What is debt consolidation and how does it work?

If you have several outstanding debts, you may be able to consolidate these into a single monthly payment that could be more manageable.

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

Here’s the lowdown.

What is debt consolidation?

Debt consolidation involves combining several existing debts into one, usually by taking out a new loan to pay them off.

Instead of making separate repayments to several lenders, you then make a single monthly repayment on the new loan.

This can make your debts easier to manage and may reduce the interest you pay, but this will depend on the interest rate, fees and repayment term of the new loan.

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 use the money to pay off your existing 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.

You could take out a £10,000 consolidation loan and use it to repay those debts.

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.

This allows you to transfer eligible credit card balances to one card and pay the outstanding balance in full during the promotional period.

What are the different 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: This allows you to borrow without securing the loan against an asset such as your home. Whether you qualify, how much you can borrow and the interest rate you are offered will depend on factors including your financial circumstances and credit history.

• A secured loan: This is secured against an asset, usually your home. You may be able to borrow more or get a lower interest rate than with an unsecured loan, but your home could be at risk if you don’t keep up with repayments. This is usually more suitable for larger loans.

What debts can you consolidate?

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

• Credit card debt

• Loans 

• Overdrafts 

• Payday loans 

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 history, the information in your application and its own lending and affordability criteria when deciding whether to approve your application.

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 usually be recorded on your credit report.

This means that any other lenders can see that you have applied for credit, and it may temporarily affect your credit score. Making several credit applications in a short period can have a greater impact.

However, debt consolidation won’t necessarily damage your credit score in the long term.

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 in the short term.

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

What are the 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 easier to manage, 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 high 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: Debt consolidation won’t automatically improve your credit score, buy meeting regular payments, you can start to build a better credit history over time.

What are the 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.

• You could pay more overall: A lower monthly repayment doesn’t necessarily mean debt consolidation is cheaper. If you repay the new loan over a longer period, you could end up paying more interest overall.

• Extra 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: If you can’t keep up with your repayments, your situation can worsen, and this could 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 may charge arrangement fees, while your existing lenders may charge you for repaying some debts early.

Before taking out a consolidation loan, check whether 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 a third-party company a fee simply to arrange a debt consolidation loan, as you may be able to apply directly to a lender without paying this additional cost

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

Compare the interest rate, fees, repayment term and total amount repayable before deciding whether debt consolidation will actually save you money.

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 deal for you.

Pay close attention to the APR, any fees, the repayment term and the total amount repayable and be wary of anyone claiming to offer an official debt consolidation loan as 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, which can give you temporary protection from most creditor action and freeze most interest and charges while you get debt advice.

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

• Speaking to a free debt advice service which  can help you formulate a plan for paying back your debts,

Seek expert financial advice

There are a few ways to manage outstanding debts.

If you’re struggling to keep up with repayments, you can get free, confidential help from a debt adviser.

If your debts are manageable but you want broader help with your finances, a financial adviser may be able to help.

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