Guide to debt consolidation loans
- Consolidating debt into one place could save you money and make finances easier to manage
- Be aware of early redemption fees on existing financial products
- Think carefully before transferring unsecured debt into a secured loan
- DON'T consolidate then use the financial breathing space to take out more short-term debt
The logic behind debt consolidation loans may seem sound and this type of borrowing can make great practical sense, but you need to beware of the pitfalls that could make it go very wrong.
The principle is simple.
Small loans, payday loans, overdrafts, store and credit card deficits can all charge extraordinarily high rates of interest, while the very best rates are usually only available on bigger loans.
This means that combining all your debt into one consolidation loan could reduce the overall rate you pay, and possibly reduce the overall amount even if you pay over an extended term.
For most people it's about saving money and getting back in control, and the black-and-white financial sums are easy enough to work out.
More difficult to deal with are the intangible factors which are related to knowing what sort of borrower you are.
Lumping all your debt into one place (perhaps secured against your home) and having lower monthly repayments could tempt you to take on additional short-term borrowing, building your overall deficits into a fiscal time-bomb.
If you feel you'd be tempted to fall into this type of destructive borrowing then a debt consolidation loan really isn't for you...
Before deciding on a debt consolidation loan...
If you're considering a debt consolidation loan, try these steps:
- Think about the type of borrower you are
- Make a list of all your existing debt
- Check existing debt for early redemption fees
- Conduct a 'smart search' for debt consolidation loan options
- Compare deals against the alternatives to debt consolidation
- Do the maths!
Beware of early redemption fees
Before consolidating, you should note that some lenders may charge exit fees or early redemption charges if you repay ahead of schedule. That's because they'll lose a chunk of the interest you would have paid if you'd stuck to the original terms.
On 2 December, 2014, Gocompare.com found that only 28% of the 126 unsecured personal loans listed on the matrix of independent financial researcher Defaqto had no fee for early redemption of the entire loan.
Advantages of debt consolidation
There are plenty of good reasons to consolidate your debts, and you don't have to be in financial difficulty in order to benefit.
Even if your finances are fairly healthy, consolidation can cut your monthly outgoings, leaving you more money for savings, to help with rising bills, or to pay back your loan more quickly (subject to terms and conditions).
If you're having financial problems, a debt consolidation loan can be a lifeline, potentially reducing your monthly outgoings. Not only that, it should make managing your deficit easier because you'll only have one monthly repayment to think about.
That can help you avoid missing payments, which is vital to obtaining good credit scores and qualifying for the best financial deals.
Extending the loan term may cost less
Another way that consolidation can cut your monthly outgoings is by letting you extend the repayment period. With most borrowing the longer you take to repay the more interest you'll pay, although for some people reducing their repayments is worth it.
Did you know...?
- Peer-to-peer debt consolidation loans can be compared against more traditional options
However, as a debt consolidation loan will usually have a lower interest rate than your existing financial products, you may find you could borrow over a longer period and still save money.
For example, let's say you owe £10,000 which you consolidate into a loan at 6% APR (that's the annual percentage rate), with repayments lasting for five years. Your monthly repayments would be £193.33, meaning you'd pay total interest of just under £1,600.
Take the time to compare debt consolidation loan rates and do the sums for your own circumstances - you could be surprised.
Soft searches for debt consolidation loans
What's more, if you apply for a loan that you find appealing and get rejected, this will leave a mark on credit files and lenders may use this to lower your credit scores further.
That's why it makes sense to make a soft search (which may be referred to as a 'smart search') for loans before applying.
If you use Gocompare.com's soft search loans tool you'll then only see the deals that you're likely to qualify for, giving you a better idea of the actual rates available to you and helping you make the right application.
Securing a debt consolidation loan
Because debt consolidation tends to involve significant sums, the products are often (but certainly not always) what's known as secured loans. This means that they're secured against your home or another significant asset. Because lenders have this extra level of security they're able to offer more attractive rates.
You should think very carefully before consolidating personal loans and other unsecured debt into a secured loan.
Debt consolidation only makes sense if you use it as an opportunity to cut your spending and get back on track, and you can keep up the payments until the balance is repaid
Money Advice Service
While the repayment rates are likely to be more attractive you must always remember that your home or other asset is at a greater risk of repossession.
Don't rule out unsecured loans - if the amount you owe is less than about £25,000, unsecured personal loan products may be a better option and many allow debt consolidation.
Of the 126 unsecured personal loans analysed on Defaqto in December 2014, 83% allowed the loan to be used to consolidate debt.
Alternatives to debt consolidation
Depending on your circumstances there are a number of alternatives to think about before opting for a debt consolidation loan.
Paying down debt with savings
If you have debt and savings it's almost always the case that you're paying a higher rate of interest on the money you owe than you're getting paid on the money you're in credit.
It's always a good idea to have an emergency savings pot topped up to a level you're comfortable with, but beyond that it's worth thinking about using your savings to repay debt.
In many ways a mortgage can be seen as the ultimate form of secured loan, so if you're considering remortgaging to consolidate debt again remember that you're putting your home at risk if you can't meet the repayments. Remortgage rates may be attractive, but pay attention to arrangement fees and other costs.
If you can find the right credit card and manage it responsibly it could be an attractive alternative to a loan.
Look into balance transfer cards and low APR cards, but again remember that you'll need a good credit rating to qualify for the best deals and that failed card applications are likely to further damage credit scores.
Peer-to-peer debt consolidation loans
Peer-to-peer lending options are increasingly popular and can offer attractive rates to those with good credit ratings. Strictly speaking these are not an 'alternative' as peer-to-peer lenders call relevant products debt consolidation loans and they can be compared against more traditional options.
Is a debt consolidation loan right for you?
When you've made all your calculations, the vital consideration is to be sure that you could afford the new repayment level if you were to take out a debt consolidation loan.
If not and you're struggling with existing repayments, speak to your lender as a first port of call. The lender won't want you to default on the debt, and may find a way to help.
Look at your income and expenditure to see what money you have available and make sure that you can comfortably afford the repayments [on debt consolidation loans]. If you can't afford them, you will end up struggling even more in the future
StepChange debt charity
If the figures on a debt consolidation product do work for you, remember that it's still not a good idea to take it out if it'll tempt you to fall further into the red.
You need to be disciplined enough to avoid more loans and credit cards, or you risk falling into an unmanageable level of debt.
Once you've consolidated, think about cancelling your credit cards and any overdraft so you're not tempted to fall back into deficit.
You may also want to think about the pros and cons of protecting your loan through an income protection policy which could help you meet your repayments at a time of crisis.
By Felicity Hannah