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.
Process of Debt Consolidation Loan
- Loan consolidation can be self-created such as balance transfer options of credit cards or can be achieved by seeking the help of a financial institution.
- As shown in the below flow diagram, the financial intermediary approaches all the lenders on behalf of the borrower and informs them of the consolidation and new terms and conditions, once it is satisfied with the ability of the borrower to pay off the loan. Secured loans have a better chance of getting consolidated while it is more difficult for unsecured loans.
- After consolidation, the borrower makes payments to the consolidation intermediary, which in turn pays to the lenders.
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:
- Interest rate and periodic payment reduce, while the term of the loan remains constant.
- Periodic payment remains constant while the term of the loan and interest rate reduces.
Example #1
Let’s look into a few examples to understand both of the above situations:
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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:
A periodic payment is calculated by solving the following equation:
We calculate the PMT under, both scenarios below, followed by their respective amortization schedules and then draw a comparison between the two to understand the impact of debt consolidation.
Before Consolidation
- = 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
Amortization schedule After Consolidation
- 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
Points for understanding the above calculations
- Opening balance = previous year’s closing balance
- Closing balance = Opening balance + Loan- Principal repayment
- PMT is calculated as per the above formula
- Interest = 0.20/12 x opening balance in before consolidation scenario and 0.15/12 x opening balance in after consolidation scenario
- Principal repayment = PMT – Interest
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:
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
We can even view the same graphically in the below chart of interest and principal payment.
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
- Favorable terms: If the central bank so desires, it reduces the policy rate and therefore the borrowing costs for commercial banks fall, which is transmitted in their lending rates. This leads to similar loans being available at a lower interest rate. In such an interest rate environment, refinancing or consolidating debt is a rational choice as it reduces borrower’s interest obligation.
- Tax deductibility: This is country-specific however, under certain circumstances, the debt backed by collateral are allowed tax deductions by the IRS in the US.
- Ease of management: Instead of several payments, consolidation leads to only a single payment, which reduces errors of omission.
- Lower collection cost: From the lender’s point of view, the collection costs reduce as instead of incurring the same for several loans, they have incurred the same for only one loan
Limitations
- Doesn’t provide debt relief: Consolidation only reduces the interest payments and not the initial obligation. It may reduce periodic payments to a more affordable level but ultimately the initial loan amount remains the same.
- Difficult for unsecured loans: Consolidation is easier for those loans which don’t offer any collateral and therefore not all borrowers can avail the benefits of the lower interest rate environment
- Strict terms and conditions: Loans backed by home as collateral may become risky if the borrower is unable to make the periodic payments. This could lead to the lender claiming the collateral itself
- Creditworthiness: A very high creditworthiness is required, for a financial institution to refinance the borrower’s loan, it may be based on several different conditions such as past payment history, collateral or innovative terms such as expected future career trajectory. Without such creditworthiness, debt consolidation may not be possible.
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.
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