Debt Consolidation Loans

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Gary Hemming

Author: Gary Hemming CeMAP CeFA CeFA CSP

20+ years experience in financial services

Credit cards, overdrafts and short-term loans can be a great way to make ends meet when times are tough, but these debts can soon start to build up.

If you’re taking out these credit agreements at a high interest rate, you’re likely paying up to hundreds of pounds each month in ‘dead money’ that does not go toward repaying your debt.

A consolidation loan can be a cost-effective way to combine all your responsibilities into one monthly payment, typically at a much lower interest rate. 

What is a debt consolidation loan?

A debt consolidation loan is the process of combining some or all of your debts into a single new facility. By taking out a loan, you can repay all credit cards, store cards, personal loans and other monthly expenses. In doing so, you will theoretically pay less out each month and potentially reduce your total interest costs.

Imagine that you take home a salary of £1,500 per month and have the following personal debts:

  • A credit card with a balance of £5,000
  • A second credit card with a balance of £3,500
  • A personal loan with an outstanding balance of £1,500
  • A current account overdraft of £2,000

Your overdraft will accrue interest every month, and you are unlikely to clear that off any time soon on your current salary. Your loan monthly payment could be around £80 per month, and your total credit card minimum payments are around £250 per month. That’s about £350 you’re releasing each month to service debt, most of which will simply go on interest and fail to reduce your outstanding balances significantly.

If you took out a debt consolidation loan for £12,000 over several years, you might pay less each month. Even if the repayments are £300, that’s a small reduction – and you will no longer have an overdraft. You will also have less to think about, as you will not need to prepare for multiple monthly charges, and your credit score will likely improve.

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What can a debt consolidation loan be used for?

Debt consolidation loans can be used to bundle all monthly repayments into one. The most popular reasons for somebody to take out a consolidation loan are paying off outstanding overdrafts, personal loans, student loans, and credit cards. You’ll theoretically pay a smaller sum in monthly repayments, often at a lower interest rate.

If you’re looking for a consolidation loan, you may need to show a lender evidence of your outstanding debts. Loans of this type are not designed for home improvements or significant one-off purchases, such as a holiday or a new car. If that’s what you’re seeking, be honest with a lender – you may receive a more favourable interest rate.

In addition to the general reduction of charges you pay each month, a consolidation loan can also be used to improve your credit score. You will take a short-term hit – any hard search credit check typically reduces a score by ten points for a few months – but future lenders are likelier to look favourably on one significant credit agreement than multiple smaller contracts.

How do secured debt consolidation loans work?

If you take on a secured consolidation loan, you will use an asset as collateral. Often, this will be a property you own. Think of this asset as a guarantee for your loan. If you cannot keep up with your repayments, the lender will have a claim on the asset.

This does not mean bailiffs will arrive on your doorstep 24 hours after missing a payment. Most lenders will consider repossession a last resort. This is always a risk with a secured loan, though, so keep this in mind when weighing up your options when it comes to debt consolidation.

Sometimes, a lender offering a secured loan for debt consolidation will also insist on paying your debts directly. With an unsecured debt consolidation loan, the funds will be placed into your bank account, and it is your responsibility to redirect them to your creditors. Some lenders that offer secured loans will not send you the money but take your details and settle accounts on your behalf. This is to ensure the funds are directed to the appropriate places.

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When should you consider a debt consolidation loan?

If you struggle to meet the financial demands of paying multiple loans and credit cards, a consolidation loan can make your life more manageable. You will also have less to remember, reducing the chances of a late or missed payment.

You should also consider taking out a debt consolidation loan if your credit score starts to slide. Every credit agreement you take out impacts your score, for good or bad. You will bolster your standing accordingly by reducing your borrowing to one contract and steadily making the repayments without fail.

Will I qualify for a debt consolidation loan?

Yes, if you have debt and hold sufficient equity in your property, you have a great chance of being approved. As a rule of thumb, most lenders prefer that debt repayments and other monthly commitments, such as rent or mortgage repayments, do not exceed 50% of household income.

Usually, you’ll need to show a lender your bank statements or proof of income to assure them that you are unlikely to default on the loan. They will also check your credit report and seek assurance that your financial situation is unlikely to change for the worst in the near future.

All lenders have their own criteria, so do not be deterred if you are declined by one lender, as another may be happy to consider your application. Just remember that every application that results in a hard credit search will impact your credit score, so consider seeking professional advice on the best sources to contact.

Is a consolidation loan a good idea?

Yes, a consolidation loan is a good idea if you’re looking to reduce or combine your monthly outgoings.

If you’re still on the fence about debt consolidation, consider the following pros and cons.

Advantages of a debt consolidation loan

You’ll likely pay less to service your debt each month

If you get a favourable interest rate, you’ll likely reduce your long-term debt repayments

One repayment a month is much easier to manage than several

Your credit score is likely to improve with fewer agreements on file

Drawbacks of a debt consolidation loan

Taking out a loan ties you into a contract for an extended period

Searching for a loan will impact your credit score, whether you’re successful or not

You may find an alternative approach, such as 0% credit card balance transfers, more cost-effective

If you run up new debts in addition to repaying your loan, you could face major hardship

If you struggle to make your repayments, the consequences can be severe, especially if you took out a secured loan – your home could be repossessed

What are the costs of debt consolidation loans?

The total cost of your debt consolidation loan will be the amount you are borrowing, plus any interest. If you come into money and want to repay your loan early, you may also need to pay an early exit fee.

