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Debt consolidation: what is it and how does it work?

If you have several outstanding debts, you may be able to consolidate these into manageable payments.

However, this isn’t always the right option for many people, so it’s important to consider the pros and cons of debt consolidation before you decide.

Here’s the lowdown.  

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What is debt consolidation?

If you have outstanding debts that you’re struggling to pay off, consolidation can help you break down your costs into manageable chunks.

To do this, you will need to approach a bank or financial lender, who will pay all your different debts off with a single loan.

You will then need to pay back this loan to your lender but in monthly and far more manageable repayments.  

How does debt consolidation work?

There are two main ways to consolidate your debts.

The first option is to take out a loan with a lender, who will then pay off your debts.

You will then only repay the consolidation loan in single monthly chunks.

For example, let’s assume that you have debts on two loans and two credit cards that currently total £10,000.

Your lender will pay the £10,000 to all four of your debtors.

Now, instead of making four different repayments in a month, you will only pay one manageable instalment back to your lender. 

Alternatively, you could take out a 0 per cent interest balance transfer card.

You could transfer all your debts to this single card and pay the outstanding balance in full during the promotional period.  

Types of debt consolidation loan

If you choose to take out a debt consolidation loan, you should be aware of the two options available to you.

These are: 

  • An unsecured loan: As a general rule, any debt consolidation loan lower than £25,000 will likely be an unsecured loan. This means that in order to borrow, you won’t need to use a valuable item, such as your home or a car, as collateral in case you can’t repay.  

  • A secured loan: For higher value loans, you may need to use a valuable asset as collateral. If you take out a consolidation loan of £50,000, your lender might not be certain you can repay. So, with a loan secured by a valuable asset, your lender can recoup the outstanding amount if you struggle. 

What debts can you consolidate?

Any debt that you can pay off early can be consolidated, including: 

  • outstanding utility debts. 

How do I get a debt consolidation loan?

You’ll need to apply for a loan in the normal way.

You can shop around for the best offers and then approach a lender of your choice.

Your lender will have certain criteria to meet, so you may or may not be successful with your first application.

For example, if you have a low credit score, you may find it more difficult to get a debt consolidation loan.

Your lender will look at your credit score, credit history, their records, and your application to decide whether or not to approve.   

How does debt consolidation affect your credit?

Consolidating your debts may have an impact on your credit score.

First of all, when you apply for any type of credit, a ‘hard search’ will be performed on your credit history.

This means that any other businesses can see that you have applied for credit, and this will normally lower your score. It’s important to only apply for credit if you really need it.  

However, debt consolidation isn’t always a guaranteed black mark against you.

If you can keep up with your payment plan, your credit history will show you can meet regular repayments on time, which is always good for your credit score.

And by consolidating your debts, you can sometimes take advantage of lower interest rates. This could help you pay off your debts early.  

Debt consolidation can sometimes be a case of things getting worse before they start to get better, and these loans may not be good for your credit score.

However, if you can budget wisely and manage your repayments well, this could quickly start to improve.  

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Advantages of debt consolidation

Some of the key benefits of debt consolidation are:  

  • You’re starting to take control of your debts: Paying off multiple debts is like swimming against the tide. Consolidating can make them manageable, help you plan your repayments, and can take some of the stress out of constantly paying out money. 

  • Lower interest: Some of your debts could have sharp interest rates, and while it’s not guaranteed, it’s possible that you can sometimes reduce the amount of interest you repay. 

  • You can boost your credit score: By meeting regular payments, you can start to improve your credit score.  

Disadvantages of debt consolidation

But while there are some advantages, debt consolidation loans can spiral into becoming a more serious problem, and there may be better options out there to help you manage debts.  

  • You’re not debt-free: For people with a regular income and the means to keep up with repayments, consolidating can make paying off debts easier. But if you don’t have a regular income, you could still struggle to meet repayments. You will need the means to repay the principal loan sum as well as interest.  

  • Hidden fees: From setting up a loan to transferring funds, you can face additional costs throughout the process.  

  • Added risk: If you’ve taken out a secured loan, you could lose a valuable asset, such as your home, potentially making a difficult debt situation even worse.  

  • Missing payments: You will need to dedicate a portion of your time and effort to meeting repayments. If you can’t keep up with these, your situation can spiral, and this will damage your credit score.  

Debt consolidation loan fees and charges

When looking into debt consolidation loans, make sure to watch out for high fees that can eat into your savings.

Some lenders or third-party companies charge expensive origination fees or prepayment penalties, so it's important to read the fine print to avoid any surprise charges.

Before signing on the dotted line, verify if there are any fees for paying off your existing debts ahead of schedule - early repayment fees can sometimes cancel out the money you save from the lower interest rate.

Also be wary of paying an arrangement fee just to have a company facilitate the loan, unless the fee includes customised financial advice and you determine the cost is justified.

The right debt consolidation loan should simplify your finances, not complicate them with layers of fees.

Doing your homework on all costs involved will help you find the most cost-effective consolidation option.

What are the best consolidation loan companies?

Many banks will offer you personal loans that can be used to consolidate your outstanding debt, but some lenders will want you to apply for a consolidation loan specifically.

Many lenders offer these, so you should always shop around to find the best options for you.

Pay close attention to interest repayments and start-up fees. Government consolidation loans do not currently exist.   

What are the alternatives to debt consolidation?

There are alternatives to debt consolidation that might be better for your circumstances. Consider: 

  • A debt management plan that helps you pay back in smaller chunks 

  • The government’s ‘breathing space’ scheme that gives you space to put together a repayment plan 

  • Negotiating with your creditors can help organise some of your payments in a more manageable way 

  • Speaking to debt charities can help you formulate a plan for paying back your debts  

There are a few ways to manage outstanding debts. If you need help, speak to a financial adviser who can help you.

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About the author
Kate has written for leading publications and blue chip companies over the last 20 years.