What Is A Debt Consolidation Loan?
A debt consolidation loan is a loan taken out in order to pay off all or some of your existing loans and credit cards and have just one monthly repayment.
Generally, the new loan amount is taken out over a longer term than the existing loans, normally at a lower interest rate which means that the new single monthly repayment is considerably less than the total monthly outgoings of the existing debts which may be at a higher interest rates.
Depending on the amount you want to borrow, the new loan could be taken out as an unsecured personal loan, a second charge mortgage or a remortgage.
If you have combined debts of more than say £25,000 it’s unlikely that you will qualify for an unsecured loan. If you were to be successful, then the monthly savings would be limited in that you can normally borrow over a relatively short term of 5 years or 7 years.
However, if you were applying for a secured charge mortgage and using the equity in your property, subject to your age, the loan term could be up to 30 years meaning that the saving each month could be considerably higher.
In addition, the interest rate with a secured loan is likely to be lower than an unsecured personal loan.
It helps to understand how you’ve got yourself into debt in the first place. You could have been simply overspending and not budgeting accurately and are not able to meet your current commitments.
Alternatively, it may have been as a result of a number of unexpected costs, perhaps a new roof or you needed to replace your car.
Is Debt Consolidation a Good Idea?
There are several pros to debt consolidation. The biggest is that you can significantly reduce your monthly outgoings if you are finding it difficult to meet the monthly repayments on your existing finances. It may be that your mortgage lender has increased its rates as a result of Bank of England interest rate rises meaning you have less disposable income to pay your credit card and loan repayments.
It's important to avoid missing any repayments and getting a poor credit record as this will a detrimental effect on your credit score and make it difficult to borrow in the future at competitive interest rates. If you consolidate your debts by taking out a consolidation loan and reduce your repayments to a manageable level, you should be able to maintain repayments and benefit from a good credit rating.
It's important to maintain a good credit rating to ensure that any future credit or mortgage applications are accepted and agreed at competitive rates of interest. For example, if you missed a number of loan repayments and your credit score reduced you may have to pay an extra say 2% if you were to apply for a new mortgage in a years' time. On a £250,000 interest only mortgage, this would result in paying an extra £417 per month.
Another benefit of paying off all your credit cards and loans is that you will only have one monthly outgoing meaning that you don’t have to worry about direct debits going out of different bank accounts on different days of the month.
Is Paying Off Your Debts A Bad Idea?
While it might be appealing to have a single lower monthly repayment there are a number of things to take into consideration.
Firstly, it’s likely that your current debts are unsecured meaning that any potential lender would find it difficult to take possession of your property were you to default on the loan.
However, if you were to take out a second mortgage, which sometimes are referred to as homeowner loans, and default on the repayments, then as a last resort, the second charge lenders could take possession of your property in order to repay the debt. Please be aware your home would be at risk, and you could lose your home.
Another factor to consider is that by taking a consolidation loan over a longer term in order to reduce outgoings, you are likely to pay considerably more money back in interest if you keep the loan for the full term.
Tips On Paying Off Your Debts
To enable you to budget accurately it would make sense to consider a fixed rate, rather than a variable mortgage rate knowing that your repayment won't change for a fixed period.
You should avoid consolidating loans where the interest rate is 0% or very low. Also, it would not be wise to consolidate a loan if the remaining term was only 6 months.
Most lenders allow you to make additional capital repayments as and when you want to which will result in you paying less interest and repaying the loan more quickly. People getting extra overtime or bonuses should try and make additional repayments whenever they can. This is strongly recommended
You also need to be aware that once you have paid off your loans and credit cards you may get the impression you have more money than you do and need to be careful not to start using your credit cards again. To start using the credit cards and taking out new loans would put you in a worse position than before you paid off your debts.
On completion of the loan most lenders will settle your debts on your behalf by sending the balances to each loan and credit card company. Some lenders will send you the loan amount for you to settle directly with the loan and credit card companies yourself. It is most important that you do this immediately so that there is no temptation to use the monies for something else resulting in you keeping all of your existing debt and also having the new loan repayment. It's unlikely that you would be able to maintain all repayments.
Some people cut up their credit cards to avoid the temptation of overspending again. However, it might be sensible to keep one credit card for use in an emergency.
Alternatives To A Consolidation Loan?
You could approach your existing credit card and loan companies to see if you can come to some arrangement whereby you might be able to reduce or stop your monthly payments for a period or ask them to reschedule the loan.
As a rule, lenders are more likely to help you if you approach them before you start missing repayments rather than they contact you once your loan or credit card falls into arrears. It is advised not to bury your head in the sand but to make early contact with all lenders that you have debt with.
Other alternatives might be a debt management plan (DMP) or individual voluntary arrangement (IVA). For further information we would direct you to Step Change.
Their website will help you to establish if a debt consolidation is something you should consider.