Understanding debt consolidation loans

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Consolidate your debts into a single monthly repayment

Person looking up debt consolidation loans on laptop

Debt consolidation usually involves taking a number of existing loans and credit card balances and combining them into one single, relatively large loan.

Why would you want to consolidate your loans like this?

There are several advantages of a debt consolidation loan. Juggling multiple debts with different lenders can be confusing. Consolidating all of your debts into a single loan allows you to focus on one repayment and deal with one lender. A single repayment leaving your bank account each month will make life a lot easier.

Debt consolidation loans can also save you money. Your existing loans and debts may attract higher interest rates than the rate you will get on a consolidation loan. Particularly if you have outstanding credit or store cards. As the rate will be lower on your consolidation loan, you’ll be paying more of the balance off each month and less interest.

You may also be able to spread your repayments over a longer term. This will help to reduce your monthly payments, which can be useful if you’re on a tight budget. However, make sure you are not paying more in the long term than you would for your existing debts. You could end up worse off!

There are two types of debt consolidation loan

Debt consolidation loans can be either secured or unsecured. If you own your home, a second mortgage may be a good option for you. Whilst you’ll be putting your home at risk, a second mortgage allows you to borrow more at a lower rate of interest and over a longer term than unsecured loans. This means you can reduce your payments as far as possible, freeing up more of your monthly cash for life’s essentials.

An unsecured loan, also known as a personal loan, is not secured against any asset. If you can’t keep up with repayments for an unsecured loan, the loan company will not be able to repossess your home, but your credit rating will be affected.

Is debt consolidation for me?

While debt consolidation has many benefits, it’s always worth bearing a few things in mind before you complete your debt consolidation loan application.

As with all borrowing, it’s important that you know you can afford the repayments. Borrowing more money when you’re already feeling the pinch isn’t always wise. It may well be a good solution to consolidate your debts, but don’t add to your debt and borrow more than you need.

Responsible lenders are committed to helping you make financial decisions that best suit your circumstances, so many may be unwilling to lend you more money if during the application process they realise you are already struggling financially.

How does debt consolidation work?

You can consolidate any kind of debt, secured or unsecured, but you need to make sure that your new consolidation loan is big enough to pay off all your other loans and debts combined. You should also be sure that you can afford the repayments on your new debt consolidation loan.

Once your debt consolidation loan has been approved, either you or the debt consolidation lender will need to pay off the existing loans from the proceeds of the new loan. If you’re paying off a balance on your credit card you may just need to pay the figure shown on your monthly statement. However, if you are paying off loans and hire purchase the lender will normally be asked to provide a settlement figure. This is the amount they will require from you to repay the loan in full and will usually be the balance less an interest rebate. Your debt consolidation lender will usually handle all of this for you.

Once the debt consolidation loan has been paid out, your existing loans will be repaid and your credit file will be updated to show this. You can then cancel the monthly payments with your bank.

All you need to do then is to make sure you have the money in your bank account each month to cover the regular loan repayments.

Advantages and disadvantages of debt consolidation

Like most things, debt consolidation has its pros and cons. The main advantage of debt consolidation is that with all your loans and debts consolidated in one place, it’s much easier to manage. It takes the stress out of having to think about a list of different payments that need to be made each month by letting you focus on one payment instead.

Debt consolidation can also help you improve your credit score. How? By showing lenders that you are a responsible borrower. This is because one debt consolidation loan will replace numerous different loans and credit cards which can be closed and your credit file updated.

Borrowing over a longer term usually means that you will be paying lower monthly instalments. However as this means that the loan may attract interest for a longer period, you may end up paying more over the longer term. This needs to be balanced against the monthly savings you will see from your debt consolidation loan.

What are the alternatives to a debt consolidation loan?

If you are having difficulty paying back your debts, there may be a better solution than a debt consolidation loan. Here are alternative options:

  • A Debt management plan or DMP, is an informal agreement between you and your creditors to pay all your debts with reduced payments. A DMP is for people, who have some money left over at the end of the month after they’ve dealt with their priority debts and essential living expenses. It can only be used to pay off unsecured loans and non-priority debts. A debt consolidation plan is typically arranged by a third party, a charities (StepChange, PayPlan, National Debtline) or debt management company. If you decide to use a debt management company be aware there is a service fee you have to pay.
  • An individual Voluntary Agreement (IVA) – this is for people in more serious debt who cannot afford their current debt repayments. An IVA is a legally binding agreement between you and your creditors to pay back all, or part of your debts over a period of time. Most debts can be included, but it’s most commonly used for unsecured, non-priority debts over £10,000.
  • A Debt Relief Order, or DRO, is a legal procedure and form of insolvency that can help you to write off debt that you’re unable to repay in a reasonable amount of time. If your application for DRO is successful, your creditors will be unable to cut against you for the debts you owe them and at the end of the order (usually 12 months) you will be free of the debts listed on your DRO. To qualify for DRO you must have debts of less than £20,000 and have no more that £50 left over each month after paying essential debts. You also won’t be able to apply for a debt relief order if you own a home, have assets of more than £1000 and own a car worth more that £1000. DROs can only be used to pay unsecured loans and non-priority debts. Bear in mind your DRO will stay on your credit record for 6 years and on the public record for 15 months.
  • Bankruptcy – a legal procedure for those who cannot pay their debts, when you are declared bankrupt your unsecured debts are written off. For a creditor to make you bankrupt, you must own at least £5,000. Details of your bankruptcy will be made public and maybe reported on in the newspapers. It will also remain on your credit record for 6 years.

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