If you're juggling several loans at once, keeping on top of your debt can be particularly challenging.
Not long after you make one payment, you may be hit by another.
If interest is being added to your debts, they can quickly become unmanageable, leaving you wondering how you'll ever pay what you owe.
This is where debt consolidation loans can be useful.
With the help of debt consolidation, you can combine all your debts into one loan. Hopefully, this will relieve the pressure and make it easier to keep up with repayments.
So, what is debt consolidation, what are the advantages and disadvantages, and how can this type of loan help you get back on track?
Debt consolidation involves combining all your debts into just one loan.
Rather than owing money to multiple creditors, you'll only owe money to one.
Debt consolidation can help you manage your debts more effectively and it can make it easier to become debt-free over time.
You can use debt consolidation to combine the following types of debt:
But how does debt consolidation work?
If you’re thinking of applying for this type of loan and you’re wondering how debt consolidation works, these are the key steps you'll need to take:
Add up all your outstanding debts including credit cards, personal loans, overdrafts, and store cards. By calculating the total value, you'll know how much you'll need to borrow when you apply for a debt consolidation loan.
If your application is approved, you can use the new loan to pay off your existing debts.
Hopefully, paying off most of your debts will feel like a weight off your shoulders. Knowing that your consolidation loan is the only one left can be really encouraging.
When your debt consolidation loan is approved, you'll be given a repayment term.
This will outline how much you’ll have to pay each month and the date you’ll have cleared the loan.
By making monthly payments on time and in full, you can get your finances in order, avoid interest being added, and even improve your credit score.
Now you know how debt consolidation works, let’s move on to the different types of debt consolidation.
While debt consolidation lets you repay multiple debts with one loan, debt settlement effectively involves asking one or more creditors to accept less than is owed as a final payment on the account.
Some people can reach an agreement with their creditor and pay a lesser amount either as a lump sum or through a series of installments.
Unfortunately, creditors are under no obligation to accept your debt settlement request and they may insist you pay the full amount.
There are two main types of debt consolidation loan: secured and unsecured.
Here's how they work.
If you need to borrow a large amount of money of £25,000 or more or you're finding it hard to get an unsecured consolidation loan, you may need to secure the money against an expensive item or asset that you own.
Lenders might use your house or car, for example, as a guarantee that you'll pay them back.
If you fail to make your repayments, this could lead to your house, car, or another secured asset being repossessed.
An unsecured debt consolidation loan is a personal loan that allows you to clear your other debts without using an expensive item or asset as collateral.
Let's take a look at the advantages and disadvantages of consolidating debt:
Lower your monthly payments - If your existing debts are accruing interest, consolidating them can be cost-effective. The overall cost may be lower once you combine your debts since debt consolidation loans tend to have a lower interest rate than other options.
Less admin and money management needed - Managing multiple debts is enough to give anyone a headache. With a debt consolidation loan, you can reduce admin and save time previously spent managing multiple debts.
Boost your credit score - Consolidating your debts won't automatically improve your credit score, but if you manage your debt consolidation loan repayments sensibly, your credit score could improve over time.
You may face fees - Some creditors charge debtors a fee for transferring the balance on their loans.
Missed payments can damage your score - As with any type of debt, missing debt consolidation loan repayments can negatively impact your credit score.
Non-payments can lead to repossession - If you have a secured loan and can't keep up with your repayments, your home or car may be repossessed.
A longer term could lead to more interest - Don't get caught out by consolidation loans with long terms. While these can be the best option for some people, others end up paying more interest overall than they did on their original debts.
Debt consolidation loans don't suit everyone - For some people, other options may be more suitable. For example, a 0% balance transfer credit card may be more appropriate.
If you're struggling to pay your existing debts and you sometimes pay late or miss payments completely, this can have an impact on your credit score.
You might be wondering ‘do consolidation loans hurt your credit score too?’
The short answer is: it depends.
When you apply for a new line of credit, the lender will take a look at your credit report to see how you’ve managed debt in the past. This search will leave a footprint on your credit file and will be visible to other lenders.
It could also lower your credit score temporarily. This is worth taking into account before applying for a debt consolidation loan as it could affect your ability to borrow money from other lenders in the near future.
If you fail to repay your debt consolidation loan, your credit score will be impacted in the same way it would be with any other loan.
However, consolidating your loans into one payment could in fact improve your credit score in the long run, if it means you’re finally able to pay on time and in full.
One of the best ways to build a strong credit history is by managing your debts effectively.
While consolidating debts can be beneficial for some people, it's not always the answer.
Some people struggle to get a consolidation loan, particularly if they have a very bad credit score.
Others feel tempted to borrow more money on top of their consolidation loan, making it harder to make progress on their debt repayments.
So, what are your other options?
You may be better suited to a Debt Management Plan.
This is an agreement between a borrower and their lenders. It outlines how the debts will be repaid going forward.
In some cases, lenders may agree to reduce the total amount payable or stop charging interest so their debtors can get back on track without costs spiralling even further.
A Debt Management Plan will be arranged by a third party. In some cases, a set-up fee may be required, but there are providers who do it for free.
A Debt Relief Order (DRO) is designed to help people who are struggling to repay their debts.
However, it comes with very strict criteria. To be eligible for a Debt Relief Order you must:
Owe less than £30,000
Not be a homeowner
You can't own a car or motorbike worth more than £2,000
Your assets must have a second-hand value of less than £2,000
You must have less than £75 a month 'spare income' after paying all your bills and expenses
You can’t have had a DRO within the last 6 years
You can’t be a company director
You can’t be an undischarged bankrupt or currently in an IVA
If you are over 55, you can’t have a large undrawn pension that you could access
For some people, an Individual Voluntary Arrangement (IVA) is more suitable than a debt consolidation loan.
An IVA is an arrangement with a creditor to pay off unsecured debt such as credit cards, loans, and overdrafts. Government debts such as tax debts and benefit overpayments can also be included.
However, it's not often possible to include secured debts such as mortgages, hire purchase, and car finance in an IVA.
It’s also worth noting that having an IVA will impact your credit score and make it harder for you to access credit. Thankfully, this won’t be permanent. In the long term, an IVA can help you improve your credit score by making it easier for you to pay off what you owe and start afresh.
An IVA is a form of insolvency and is a legally binding contract between you and the companies you owe money to.
Usually, you'll receive a contract that outlines how much you must pay and when it must be paid. You'll pay this money to the IVA firm for a set period of time. The firm will deduct fees from this amount and divide the rest between your creditors.
If you're a homeowner, you may be advised to release equity from your property to pay towards your IVA.