The Good, the Bad and the Ugly of Consolidation and Refinancing

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Debt in any way is a necessary evil of the modern world. The “now” culture has forced us to eliminate postponing wishes from out behavior and has reduced saving habits to a minimum, if not a negative value. While some spending is an investment, like student loans, shopping sprees at the mall can hardly be regarded as so. Two of the most useful tools of the debt universe are consolidation and refinancing, concepts tailor made for the individual who has gathered a bit of debt in their youth and now wants to put their financial affairs in order.

What is the difference between consolidation and refinancing?

First, let’s start by saying that consolidation and refinancing are different things, even if some consultants use these terms interchangeably. A consolidation takes all your loans, averages the interest rates and rolls them into one loan, with one payment date and a single interest rate, which helps you keep track of your finances in a better way, making you pay the same amounts and the same interest. A refinancing is just taking a new loan, in different terms, which covers your old loan, changes the interest rate and most of the times the repayment period. The reason for which these words have been used as synonyms comes from the fact that both methods give you the opportunity to make just one monthly payment.

How can I consolidate or refinance?

People usually think about consolidation or refinancing when it comes to their student loans, as soon as they have reached a point of steady income.

Consolidation of federal student loans can be made by a Direct Loan Consolidation which includes:

  • Direct Subsidized and Unsubsidized Loans
  • Federal Stafford Subsidized and Direct Unsubsidized Loans
  • Direct PLUS and FFELP Plus Loans for Parents and Graduate Students
  • Health Education Assistance Loans (HEAL)
  • Supplemental Loans for Students (SLS), Federal Perkins Loans, and Federal Nursing Loans

Private student loans are NOT eligible for consolidation into a Direct Consolidation Loan; in this case you are better off with the refinancing option.

Depending on the type of loan, there are different ways of refinancing your loans. You can opt for a personal, unsecured loan, get your money directly form an investor by peer loans or leverage the equity of your home, in a secured loan.

The unsecured loan usually is no more that $35 K, but comes with an interest in the range 10% up to 30% depending on your FICO scores and it is granted for a period of one to five years. The good thing is that it comes with no prepay penalty, so with diligent budgeting, you could get out of debt sooner at no additional cost. The same goes for peer loans, which have an average APR of 17%, with rates fluctuating from 5% to 36%.

If you have some equity, either in your home, your 401K savings or your life insurance you can consider putting these as collateral and getting a new mortgage, with a better interest rate and even a deductible interest rate. The downside is that in this way you are putting your assets on the line in case of missing a few payments.

But one might wonder, is it worth to go to all that trouble?

The good

The most important thing about consolidation or refinancing is that it helps you get your money problems in order. Keeping track of one monthly payment and setting aside the amount for that is easier than having a whole agenda of payments due. Most people miss out on different payments they have to make and they end up with lower credit scores and increased interest rates. Having all your troubles in one basket can help you be more diligent about your duties and gradually increase your score.

Consolidation won’t decrease your interest rate, but will qualify you for income driven repayment plans, like pay as you earn, a good alternative for huge debts but low salary.

Another important benefit of refinancing is the ability to access lower interest rates, either by selecting a longer time period, or by taking advantage of your improved credibility. Just be sure to check APR versus APR to make sure you are really paying less, not just imagine you are doing so. Commissions and fees can be sometimes as much burden as the interest.

For example, a $ 10.000 loan for 10 years with 17% interest  rate (18.39% APR) would yield a total amount of $20760, while refinancing the remaining $7000 after 5 years at 13% interest rate (13.8% APR) interest rate for 8 years, would result in a monthly payment of $117.65, compared to $173.80, which would add up to paying $11.295 to the originally $7067 already paid in the first five years, therefore saving you $2398.

The bad

When computing the total amounts spent on loans, refinancing, and the interest paid via refinancing you might end up paying more than you had originally intended, due to the extended time frame. You are only allowed to consolidate once, if the fixed rate drops below your consolidated rate, you can’t benefit from this change and are stuck with the higher rate.

If you are choosing secured loans for their obvious advantages, like the low rates, only do so if you are able to keep track with payments, or you risk both your collateral good to be taken by the bank and your score to go down with it, making it almost impossible to restore your credibility.

For those who have a Perkin student loan, consolidation is not the best option. In this case you might lose more than you get, since you lose your eligibility to apply to certain forgiveness programs for teachers, firefighters, police officers or active military and registered nurses which wipe your debt after 10 years of payment.

It is also a bad idea to consolidate towards the end of the repayment period. As all loans are paid interest first, principal later, you will be taking on more interest for the same principal. If you choose consolidation any other benefits like a grace period is also gone.

The ugly

The trickiest aspect of refinancing or consolidating is the apparent feeling of being liberated from debt ant the temptation to build on more debt by redirecting the money that were once absorbed by loans and credits into shopping or taking on new credit cards. The problem here is that you only treat the symptoms, without addressing the underlying cause. The point of refinancing or consolidation is to help you repay your debts, not create more, so the wisest thing to do is trying to pay it out as soon as possible.

Another potentially dangerous situation is to use the services of a debt management company, which could market a service similar to a private loan consolidation and pretend that they will manage all the payments for you, as long as you pay the lump amount to them. As Nick Clements explains for Forbes: “These companies will hold the money in an escrow account and will not pay the credit card bills. As a result, your accounts will become delinquent. Your credit score will be negatively impacted. And collection calls will be initiated.” The best advice is to take interest in your finances or ask for help from a non-profit financial advisor, not a company specialized in debts.

In conclusion

Both refinancing and consolidation are useful tools as long as you are aware of your credit score, its impact on the rates you can obtain and have a budget and  goal to get out of debt. Before consolidating make sure you check your eligibility for forgiveness or other programs that could wipe your debt completely, instead of paying more interest. Make sure you do your homework and use calculators to determine the best options for you.

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