How does debt consolidation work?
An important part of debt management is taking action before debt problems become serious. It can be tempting to ignore mounting debts, especially if it seems like there’s no solution. However, there are different alternatives when it comes to coping with debt, some of which might help prevent further trouble in the long term.
One option is debt consolidation and here we explain why someone might use it, how it works and the effect it might have on your future chances of getting credit.
What is debt consolidation and how does it work?
Debt consolidation is where an individual takes out a loan to pay off several different existing debts, e.g. loans, overdrafts or credit card borrowing. Consolidating these different loans into one means there is only one monthly repayment to make, instead of several. This can make it easier for some people to keep track of debts and to manage their cashflow when making repayments.
The main motivation for debt consolidation is often to lower the size of the monthly repayments. It’s important to calculate exactly how much is already being paid back each month on existing loans to compare it to the consolidated payment. If the payment is higher it might not be a good idea to switch, even if a single repayment is easier to manage.
Debt consolidation may also allow someone to take advantage of lower interest rates, by switching higher interest loans into one lower rate loan. This will depend on creditworthiness and more favourable rates may not be available to everyone. A lower interest rate will lower repayments, but there are other factors at play.
It’s also important to consider the period of repayment as well as any fees involved. The monthly consolidated repayment might be lower than the existing total, but if repayments go on for longer, the total amount repaid might end up being higher. There may also be upfront or hidden fees, which make the loan more expensive than anticipated.
Some debt consolidation loans come in the form of secured loans, which means the lender uses an asset as security against the loan. For homeowners, this asset will normally be their house, meaning it could be repossessed if repayments are not made. It’s particularly important for people to get expert advice before taking on this type of loan, as in extreme circumstances it could mean losing their home.
Alternatives to debt consolidation
Taking out further loans if you’re already in debt is not always a good idea, especially if it encourages even more borrowing on top of the consolidated loan. It may also be the case that it’s not possible to get a consolidated loan, if you have a poor credit history.
It is possible to arrange something called a Debt Management Plan, which is an agreement between a borrower and their lenders on how debts will be repaid. This will be arranged by a third party and may involve some kind of set-up or handling fee. But there are providers that do this for free, such as StepChange, Payplan and National Debtline. It can be useful for people who are struggling to make repayments in the short-term and need to rearrange how they pay.
For people in more serious debt, it may be necessary to consider insolvency procedures like a Debt Relief Order> or an Individual Voluntary Arrangement. Both of these options are formal procedures which prevent creditors taking legal action for a period of time.
How does debt consolidation affect credit scores?
Missed repayments can have a negative effect on your credit report, which may indicate to lenders that you have trouble paying back loans. Finding a more manageable way to make repayments, such as a consolidated loan, could reduce the chances of missed payments and defaults. However, it’s also important to get independent advice about how a consolidated loan might affect your financial future, not just how it will affect your credit report.
Applying for a consolidated loan will also leave a footprint on your credit report – this is known as a ‘credit search’. Trying to take out lots of different loans in a short space of time may also indicate to lenders that you are overly reliant on credit. This may also negatively affect your chances of getting credit in the future.
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