How does debt consolidation work?

Using consolidation loans to help clear debt

There are lots of different options when it comes to coping with debt, some of which might help prevent further issues in the long term.

One option is debt consolidation. This is when all of your debts are combined into one individual ‘lump sum’ – so instead of making lots of smaller individual payments every month, you’re just making just one payment to one lender.
If your debts are starting to become unmanageable, the best course of action is trying to tackle the problem before your debt problems become more serious. It can be tempting to ignore mounting debts, especially if it seems like there’s no solution.

What is debt consolidation?

Debt consolidation is when 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 benefits of debt consolidation loans

  • Debt consolidation may also allow you to take advantage of lower interest rates, by switching higher interest loans into one lower rate loan.
  • If you find organising and remembering to make multiple payments confusing, this can help streamline the process, as you’ll only have one payment to manage.
  • Having an easily-manageable payment can help you safeguard your credit score, as you may minimise your chances of missing a repayment.
  • Having a single payment can help you budget, as you’ll know exactly how much you’re paying back every month.

The challenges of debt consolidation loans

  • You could end up paying a higher rate of interest on your debt consolidation loan. If it has a longer term, you may also pay more overall.
  • Depending on the size of your original debt, you may end up taking out a consolidation loan which is larger than all of your combined debts.
  • You may have to pay hidden or extra fees to clear your existing debts.

Please remember that it’s important to calculate exactly how much is already being paid back each month on existing loans and then 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.

What is an unsecured debt consolidation loan?

An unsecured debt consolidation loan is a personal loan you can use to clear your other debts without using an expensive or high-value item – such as your home – as collateral.

As a rule, you can borrow up to £25,000. If you want to borrow more, a secured loan may be better for you.

What is a secured debt consolidation loan?

If you need to borrow over £25,000 – the maximum amount you can get with an unsecured consolidation loan - or you’re finding it hard to get an unsecured loan, a secured debt consolidation loan lets you borrow money by using a high-value item – such as a house or a car – as security for your lender.

Homes and cars are used as collateral for your lender – they’ll be thought of as a ‘safety net’ to ensure that the lender will still be able to get their money if you fail to pay back the loan. It’s best to research a secured loan carefully to ensure you can make repayments; if you’re unable to keep up with repayments, your lender may repossess the item you’ve borrowed against to ensure full repayment.

Alternative options to debt consolidation

Taking out further loans if you’re already in debt is not always the best way to manage your money, especially if it encourages even more borrowing on top of the consolidated loan. You may also not be able 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.

There are providers that do this for free, such as StepChangePayplan and National Debtline. These plans 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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