A debt consolidation loan combines all your debts in one personal loan, which usually saves you money on interest costs.
This type of loan also simplifies your payment schedule as you only have to pay off one loan per month.
Here’s how debt consolidation works and when to consider it.
What is a debt consolidation loan?
A debt consolidation loan is a form of personal loan taken to pay off other debts.
The money from a debt consolidation loan can be used to pay off credit cards, store cards, payday loans, buy-now-pay-later deals, and overdrafts. It can also be used to pay off debts with utility or council taxes, collection agencies, and bailiffs.
The idea behind debt consolidation loans is twofold:
By merging all your debts into one loan, you only have to pay once a month.
To reduce the total interest you pay so that you save money.
The golden rule of debt consolidation is to be disciplined enough not to re-borrow on credit cards, overdrafts and the like – this would negate the point of the debt consolidation loan.
How Do Debt Consolidation Loans Work?
You have to put in quite a bit of work when taking out a debt consolidation loan – paying off your other debts isn’t automatic.
First, calculate how much you need to borrow. You do this by adding up how much you owe, including any penalties for early repayment of your debts.
Next, you need to apply for a debt consolidation loan where the loan amount covers what you owe. When the loan is approved, the lender deposits the money into your bank account.
You must then manually use this money to pay off your other loans.
Finally, you must repay your debt consolidation loan as agreed with the new lender.
How does a debt consolidation loan save me money?
Other types of loans, such as credit cards, store card financing, buy now pay later plans, payday loans, overdrafts and some personal loans can come with high interest rates.
For example, overdrafts usually have an APR of close to 40%, while most credit cards charge about 18% APR.
Debt consolidation loans generally offer competitive interest rates compared to other forms of borrowing. So by swapping a series of expensive debt for one debt consolidation loan, you reduce the total amount of interest you pay.
The interest rates are also usually fixed, so you can be sure that your monthly repayments will not go up over the agreed term.
Is a Debt Consolidation Loan Secured or Unsecured?
Debt consolidation loans can be secured or unsecured. But unsecured debt consolidation loans are almost always the best choice. They can save you money and you don’t have to put your house (or anything else) as security to get one.
If you are a homeowner but have poor credit, a secured debt consolidation loan may be your only option. But be careful – you will have to put your property as security for the loan. If you fail to pay, you run the risk of having your home repossessed.
How long can I borrow with a debt consolidation loan?
Unsecured debt consolidation loans are normally available on repayment terms ranging from one year to seven.
However, secured debt consolidation loans can last up to 25 years.
The longer the term of your debt consolidation loan, the more interest you will pay in total. But a shorter term means higher monthly payments.
What interest do I pay on a debt consolidation loan?
How much interest you pay on a debt consolidation loan depends on:
how much do you borrow?
the repayment term
the lender and deal
Debt consolidation loans usually come with tiered interest rates. This means that interest rates are normally higher for small amounts than for larger amounts. The lowest interest rates are usually offered to people who borrow £7,500 or more.
Keep in mind that you may not get the advertised APR when you apply for a debt consolidation loan. Lenders only need to give their headline rate to 51% of successful applicants.
How Much Debt Can You Consolidate?
An unsecured debt consolidation loan is essentially just a personal loan – so the maximum amount borrowed depends on the lender and your personal circumstances.
Unsecured loans normally run up to £25,000 or £30,000 in some cases. You may be able to borrow more with a secured loan.
Will a Debt Consolidation Loan Affect My Credit Score?
A debt consolidation has the potential to improve or damage your credit score.
Paying off your loan on time will improve your credit score. But failing to keep track of the refunds will negatively impact your score.
When you pay off your other debts, you must close these accounts so that this credit is no longer available to you. Having too much available credit can negatively affect your credit score.
How much interest do I pay?
The cheapest debt consolidation loans start at about 3% APR (fixed).
If you borrow less than €5,000, the interest may be higher.
You will also be charged more if you have a bad credit score, up to 99% in some cases.
Before applying for a debt consolidation loan, be sure to shop around. Using a loan eligibility checker can help you discover which loans you are likely to be hired for.
Is a Debt Consolidation Loan a Good Idea?
A debt consolidation loan can help you get your finances in order if you:
have trouble keeping track of multiple payments per month
have high-interest debt
don’t know which debts to prioritize
will be disciplined enough to repay the debt consolidation loan
will save money overall
won’t be tempted to borrow money elsewhere
can pay the monthly repayments on the debt consolidation loan
What are the alternatives to a debt consolidation loan?
If the debt you want to repay is on one or more credit cards, a 0% interest balance transfer card can be a good alternative to a debt consolidation loan.
With a 0% balance transfer card, you can move existing credit card debt to a new credit card with 0% interest charged for a period of time, usually up to two years. Most balance transfer cards charge a balance transfer fee, expressed as a percentage of the amount transferred.
With a Money Transfer credit card, you can transfer cash to your current account to pay off overdrafts, loans, and other debts. Then you repay the debt for a certain period at 0% interest.
Almost all remittance cards charge a remittance fee, expressed as a percentage of the amount transferred.
If you own your home and it has appreciated in value, you may be able to re-mortgage for a higher amount to free up equity. You can then use the equity to pay off your debts.