Paying off multiple debts can be difficult. It’s stressful to deal with different providers, and with lots of different bills to pay, it can feel as if there’s no way out. If you’re in this position, debt consolidation might be a good option: it’s a way to bring all your debts together, which can make them easier to pay off.
In this post we’ll explain what debt consolidation is, how it works, and whether it’s something you should consider.
What is debt consolidation?
Debt consolidation is a way to “consolidate” - bring together - different debts into one. This means you take out a new loan and use that lump sum to pay off all your current debts. Once that’s done, you owe money to only one lender.
Done right, a debt consolidation loan can have two benefits:
- It gives you one single monthly payment, making your finances simpler and easy to manage
- It can reduce the total amount you have to repay, usually by reducing your rate of interest
You can consolidate many different forms of debt, but some of the most popular are store cards, payday loans, student loans and credit cards.
How does debt consolidation work?
Imagine a borrower - we’ll call her Emily - has three kinds of debt:
- A £500 payday loan, with an APR of 1,000%
- A credit card with £2,000 outstanding, with an APR of 25%
- A store card with £1,500 outstanding, with an APR of 30%
APR stands for “annual percentage rate”. It includes all costs associated with a loan, and is a really useful way to compare the total cost of different products - for more information on how they work, we’ve broken APRs down here.
Emily has £4,000 of debt outstanding, and is paying a weighted interest rate of almost 50 per cent. (A “weighted” interest rate takes into account the relative size of each loan).
So, in our simplified example, Emily can take out a new loan for £4,000 and pay off the original creditors. And if the loan has an APR below 50 per cent, she’ll repay a smaller amount, too.
That’s a simple overview, but there are a few more things to be aware of, which we’ll explain over the rest of the article.
When is debt consolidation a good idea?
There are two big questions you need to ask yourself when considering a debt consolidation loan.
Will it save me money?
A good debt consolidation loan will often mean a lower monthly payment. But that’s not the whole story. You need to bear in mind two other things:
Borrowing over a longer period might mean that you end up repaying more, even if the interest rate is lower. In another simplified example, imagine that you borrow £100 at 20% APR for a year. You’ll repay £120 (the original £100, plus £20 interest).
If you instead borrowed £100 at 3% APR for 10 years, you’d repay £130 (the original £100 plus £30 interest). In this example, you end up repaying more in total, even though the interest rate is much lower.
This is an extreme example, and a lower rate of interest is still usually a good thing. And a borrower might also find that lower monthly repayments over a longer period suit his or her circumstances better. But make sure that you weigh up the pros and cons before increasing the length of a loan.
An online loan calculator should help you with the maths here, but any good loan provider will help by telling you the total amount repayable.
Can I afford the monthly repayments?
When taking out a debt consolidation loan, you need to be sure that you can afford the monthly repayments. Missing a loan payment on any form of debt is one of the surest ways to a bad credit score.
Responsible loan providers do their bit to help here.
When deciding whether to offer you a loan, lenders should carry out an affordability check, as well as checking your credit rating.
However, you still need to weigh up affordability for yourself, particularly if you’re expecting any big life changes. Might you have a child soon? Are you planning on moving house? Could your job be at risk? If so, you should factor these into your decision, and you have a duty to be truthful when applying for a loan.
Debt consolidation to pay off a credit card
Credit card debt can be expensive. As a result, many people use a personal loan - which can often have a lower interest rate - to pay off a credit card balance, reducing monthly repayments in the process.
In many cases, credit cards start off with a low interest rate, but this rate will generally increase as you borrow for a longer period of time, particularly if you don’t make the minimum payments.
Consolidating debt with a personal loan
Another option is to consolidate existing debts with a personal loan. The advantage here is that you can tailor a product to suit your circumstances: modern loan providers will allow you to choose exactly how much you want to borrow, and how long for.
So, you can set up a loan that suits you, and unlike a balance transfer using a credit card, the interest rate that you pay is generally locked in - so you don’t have to worry about moving money again a few months down the line.
Secured vs unsecured personal loans
There are two kinds of personal loans: secured and unsecured. A secured loan is one where you borrow against the value of an asset - often a house or car. If you fail to make the monthly repayments, your asset may be at risk, so it’s something to think very carefully about. However, the advantage is that you may be able to borrow more, or at a lower rate, if you use a secured loan.
