Consolidating all your debts into one loan might appear to make life easier, but more often than not it’s a bad idea. If you miss repayments on a secured debt consolidation loan, you could lose your home.
Get free debt advice first
If you’re seriously considering a consolidation loan, you may already be struggling with debt.
You may feel you don’t have many options, but there may be more than you think. There are several debt advice charities that can give you free advice to help you improve your debt situation.
What are debt consolidation loans?
If you’ve got lots of different debts and you’re struggling to keep up with repayments, you can merge these together into one loan as a way of potentially lowering your monthly payments. These loans are usually secured against your home although some lenders do offer unsecured consolidation loans, but for smaller amounts.
With a consolidation loan (which can be secured or homeowner loans) you borrow enough money to pay off all your current debts and owe money to just one lender.
Be careful though, as consolidation loans can be dangerous and lead to more debt.
They were heavily marketed in the years leading up to the financial crisis, but are much less common now. Even if you decide you want one, you may struggle to find someone who will lend to you.
Debt consolidation only makes sense if you use it as an opportunity to cut your spending and get back on track, you can keep up the payments until the loan is repaid and you can afford to pay off any fees or charges to your old lender(s).
When getting a debt consolidation loan makes sense
A debt consolidation loan only makes sense if:
- You end up paying less interest than you were paying before
- The overall amount you will repay won’t increase, and
- You can afford the new payment
Even then, you need to consider the potential downside of putting your home at risk remember, your circumstances might change in the future) and the temptation to carry on spending.
Here’s an example of when a debt consolidation loan would make sense (figures correct as of 1 June 2012).
Steve owes £10,000, made up of:
- £7,500 on a credit card that charges 17.9% interest
- £2,000 on an overdraft at 18.9% interest, and £20 monthly fee
- £500 on a pawnbroker debt of £500 charging 68.8% interest
Steve pays a total of £435.83 in interest and fees each month. If he sticks with his current loans it will cost him £4,145.99 in interest and fees to pay off his debt.
If Steve switched to a debt consolidation loan he would only pay 12.6% interest. It would cost him £3,529.30 in interest to pay off his debt, rather than £4,145.99. So Steve would save money by switching.
When getting a debt consolidation loan doesn’t make sense
A debt consolidation loan definitely doesn’t make sense if:
the interest rate means your monthly repayment will be more than what you’re paying at the moment.
- You can’t afford the new loan payments or don’t clear all your debts with the loan.
- Your monthly repayments are lower but your loan will last much longer, as this means the total amount you will repay could be higher.
- You can shift all your debts to a 0% or low-interest balance transfer credit card. This is the cheapest way to borrow if you repay within the 0% or low interest period and you won’t be putting your home at risk. However, you need a good credit rating to get one of these cards.
You could also consolidate your debts into an unsecured personal loan, which doesn’t put your home at risk. Again, you will need a good credit score to get a low interest rate.
If you do opt for a secured loan
- Make sure you shop around using comparison websites to find the best deal.
- Don’t just look at the interest rate, but compare the APR (the annual percentage rate) as this will include extra costs such as an arrangement fee.
- Take advice if you don’t know how to compare the different deals available.
- Beware of the high fees some companies charge for arranging the loan. Read the small print carefully for any extra fees or charges before you sign anything and make sure you check whether there are any fees for paying off the loan early. And avoid paying a fee for a company to arrange the loan on your behalf unless you are getting advice.
- Cut up your credit cards and cancel any overdrafts you have to avoid the temptation to spend again.
This article is provided by the Money Advice Service.