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Published 31 January 2024
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Debt Consolidation Loan: What is it and How Does it Work?

Taking out a debt consolidation loan allows you to turn multiple debt payments into one ‘consolidated’ loan and monthly payment. This could save you money, but you need to factor in all the costs and risks involved.

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If you’re repaying multiple debts to different lenders, you might be thinking about combining some or all of them by taking out a debt consolidation loan.

While consolidating debts can have some benefits, it’s also important to consider the risks to help you understand whether it’s suitable for your situation.

Read on to find out how debt consolidation loans work and what factors you need to consider.

At a glance:

  • Debt consolidation may be an option if you want to combine multiple debts into one monthly repayment. But it isn’t the right choice for everyone. 
  • It works by taking out a new loan to pay off your existing debts (including any early repayment charges).
  • Depending on the loan and your individual situation, consolidating debts could reduce your monthly payments and save you money on interest.
  • But, if the new loan has a higher interest rate or a longer repayment term than your current debts, debt consolidation could mean you pay more in interest overall.

What is debt consolidation?

Debt consolidation works by taking out a form of credit to pay off some, or all, of your existing debts. Your existing debt may include loans, credit cards and overdrafts. Consolidating debts means you can focus on paying off one debt in place of those being consolidated.

A loan to consolidate debt may be an option if you want to combine multiple debts into one monthly repayment, but it won’t be the right choice for everyone. 

Depending on your situation, debt consolidation could help you to lower the amount you pay in interest. For example, if you’re currently paying off a couple of short-term loans that have high APRs, consolidating them with a personal loan that has a lower APR could cost you less overall. 

Consolidating debts could also allow you to reduce your monthly payments, though this may mean you need to pay more in interest overall if you repay the new loan over a longer period.

What is a debt consolidation loan?

There isn’t a particular type of loan that’s designed solely for debt consolidation. Even if they’re referred to as debt consolidation loans, they’re no different to any personal loan and work in the same way. 

If you consolidate all of your debt using a debt consolidation loan, you would only need to make one monthly repayment to one lender, rather than keeping track of multiple payments. 

Here’s an example:

  • You owe £2,000 on a credit card, £2,500 on a loan, plus you have a £500 overdraft.
  • You may be able to apply for a new loan of £5,000 to pay off these debts.
  • You would then repay the new £5,000 loan in instalments to one lender over the agreed term.

When you apply for a loan, you will typically be asked what you want to use the loan for. You will need to choose the ‘debt consolidation’ option. 

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Types of debt consolidation loan

Your choice when looking for loans to consolidate debt will likely be between an unsecured or secured debt consolidation loan. 

Unsecured loans are personal loans that are used for debt consolidation. 

These loans are not secured against any asset, such as your home or vehicle, and the rate you get will depend on your credit history, your finances, and the terms and conditions of the lender. 

Alternatively, you could apply for a secured loan for debt consolidation. Secured loans are loans that are secured against a particular asset, usually your home. Because you are using your property as security against the debt, the lender may offer larger loans at lower interest rates, as well as consider applications from people with poorer credit histories.

But you should take particular care with secured loans. If you miss any repayments, you risk losing your home, so it’s important not to make this decision lightly. You should also consider the fact that you may be converting less risky unsecured debt into riskier secured debt.

» MORE: Secured vs unsecured loan: what’s the difference?

Are loans the only option for debt consolidation?

No – you could choose to take out another type of credit, such as a credit card. 

If you have credit card debts, for example, options include paying them off with a loan or transferring them to a 0% balance transfer credit card.

By moving credit card debt to a card with a low or 0% interest rate, you could save money on interest as long as you meet the terms of the card and pay off your balance in full before the lower rate expires. 

However, these cards usually charge a balance transfer fee of between 2% and 4% of the amount you’re moving across. It’s important to consider this fee when you’re working out whether debt consolidation will save you money.

Bear in mind that debt consolidation is completely different to a debt management plan (DMP), which is an agreement between you and your creditors, and is set up by a debt charity or other DMP provider.

And if you have savings, you could consider using them to pay off debt, avoiding the need to borrow more. But it’s important to check whether this would ultimately cost you more, for example in fees for early repayment, and whether you would still have access to funds that you could use in an emergency.

» MORE: Paying off a loan early

Pros and cons of a debt consolidation loan

Debt consolidation can be useful, but it may not be the right option for everyone. Consider the potential advantages and disadvantages below before deciding whether to consolidate your debts using a loan.

Benefits of a debt consolidation loan

Potential advantages of consolidating your debts include the following:

  • You may be able to get a loan with a lower interest rate.
  • It may be easier to manage one debt with one lender rather than multiple debts with different lenders.
  • You may be able to reduce your monthly repayments (although you may pay more overall if you repay the loan over a longer period).

Risks of a debt consolidation loan

Potential disadvantages of debt consolidation loans to consider are:

  • You could end up paying more overall if the interest rate on your new loan is higher or you repay it over a longer period.
  • You need to factor in any early repayment charges on existing loans.
  • Applying for a debt consolidation loan will usually involve a hard credit check, which will be recorded on your credit history.
  • If you continue to borrow while paying off a debt consolidation loan, you risk getting caught in a cycle of debt.
  • If you use a secured loan to consolidate debt, your property or other asset is at risk if you can’t keep up with repayments.

Should I consolidate my debt?

