Debt Consolidation Loan

A debt consolidation loan is an unsecured installment loan whose proceeds are used to pay off existing debts, most often credit card balances. The borrower receives a fixed sum, or the lender pays the old creditors directly, and then repays the new loan in equal installments over a set term.

The naming deserves one sentence, because two other terms cover the same ground from different directions. Debt consolidation is the act, and it is a category rather than a product: the same act can be carried out with a balance transfer, a home equity loan, or a debt management plan involving no new credit at all. A personal loan is the instrument, and in federal law it is simply closed-end credit. A debt consolidation loan is the intersection of the two, the personal loan marketed and used for that one purpose. Nothing in law distinguishes it: the lender's underwriting, its Regulation Z disclosures and its remedies are those of any personal loan.

What is genuinely distinctive is therefore not legal but operational, and it is where the failures happen. The amount is fixed by other people's payoff figures. The money frequently goes to those creditors rather than to the borrower. And the accounts being paid off survive the transaction with their limits intact.

The loan is sized by other creditors' numbers, which is a harder problem than it sounds. An ordinary personal loan borrower decides how much to borrow. Here the amount is determined by the sum of the payoffs, and each of those is a moving figure until the day it is paid. Balances accrue interest between the quote and the payment, a statement can post in between, and a payoff on a revolving account is not a fixed number the way a closed-end payoff is. So a loan sized to the balances as they stood at application is systematically slightly too small.

The origination fee makes that worse in a way the interest rate does not show, and this is the arithmetic to do before signing. Where a lender deducts an origination fee from the advance, the borrower receives less than the loan amount while owing and paying interest on the whole of it. Published material on personal loans covers what that does to the annual percentage rate. The consequence specific to a consolidation is different and more concrete: the money that reaches the creditors is the advance, not the loan amount, so the fee comes directly out of the balances being retired. A loan whose face amount equals the balances leaves the fee unpaid on those accounts, where it continues to accrue at the card rate. The fix is to gross the loan up, and the worked example below does the arithmetic.

Direct disbursement changes several things at once, and only one of them is convenience. Where the lender pays the old creditors rather than advancing the money to the borrower, the payee is the creditor and the borrower never controls the funds, which removes both a step and a temptation. Three mechanical consequences follow, and each one is a place a consolidation goes slightly wrong.

The payoff figure is dated. Interest accrues on a revolving balance until the payment posts, so an amount quoted on one day and paid a week later leaves a residual. A residual balance means the account is still revolving, which matters more than its size, because a card carrying a balance is a card that keeps accruing.

The old payment is still due until the payoff posts. Nothing about applying for or being approved for a consolidation loan suspends the contractual minimum on the accounts being consolidated. A borrower who stops paying the cards on the strength of an approval can pick up a delinquency on an account that was about to reach zero.

And the payoff does not close the account. Paying a revolving balance to zero leaves the account open with its full credit limit available, unless the borrower separately asks for it to be closed.

The re-accumulation problem has a mechanism, and it is not weak will. The parent page notes that the old accounts stay open. The mechanism underneath it is worth stating precisely, because it explains why the pattern is so consistent. At the moment the loan funds, three things are simultaneously true. The share of available revolving credit in use collapses to near zero, because the balances are gone and the limits remain, and the credit utilization page covers what that does. The household's total available credit is unchanged, so its capacity to borrow again is at its maximum. And a new fixed monthly obligation has been added to the same income, so its capacity to absorb a shock is at its minimum. Maximum available credit and minimum slack arrive on the same day, which is the mechanism behind a second set of balances rather than any failure of resolve.

Closing the emptied accounts is the obvious response and it is not automatically the right one, because removing those limits raises the share of the remaining credit in use. That trade-off belongs to the consolidation decision as a whole rather than to this instrument, and the parent page treats it.

Two things this page deliberately does not decide. Whether to consolidate at all, and how to compare offers, is the parent page's subject, and its test is total cost against total cost rather than payment against payment. Whether to use an unsecured loan or something secured by your home is the same page's most consequential question, because the cheaper rate is bought with the lender's better remedy. Both are prior questions to anything here.

The borrower applies, the lender underwrites the whole obligation set as it stands today, and an amount, rate and term are offered. The borrower supplies the accounts to be paid off and their payoff figures. At funding the lender either advances the money or pays the creditors directly, less any origination fee. The old accounts drop toward zero and stay open. The borrower repays the new loan in equal installments over the term.

A hypothetical example of sizing, which is the arithmetic easiest to get wrong. Priya owes $18,400 across three cards and is offered a loan at a 6 percent origination fee deducted from the advance.

Sizing it to the balances. She signs for $18,400. The fee is $1,104 ($18,400 × 0.06), so the advance is $17,296 ($18,400 − $1,104). That is what reaches the creditors, which leaves $1,104 outstanding across the three cards, accruing at their own rates, on accounts she believed were cleared. She is now paying a consolidation loan and carrying card balances.

Grossing it up. To net the $18,400 she needs a loan large enough that 94 percent of it covers the balances, which is $19,575 ($18,400 ÷ 0.94, rounded up to the next $25). The fee on that is $1,174.50, the advance is $18,400.50, and the balances are actually retired. She borrows $1,175 more and pays interest on it for the term, which is the real price of the fee rather than the price the fee appeared to be.

Two refinements worth adding to whichever figure you use. Ask each creditor for a payoff good through a specific date rather than a current balance, since interest accrues until the payment posts. And keep paying the old minimums until each payoff actually posts, because the contractual obligation on those accounts does not pause for an approval.

Pros

• One fixed payment on one date with a stated end, which is something a revolving balance never has.
• Where the lender disburses directly to the creditors, the borrower never holds the money, which removes one way a consolidation fails at the outset.
• The instrument is unsecured, so falling behind cannot directly cost the borrower a house, which is the trade-off the home-equity route makes in the other direction.
• Because it is closed-end credit, the annual percentage rate folds in the financing costs, so two offers can be compared on a single regulated figure.
• Paying revolving balances to zero moves the share of available revolving credit in use sharply, which is the fastest-moving input to a credit score.

Cons

• The amount is set by other creditors' payoff figures, which move, so a loan sized at application is systematically slightly too small.
• An origination fee deducted from the advance comes straight out of the balances being retired, leaving a remainder on the cards unless the loan is grossed up for it.
• A payoff quote is dated, and a residual left behind means the account is still revolving.
• The old minimum payments remain contractually due until each payoff posts, and an approval is not a payment.
• The accounts are not closed by the payoff, so full borrowing capacity and a new fixed obligation arrive on the same day.
• It does not reduce what is owed by a cent, and a longer term can raise the total cost substantially while lowering the payment.