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Debt Consolidation Loans: Meaning and How It Works

Debt Consolidation Loans

Debt consolidation loans refer to the act of refinancing one or multiple debts into a new loan. Debt consolidation can be used to reduce interest rates, reduce monthly repayments or make finances easier to manage by consolidating several monthly payments into one. Debt consolidation loans can reduce the interest paid by borrowers and in some cases, make monthly repayments work better for the borrower.

That said, extending the term of debts to reduce their monthly repayments can lead to more interest being paid over the loan term.

What is Debt Consolidation?

Debt consolidation is the process of repaying a number of debts into one product, usually a loan. Debt consolidation loans usually involve a borrower improving their financial position by consolidating a number of debts into a format that works better for them. For example, a borrower who is refinancing an overdraft and multiple credit cards will usually benefit greatly by reducing their interest rate.

Debt consolidation loans should be considered by any borrower who has debt. Even a single personal loan could be consolidated into a new loan, and this would be beneficial if the lender offers a low enough APR to result in a cost saving.

How does Debt Consolidation Work?

Debt consolidation is usually taken for one of a few reasons, to reduce a borrower’s interest rate, to reduce their monthly repayments or to make budgeting simpler. As such, there’s no sweeping correct time to consolidate debt, it’s important to look at your own financial situation and consider the pros and cons of debt consolidation.

Anyone who has existing finance outstanding can apply for a debt consolidation loan. Most unsecured loan lenders offer up to £50,000 and secured loan lenders have no defined maximum loan.

What are the Types of Debt Consolidation?

There are several types of debt consolidation to consider. The main ones are:

1. Debt consolidation loan

2. Student loan consolidation

3. Credit card balance transfer

4. Secured loans

5. Remortgage with capital raise

Each type has its own individual features. For example, debt consolidation loans and student loans are a type of unsecured loan, while credit card balance transfers are revolving credit. Secured loans and remortgages are secured against property and can usually mean that larger loans and longer terms are available, often at lower interest rates.

1. Debt Consolidation Loan

Debt consolidation loans are usually a type of personal loan, they are usually arranged on an unsecured basis, meaning no security is taken over a borrower’s assets. Debt consolidation loans are usually available from most unsecured loan lenders, with eligibility decided based mainly on your income and credit history.

As a type of personal loan, interest rates are usually between 2.7%-15% APR.

2. Student Loan Consolidation

While this isn’t possible in the UK due to the Government student loan scheme being centralised, in America, student loan consolidation is very important. They allow borrowers to consolidate multiple federal loans and save money.

In the US, student loan consolidation is best achieved by making an application through one of the leading US loan providers such as Upstart, Lending Club or Avant.

3. Credit Card Balance Transfer

Credit card balance transfers allow you to transfer the outstanding balance on a credit card to a new credit card provider. This is a method of debt consolidation used regularly by borrowers to take advantage of promotions from credit card providers, such as 0% interest for a set period. Credit card balance transfer offers usually come with a fee for switching, which can be added to your balance. When considering a credit card balance transfer, it’s important that you consider the length of the promotional rate as well as the setup fee to find the best deal.

4. Secured loans

Secured loans, also known as home equity loans are a type of loan that is secured against your home or an investment property. These loans can be used for debt consolidation and allow borrowers to take out larger loans, over longer terms and often at lower interest rates than unsecured loans. Secured loans come with a more detailed application process than personal loans, so consulting a secured loan broker may be helpful if you feel like you’d benefit from support.

5. Remortgage with capital raise

Remortgages allow you to raise capital by releasing equity from your home. Much like secured loans, they allow you to borrow more money, at a lower rate over a longer-term, reducing your monthly payments significantly. That said, when extending the term of your borrowing, you may find that you end up paying more interest in the long run, even if you have a lower rate, so care must be taken.

What are the Advantages of Debt Consolidation?

There are some major advantages to consolidating debt, which include:

  • Reducing your borrowing costs – A switch to a lower interest rate could massively reduce the amount of interest you pay on your debts, saving you money. This will then free up cash, which can be used profitably elsewhere.
  • Getting out of debt faster – When reducing the cost of borrowing, free cash can be used to repay the loan quicker, meaning you’re able to get out of debt faster.
  • Simplify your finances – Consolidating multiple monthly payments into one simple payment can make it easier to budget. With less payments to make, it’s easier to understand how much money you have left, without having to check what bills have already been paid, and which are due later in the month.

What are the Disadvantages of Debt Consolidation?

While debt consolidation comes with major benefits, there can also be drawbacks. Here we break down the pros and cons of debt consolidation:

  • You may end up paying higher fees – When switching from one lender to another, you may face fees from both, which can wipe out any potential savings.
  • You may end up paying more interest – When extending the term of a loan to reduce the repayments, you will usually end up paying more interest, even if the APR is lower.
  • Could lead to missed payments – The switch from one lender to another requires careful management and could lead to missed payments if direct debits aren’t set up correctly.

How to Consolidate Your Debt

The best approach to consolidating your debts depends on the type of debt consolidation that you’re planning on applying for. Generally speaking, a debt consolidation loan and credit card balance transfer can be applied for online through a loan comparison tool.

Secured loans can be more complex, so it may beneficial to speak to a secured loan broker, or a mortgage broker if you’re planning to remortgage. They will talk through your requirements and handle the application for you, just be careful of high broker fees, which should ideally be avoided.

When should You Consider Debt Consolidation?

Debt consolidation should be considered by anyone who has outstanding debt, as you should always look at ways to save money on your debts. That said, it won’t always be the right option for everyone. There are lots of types of debt and lots of ways to consolidate debt, so you must consider the best approach based on your circumstances.

It’s usually a good idea to consolidate your debts if you’re able to reduce your borrowing costs and save money.

What are the Requirements for Debt Consolidation?

Regardless of the type of loan or credit that you require, there are some common debt consolidation qualifications that each lender will usually require:

  • Proof of income – proof of income allows lenders to check that the proposed loan is affordable by checking the proposed repayments against your income.
  • A credit check – lenders used a credit check to produce a credit score and ensure that you meet their lending criteria. Should you have any bad credit such as CCJs, defaults or previous bankruptcy, this will reduce your credit score and may mean that you need a bad credit loan.
  • Proof of ID – lenders are legally obliged to verify your ID and proof of address, although this can often be done electronically by most lenders.

How does Debt Consolidation Affect Your Credit Score?

Your credit score is a method of assigning a score to borrowers based on the information held on their credit file. Credit scoring isn’t a central system, each lender uses their own formula for scoring credit files. Debt consolidation can improve your credit file in the long term, especially when you consolidate a number of debts into one. That said, your score may temporarily drop initially, before rebounding higher.

What is the Difference between Debt Settlement and Debt Consolidation?

Debt consolidation and debt settlement are two different strategies for improving a borrower’s financial position in the face of debt. Debt settlement involves making an offer to a lender to repay their debt at a level that is lower than the outstanding balance. If an agreement is reached, the lender will close your file on receipt of the reduced settlement.

While your lender may accept this, debt settlement will have a negative impact on your credit file and may make future borrowing more difficult. Debt consolidation is different in that it can actually help to improve your credit history.