You may want to consider debt consolidation if:

  • You have multiple debts.
  • You are paying a higher interest rate on these debts than you could get by applying for a loan now (if you’ve since improved your credit score, for example).
  • Any money you would save on interest isn’t outweighed by any early repayment charges.
  • The total amount you would repay with the new loan is less than the total amount payable on your existing debts.
  • You prefer to have one monthly repayment to keep track of, instead of multiple payments.

If you choose to take out a debt consolidation loan, you need to be disciplined and make sure you stay on top of your payments. Taking out credit to pay off credit can be risky and could make your situation worse if you continue to use your credit cards and borrow more money. 

It’s important to calculate exactly how much you can realistically afford to repay each month, to make sure you don’t borrow beyond your means. You can use a loan calculator to help with this.

If you’re struggling with your existing loan payments, then taking out more credit is unlikely to be the best option for you. You should contact your current lenders to see if you can come to an alternative payment arrangement. 

It may also be worth contacting a debt charity for advice on your situation. Asking for advice is free and won’t affect your credit score.

Will debt consolidation save me money?

It’s important to understand and compare the cost of your existing loans compared to the new single loan. 

To work out whether debt consolidation could save you money, you need to know: 

  • How much you are set to repay overall on your existing debts.
  • How much it will cost to pay off your debts early (in early repayment fees and charges).
  • How much you will pay overall on the new loan (and whether you can meet the monthly repayments).

If the interest rate on the debt consolidation loan is lower than the rates on your existing loans, and the money you would save isn’t cancelled out by early repayment charges, consolidating your debts could save you money.

Bear in mind that your credit score will affect the interest rate you qualify for and those with better scores are likely to access lower rates of interest.

It’s also important to consider the length of the repayment term on your debt consolidation loan. A longer repayment term may reduce your monthly payments, but you can end up paying more in interest, which wouldn’t save you any money overall.

Getting a debt consolidation loan with bad credit: steps to consider

You may be able to get a debt consolidation loan if you have a bad credit history. However, people with bad credit are likely to be charged a higher rate of interest than those with better credit histories, so it may not make financial sense to consolidate your debts.

If the interest rate on a consolidation loan is higher than the rate on your existing debts, then it will probably cost you more to consolidate your debts. Here are three steps to take before applying for a debt consolidation loan with bad credit:

  • Look at loans available that you are likely to be accepted for, and consider whether they would suit your situation. For example, you may find it easier to get a secured loan if you have a bad credit score, but this comes with the risk that the lender could repossess your property if you fall behind with payments.
  • Before applying for a loan, work out all the costs involved to see if it would save money by consolidating your debts, because with higher interest rates and longer loan terms, you may end up paying more. Crucially, work out whether you would be able to afford the repayments.
  • Consider your own relationship with borrowing. For example, do you consistently have trouble making repayments, and are you likely to borrow more outside of your debt consolidation loan, creating repayments to more lenders – and a cycle of debt? 

If you’re struggling with debt you should seriously consider whether debt consolidation is right for you.

Instead, you may be better off finding an alternative solution. This might involve getting debt advice or contacting your lenders to explain that you’re finding it hard to repay your debt.

Does debt consolidation hurt your credit?

Because debt consolidation involves an application for a loan, most lenders will conduct a hard credit check that will be recorded on your credit history.

Multiple hard credit checks in a short space of time can affect your credit score. As a result, you should aim to minimise the number of applications for credit you make, and carefully consider whether you’re likely to be accepted before applying.

However, as long as you make all the repayments on your debt consolidation loan, as well as meeting all your other credit commitments, your credit score should start to improve.

Bear in mind that if you close a credit card after paying off the balance it can also affect your score. Even though closing a credit card can stop you from building up debt on it, it also means you have less available credit and a higher credit utilisation ratio.

What is a credit utilisation ratio?

A credit utilisation ratio tells you how much of your total available credit you are currently using. For example:

  • If you have three credit cards, two with a £3,000 credit limit and one with a £2,000 credit limit you have an overall credit limit of £8,000 
  • If add up what you owe across all of these cards and the total is £4,000 you are using half of your available credit.
  • But if you don’t use the credit card with a £2,000 limit, meaning your balance on it is zero and you close this unused credit card, you will still owe £4,000. Your debt is still spread over the two cards but your available credit limit will drop to £6,000. 
  • This means you’re using two-thirds of your available credit – a higher credit utilisation ratio than when you were using half.

A lower credit utilisation ratio is typically better for your credit score.

How to consolidate debt using a loan

Before doing anything, you need to work out how much you owe across all your debts. Ask your lenders for a settlement figure (the amount you need to pay to clear your debt, including any early repayment charges).

Once you have these figures, you know how much you need to borrow to pay off your debts. You would then need to apply for a large enough loan to pay them off. 

When you choose a lender, double-check that it will allow you to use the personal loan for debt consolidation before applying.

Lenders will need to know your personal details and information about your income, employment status and expenses. They will use this information, and the findings from a credit check, to decide whether to offer you a loan.

If your application is accepted, you can use the loan to pay off some or all of your existing debts. You would then repay this new loan as specified in your loan agreement.

You may be able to check your eligibility for a loan before formally applying. This won’t affect your credit score and it can help you see your chances of approval.

» MORE: How to get a loan

Alternatives to a debt consolidation loan

Instead of taking out a debt consolidation loan, there are other options you might consider. The right choice for you will depend on your situation, but some possible alternatives include:

If you’re struggling with debt, there are free charities that can help. These include StepChange, National Debtline, and Citizens Advice. Advisers at these charities can help you budget and come up with a plan to repay your creditors. 

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