A loan which is secured against your house may also be called a home equity loan.
As a general rule, if you’re borrowing less than £25,000 and have a good credit history, it’s likely that you’ll be able to take out an unsecured loan.
However, if you’re borrowing more than £25,000, or have a poor credit history, you might need to consider a secured loan.The above is just an indication - which option is right for you will depend on your individual circumstances, so always shop around. It’s generally considered a bad move to take out a secured loan in order to pay off unsecured debt.
Consolidating debt with a balance transfer
With this option, you transfer the debts you have to a balance transfer credit card with a lower APR. In some cases you can even find credit cards with zero APR to start with.
However, these introductory offers only last for a specific period of time, so you need to check what the APR will be when the offer ends. You’ll also need to repay at least the monthly minimum, otherwise costs increase sharply - if so, you may even end up with higher monthly repayments than you started with.
Another thing to be aware of is that balance transfer credit cards often have a fee, which might be as high as 5%. We’ll take another look at fees in detail later, but of course, it’s usually better to avoid them. Fees are usually added to the balance of the loan, rather than paid up front.
In general, borrowers with good credit scores are likely to be offered deals with long interest-free periods and low or zero fees, while borrowers with a poor credit history will get lower interest-free periods and usually have to pay a fee.
Consolidating debt with a debt management company
If you are really struggling with your existing debts, and don’t believe you will be able to pay them off, you may be eligible for debt relief. This is a last resort, and not to be taken lightly. It will have a lasting impact on your credit score, but can be helpful if you are having serious financial problems. This means that a lender would put you on a debt management plan (DMP), and generally reduce your monthly repayments, so that you pay the loan off over a longer period.
There are real consequences to doing this though, and it is very likely that you will struggle to get credit in the future. Certainly it will take a long time before you’re able to improve your credit history.
If you’re struggling with debt, a good place to start is StepChange, a UK debt charity, which has resources and free advice to help.
Will I have to pay a fee?
The last thing you should consider is the up-front cost of a debt consolidation loan.
Some providers charge different kinds of fees, which can add up. These have different names and serve different purposes - if you have a mortgage, for example, you’ve probably paid an arrangement fee and maybe even a broker fee.
Here’s a quick guide to what to look out for:
Early repayment fee.
Some lenders charge you a fee for repaying early. If your current creditors charge an early repayment fee, you need to include this cost when working out whether it makes sense to take out a debt consolidation loan.
This is charged by a lender up front, meaning that you have to pay before you receive the loan. The FCA has reported growing concerns about scam loan fees - you should always be very careful if you are asked to pay up front for a loan, and if you’re concerned, you can view their guide here.
Balance transfer fee.
This only applies to balance transfer credit cards: usually, the fee is added to the amount you owe, rather than charged up front. So, if you transfer £1,000 in debt to a credit card with a 3% fee, you’ll then have a balance of £1,030 to pay off.
You may also find companies who want to charge you a fee for managing the process of debt consolidation, or giving you advice. In general, debt consolidation is something you can arrange yourself, so you should avoid paying for management fees or advice unless you’re sure it’s worthwhile.
One last thing to consider when it comes to fees is that it’s important to keep savings for emergencies. A debt consolidation loan or balance transfer could be a bad idea if it means paying an upfront fee and wiping out your savings.
Will it affect my credit score?
So long as you use it correctly, a debt consolidation loan will not harm your credit score. In fact, it may give your score a boost.
A debt consolidation loan works just like any other form of credit. You need to make your monthly repayments on time, in full, every time they come due. If you do that, your credit score should improve. That means that lenders will look at you more positively in future, because you’ve proved that you can repay debt.
On the other hand, making late payments - or missing them entirely - will seriously harm your credit score. As a result, you’d be likely to struggle to get credit in the future.
For any form of debt, you should only borrow what you’re comfortable you can repay.
Should I consolidate my debt?
The answer depends on your financial situation. For manry borrowers, a debt consolidation loan could be an effective way to manage your monthly bills and avoid other, higher interest, forms of lending.