If you have £25,000 in unsecured debt and take out a loan for this amount over ten years, at an interest rate of 6% APR, your total repayment will be £33,306. So, the loan has cost you £8,306.

However, look at it another way – your monthly repayments will be £277.55 per month. This is one lump sum payment each month, and every payment you make will reduce your overall debt.

If you are paying the same amount or more each month on credit cards and loans, interest repayments likely mean that your balances are not dropping as quickly as you would like. Consider these factors when deciding whether to take out a debt consolidation loan.

Can I get a fixed rate debt consolidation loan?

Yes, most debt consolidation loans should be set at fixed interest rates. This is why finding a lender that offers an agreeable interest rate is so important. You will likely be repaying this loan for around several years, so do not agree to a substandard offer in short-term desperation – consider alternatives to a consolidation loan to manage your debt repayments.

What are the alternatives to debt consolidation loans?

The alternatives to debt consolidation loans are:

Credit card balance transfers

If you have a credit card with a high balance, you will likely be paying just as much interest each month as debt repayments – if not more. Investigate 0% interest credit card transfer offers. These will allow you to make significant inroads into your debt without losing money to interest for a limited time.

Remortgaging or investigating equity release

If you’re a homeowner, you may be able to release funds from your property to clear down your debts. If you remortgage, you will either increase your monthly mortgage repayments or extend the mortgage term. If you opt for equity release, you will reduce the eventual value of your estate upon death or sale.

Formal debt agreements

If you’re struggling to make your monthly repayments, you could try to come to an arrangement with your creditors. Talk to your lenders and ask how you can ease your financial burdens. No lender will wipe out your debt, but they may offer a repayment holiday while you get your affairs in order or reduce your minimum payments.

Many people disregard this option as it’s such an awkward conversation, but you’d be surprised at how accommodating some lenders can be. They would rather receive some level of repayment than have you default. However, this approach will have a long-term impact on your credit score, so consider getting financial advice from a professional before entering such an agreement.

Individual Voluntary Agreement (IVA)

If you can’t see any way out of your debts, consider applying for an IVA. This will essentially declare you insolvent, but unlike bankruptcy, you will not be forced to relinquish reasonable assets such as a residential home or vehicle.

Applying for an IVA means that an insolvency practitioner will contact your creditors and ask them to agree to a smaller settlement figure for your debt. Usually, this will be around 1p for every £1 owed. You will then repay this limited amount over five or six years. If you owe tens of thousands of pounds and pay hundreds each month in repayments, an IVA will drastically reduce these outgoings.

However, an IVA should be considered something of an apocalypse scenario. If you take out such an agreement, it will remain on your credit file for at least six years, and an IVA is equivalent to bankruptcy for many lenders. You’ll find it extremely difficult to gain credit for the duration of the agreement, especially for a significant purchase such as a home or car.

What is the difference between an unsecured and secured debt consolidation loan?

A secured loan for debt consolidation loan is an agreement to leverage your loan against an asset, usually a home or vehicle. This adds a layer of security for a lender, so you may find that you get a more agreeable interest rate.

However, this security for the lender is tempered by risk to the borrower. If you take out a secured loan and cannot keep up with your repayments, you risk your asset. The lender will have the legal right to repossess your home or vehicle to regain their lost investment.

An unsecured loan offers no such risk to a borrower. If you default on payments of an unsecured loan, it will damage your credit score, but your assets are not at risk unless the lender passes your debt to a collection agency.

This may leave you wondering why anybody would take a chance on a secured loan. The first reason is that you may not have any other choice. Some lenders will only consider a secured loan to mitigate any risk if you have a low credit score.

It also depends on how much you are looking to borrow. Most conventional lenders will cap unsecured lending at around £25,000. If you need more than this to service your debts, you may need to agree to a secured loan.

Can you get a debt consolidation loan with bad credit?

It’s sometimes possible to get a debt consolidation loan if you have bad credit, but as always, you may not get the most encouraging interest rate. If you have bad credit, some lenders will consider you a risk and decline to work with you, while others will increase interest rates to counter these risks.

You may need to consult a specialist broker, as conventional high street and online lenders sometimes apply blanket bans to applicants with bad credit. You may also find that some lenders will only consider a secured loan if you have a poor credit history.

If you have bad credit, consider whether debt consolidation is the best course of action. If you cannot see any way of repaying your credit cards and loans quickly or struggle to balance multiple payments each month, you may appreciate making one repayment. Just ensure you’re not throwing good money after bad by taking out a loan at an unfavourable interest rate.

Will a debt consolidation loan save me money?

Yes, a debt consolidation loan will save you money – as long as you find a lender that offers a reasonable interest rate, stick to the scheduled repayments, and do not accrue additional debts on top of those you have consolidated.

Remember that a debt consolidation loan is not the forgiveness of debt. You’ll need to use the financing provided to pay off any loans or credit cards in your name. If you do this promptly, you’ll still owe the same amount, but you’ll theoretically pay considerably less interest and face smaller monthly payments. If you use a consolidation loan to pay off your credit cards and continue spending freely on them, you’ll be paying double. Missed payments on a consolidation loan, and you’ll find that the costs can start to add up. Most lenders will install penalty fees into your contract, and missed payments or defaults will negatively impact your credit rating. This will have a knock-on effect on any future borrowing, potentially leading to higher interest rates.

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