan remains constant.
  2. Periodic payment remains constant while the term of the loan and interest rate reduces.

Let’s look into a few examples to understand both of the above situations:

You can download this Debt Consolidation Excel Template here – Debt Consolidation Excel Template

Example #1

Suppose we have 4 loans of $250,000.00 each with an average interest rate of 20% p.a. We find out that we can consolidate it into one loan at 15% p.a. Therefore, if we are given the information 1-4 as shown below, we calculate the 5th, i.e. PMT:

Given data Example 1

A periodic payment is calculated by solving the following equation:

PV = PMT* (1-(1+r/frequency)-n*frequency) / (r/frequency)

We calculate the PMT under, both scenarios below, followed by their respective amortization schedulesAmortization SchedulesThe amortization schedule for a mortgage is an index that provides the details of a mortgage loan repayment. It shows both the amount repaid as the principal and the sum paid as interest to date by the borrower.read more and then draw a comparison between the two to understand the impact of debt consolidation.

Before Consolidation

Debt consolidation Example 1-1
  • = PVBefore Consolidation  = PMT *(1+(1+20%/12)^(-2*12))/(20%/12)
  • = 10000000 = PMT * (1+(1+20%/12)^(-2*12))/(20%/12)
  • PMT = 10000000/196480
  • PMT = $50,895.80

Amortization schedule Before Consolidation

Debt consolidation Example 1-2

Amortization schedule After Consolidation

Debt consolidation Example 1-3
  • PVAfter Consolidation  = PMT *(1+(1+15%/12)^(-2*12))/(15%/12)
  • 10000000 = PMT * (1+(1+15%/12)^(-2*12))/(15%/12)
  • PMT = 10000000/20.6242
  • PMT = $48,486.65
Debt consolidation Example 1-4

Points for understanding the above calculations

Comparing the two scenarios, we observe

  • This example if of the first type mentioned above, wherein the interest rate and periodic payments both get reduced due to a fall in the interest rate from 20% to 15%
  • Total interest paid before consolidation over the 2 years was $221,499.26 while that after the consolidation is 163,679.55, therefore this leads to a saving of $57,819.71
  • Monthly payment before consolidation was $50895.80 while that after the consolidation is $48486.65, therefore this leads to a saving of $2,409.15 per month
  • To pay off a loan of $1,000,000, before consolidation, we pay a total amount of $50,895.80 x 24 = $1,221,499.26 while after consolidation we pay off the same loan by paying only $48,486.65 x 24 =  $1,163,679.55, which is a saving of $57,819.71, same as the difference between the total interest mentioned in the first bullet point

Example #2

Now let’s look at an example where the periodic payment remains constant while interest rate and the term of the loan reduce:

Given data Example 2

Point to be noted:

Here before the consolidation scenario is exactly the same as in the previous example and the PMT calculation is also the same. However, after the consolidation scenario, we keep the PMT the same as it was before consolidation but the interest rate falls. Therefore the time taken for the loan to repay has shortened to 23 months instead of full 2 years and the last payment will be less than $50,895.80 so that it is sufficient to pay off the loan.

Therefore, all the calculation for before consolidation scenario remain the same while those for after consolidation are as follows:

  • PVAfter Consolidation  = PMT *(1+(1+15%/12)^(-n*12))/(15%/12)
  • 10000000 = 50895.80* (1+(1+15%/12)^(-n*12))/(15%/12)
  • n = 1.89 years

Amortization Schedule After Consolidation

Amortization schedule after Example 2-1

We can even view the same graphically in the below chart of interest and principal paymentPrincipal PaymentThe principle amount is a significant portion of the total loan amount. Aside from monthly installments, when a borrower pays a part of the principal amount, the loan's original amount is directly reduced.read more.

Graph Example 2-2

Comparing the two scenarios, we observe:

  • This example if of the second type mentioned above
  • Total interest paid before consolidation over the 2 years was $221,499.26 while that after the consolidation is 154,751.62, therefore this leads to a saving of $66,747.64
  • Time is taken to pay off before consolidation was 24 months while that after the consolidation is 22 months when the PMT = $50,895.80 and 23rd month of liquidating payment of $35,043.96

Benefits

Limitations

Conclusion

Debt consolidation is the process of combining multiple debts to take advantage of lower interest rates and convert multiple payment streams into a single one leading to an easier repayment structure. The borrower must assess the appropriateness of the same before trying to consolidate his debt because defaulting on even a single payment can cost him dearly unlike in case of unconsolidated loans because the risk becomes non-diversified.

This has been a guide to what is debt consolidation and its meaning. Here we discuss the process and calculation of debt consolidation loan with examples. You can learn more about financing from the following articles –