Understanding debt consolidation

Taking out a loan for debt consolidation allows you to turn multiple debt payments such as credit cards and student loans into one ‘consolidated’ loan and monthly payment. This can potentially offer you a better interest rate and added convenience, saving you time and money.

Jim Kersey Last updated on 20 January 2021.
Understanding debt consolidation

There are many different ways to tackle debt. The most effective method is obviously not accumulating it in the first place, but this is not always realistic - especially with things like student loans, mortgages and credit cards being a necessary part of most people’s lives.

To handle all this debt – and it’s not uncommon for individuals to have several different kinds of debt at any one time – it helps to create a debt management plan.

Whether it’s a brief timeline of when you plan to pay off certain loans, or you take things further and consider taking out a debt consolidation loan to help you organise and reduce your overall interest, don’t underestimate the value of putting a plan in place to stop your debt from growing out of control.

If you’re interested in how a debt consolidation loans work, here’s what you need to know.

What is a debt consolidation loan?

A debt consolidation loan takes various different debts and combines them all into one single debt and one single monthly payment. It can be a way to lower your monthly payments as well as focus your efforts on one manageable debt, rather than several on multiple interest rates.

This also means dealing with just one lender rather than multiple lenders, cutting out the need to communicate with them all separately.

Who needs a loan for debt consolidation?

Sometimes it’s just a case of realising that you have too many credit agreements going on and proactively decide to review your debt and tidy things up. Rates may have improved since those loans were taken out and you want to take advantage.

However, more likely, is the realisation that repayments are becoming unmanageable which can happen if you commit to too many loans. Most consumers are looking to reduce their monthly outgoings caused by multiple debts and this is their primary focus.

Will consolidating my debt save me money?

It’s important to understand and compare the cost of your existing loans compared to the new single loan. You may be able to achieve an overall lower interest rate with one single consolidation loan. However, you may end up extending the term of your debt and therefore the total amount you repay.

All this depends on whether you can get a loan that is big enough to cover all your current debts though. Therefore, it’s important to calculate exactly how much you owe and what you can handle each month in terms of your repayments.

Your credit rating will also affect the interest rate you are offered. If you have a less than perfect credit score, you may see rates you are offered higher than you expected, and you might need to explore other options to manage your debt.

What types of debt consolidation loans are available?

For those who decide that debt consolidation is the right choice for them, there are two main types of available loans to choose from:

Secured loans

Secured loans are loans that are secured against a particular asset, which is usually your home. These are sometimes called homeowner loans or second charge loans depending on the lender.

If you should miss any repayments, you could potentially lose your home in the most serious circumstances, so it’s important not to make this decision lightly and to consult other members of your family who may be affected by this.

Because you are using your home as security against the debt, the lender is more willing to consider larger, longer term loans and various type of credit profile including those with bad credit.

Unsecured loans

Unsecured loans are personal loans, being used for debt consolidation. They are not secured against any asset, and the rate you get will depend on your financial status and the policy of the lender.

There are a number of debt consolidation loans online that you can browse, but as a general rule, it will be easier to get a loan if you have a good credit history and can make term five years or less.

» MORE: What's the difference between secured and unsecured debt consolidation loans?

The benefits of a debt consolidation loan

  • A potentially lower interest rate with lower monthly payments
  • A streamlined process with fewer payments to juggle (one payment every month)
  • A potential improvement of your credit rating after lenders see that you are managing your finances responsibly and have paid off multiple credit cards, for example

The risks of a debt consolidation loan

  • A higher interest rate depending on your lender and the deal you get
  • Additional charges or expenses for missing repayments
  • Potential early repayment charges on existing loans can add extra to the debt
  • A lower interest rate might not reduce you overall cost of borrowing, if in finding a manageable repayment term you extend the term, you are increasing the total amount you repay.

What are the important considerations for debt consolidation loans?

Lenders that offer debt consolidation loans will often prefer to secure larger loans against assets such as your home. This is one of the most important things to consider before you decide to go with one of these loans because ultimately, your property will be at risk if you do not keep up with your repayments.

In a more general sense, it’s not wise to take out any loan before you know you can handle the repayments over the full term of the loan. You should factor in any changes that could take place over the coming years such as changes in job or location that might affect your ability to make the repayments.

Also, if you do decide to consolidate your debts with a single loan, make sure you don’t accumulate any additional debt whilst you’re still paying off your previous debts. Just because you have fewer individual debts to pay off, this doesn’t mean that the total that you owe is any less.

Finally, everything comes down to the specific loan deal that you receive from your lender. This can vary massively depending on your credit history, how much you wish to borrow and the policy of your lender.

Are there alternatives to debt consolidation loans?

There are a few alternative ways to clear your debts that you can consider instead of taking out a debt consolidation loan. For instance, using your savings or selling an asset may be the fastest and easiest way to pay off your debt. Or how about searching for a better mortgage deal?

Taking out a single loan may sound good in theory, but if you can’t handle this, you are in a similar, if not worse, position than you started in.

It may be worth finding ways to pay off your loans that do not involve any further debt. You can find many tips and strategies to do this from helpful sources like StepChange, The Money Advice Service or the National Debtline. These organisations also offer personal advice for those looking for additional help and support for debt.

Is debt consolidation right for you?

If you choose to look for a debt consolidation loan, make sure you carefully review the options that are on the market. Compare the terms offered by different lenders and seek advice from professionals whenever possible before making a final decision.

Pay extra close attention to additional costs such as arrangement fees or early repayment charges. If you simply look at the headline interest rate, you may get a distorted view of what your repayments will look like.

About the author:

Jim brings together unique data insights, contextual knowledge and thought provoking themes, to shed new light on important issues affecting both UK businesses and individuals. Read more

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