How does debt consolidation work?
Debt consolidation is very simple in theory. You take a number of loans that you already have and you consolidate them into one debt. Often a longer term means that the monthly repayment costs come down quite significantly and ideally you get a lower interest rate too.
The whole idea of debt consolidation is to reduce your outgoings. It’s not necessarily to allow you to borrow more, but to allow you to restructure your debt. You might just want to have more disposable income each month while you repay your debts, so that is the theory behind it. Think of debt consolidation loans as part of a solution to help you financially.
An example – Note interest rates quoted are for illustrative purposes and may not be available.
Here are some worked examples just to show you some of the considerations when you are consolidating debt. Sometimes, it might not be the right thing for you – so here’s a very simple example.
|Loan – £7000||5 years||11%||£150|
|Credit Card A – £2000||Revolving||3%||£60|
|Credit Card B – £6000||Revolving||3%||£180|
Reduction = £288/month
The first example is where we look to consolidate a £7000 loan over five years, at the rate of 11%. The monthly repayments are £150. You must bear in mind this is a loan, and by paying £150 a month you’re actually reducing the balance.
Credit cards are usually revolving credit, but they’ve generally got a minimum payment that you have to make each month. We put that in at 3%. With a credit card the actual interest rate may be lower but the minimum payment is 3% so that’s how much it costs you each month. You’re probably not reducing the balance if you’re making the minimum payments.
And then we’ve got another credit card, revolving credit at 3% minimum payment to £180 a month. So you’ve got £15,000 worth of credit there and you’re paying £390 a month. So the typical scenario could be that you think “I’m going to take out a consolidation loan. I’m going to take it over a longer term so that I’m restructuring it over a 15 year period. I’m also getting a lower rate of interest so now paying £102 monthly and saving £288 a month”.
That is the theory for debt consolidation – reducing your outgoings. But there is more to it than that.
Things to consider about debt consolidation
There are many things to think about. It could be that Credit Card A is a 0% interest card, but you’re still making minimum payments. This means you are saving on the interest rate, but you still have to make the minimum monthly payments. In this scenario it’s best to have a conversation with an advisor. You must ask yourself “do I want to move my 0% to 4% in order to save me some money each month?” And that answer might be yes, as it may be a price worth paying. However, if you can afford the payments, there is an argument to keep the loan at a lower rate and pay it off sooner.
You could have a scenario where you’re on 0% interest on a credit card but it’s soon going to roll over into the default interest rate. For example, you’re coming to the end of the offer and the interest is going to go up. That’s a scenario where you might want to look at a debt consolidation – before your repayments go up. The key thing here is don’t necessarily consolidate every bit of debt you’ve got unless it’s the right thing to do. That’s where advice comes in, because it might not be the best thing to do for you.
Remember, if you’ve taken unsecured debt over five years and if you keep paying that off, you get it paid off in a shorter period of time. This is because it’s only five years. So it isn’t a magic formula. You could be stretching it over 15 years and repaying £102 a month but you are paying it for longer.
So unless the interest rate is significantly less than what you’re paying at the moment, you could actually end up paying more interest over the long term. However, you’re going to be paying less each month. So again, there’s that calculation to do. Try not to automatically go for a 15 or a 20 year term if you don’t need to.
Different types of debt consolidation loans
Generally speaking, unsecured loans are very much dependent on credit score. If you haven’t got a really good credit score, a consolidation unsecured loan may not be an option for you. The reason for that is, if you haven’t got a really high credit score you’re probably not going to qualify for the low interest rates as you will be seen as “high risk”.
The other thing is, a lot of unsecured lenders don’t like debt consolidation. They don’t want to take on somebody else’s debt, they just want to lend you money. Unsecured loans are a lot more difficult to get a debt consolidation loan for. With that being said, if your credit score isn’t perfect and you don’t qualify for a “premium” interest rate, then it’s very easy to drop into poor interest rates. Which makes debt consolidation with an unsecured loan really not a sensible idea.
It’s very easy to move from rates of 5% to 10%. With a poor credit score, you could easily end up with 25% to 49% interest, and you’ll see lots of unsecured loan specialists quoting typical rates of around 49%. If your current debt is at a lower interest rate around around 11%, the chances are you’re going to be worse off. So, unsecured debt consolidation may not be a solution for you. In summary, unsecured loans for debt consolidation may represent a solution, but it’s probably unlikely that it will be fully satisfactory.
An even worse solution would be to rely on payday loans. This is because if you’re already in debt and struggling to make your repayments, the payday loan rates can easily be a thousand percent and you have to pay them back very quickly.
Beware of them. Not just because they’re expensive but because any lender that’s assessing you for future borrowing, is going to look to see whether you’ve had payday loans before. And if you have, that is really a marker that you’ve tried every other avenue and not been able to raise money. That is a sign of stress to lenders, so a lot of them will refuse to lend to you.
If you’re a homeowner, you could possibly take a secured loan out. Obviously, it’s subject to the equity in your house and full affordability assessments. Just like a standard mortgage, your home is at risk if you don’t keep up with the repayments. You are converting unsecured debt to secured debt but with secured loans, you can borrow larger amounts.
It’s very typical for lenders to be looking at consolidation loads of £25,000 – £100,000 where people have run up a load of credit, and then need to get it back under control. So with a secured loan, you could get to those loan amounts. One of the advantages of a secured loan is it’s going to be secured on your property. Normally your home. Therefore, it’s regulated and it has to be fully advised by a qualified advisor. That advisor has to make sure that the outcome is suitable for you, so they should tell you which debt to consolidate and when you should look at an alternative.
As mentioned previously, secured loans are secured on your property. It sits behind your mortgage but they are very much more geared up for debt consolidation. It’s how the market has evolved, looking to help out people who need to consolidate debts. They tend to offer a higher high loan to value than a remortgage, so you can raise more money. They’re also more generous than most mortgage lenders on affordability. They are good at handling niche scenarios relating to income for self-employed, for contractors and more. So secured loans are a product typically used by homeowners for debt consolidation.
In terms of loan amounts, you can get secured loans up to £1,000,000. You may not need that amount, however it gives you an idea of how much you could borrow. Terms and amounts depend on factors such as your age, affordability, equity and credit history, They could be up to 30 years so you can bring your repayments right down.
Debt consolidation secured loans – Bad Credit
Rates available are generally 1% to 2 % higher than remortgage rates for people with good credit. But, even if you haven’t got a really good credit history, secured loan lenders are really good at dealing with that. They’ll disregard a lot of adverse credit which is over 12 months old, so you still could be looking at rates which make it cost effective.
There are secured loan products which can cater for very high levels of arrears, court judgements and defaults so don’t assume you will be turned down.
Secured loans are really geared up for debt consolidation. So, going back to the earlier example. If you had a secured loan of £15,000 at 4%, monthly repayments would be £102. When you compare that to the £390 you would be paying on the original debts, you could save £288 per month. However, don’t forget it’s secured to your house. And you are taking the term over a longer period (15 years, as shown in the example). If it was a 20 year term, that would be considerably lower (possibly £80).
Remortgage for debt consolidation
You could also remortgage. A remortgage means taking an existing mortgage, borrowing the extra amount (for example £15,000) and remortgaging your property. In some cases, it might not be suitable advice because of the current deal you’re on at the mortgage. It could even cost you more because the new mortgage isn’t as completive as the one you already have. There could also be early settlement charges that you have to pay.
But the other factor is that most mortgage lenders aren’t terribly keen on unsecured debt consolidation. They’re okay with consolidating secured debt but they don’t like consolidating unsecured debt. Also, affordability is crucial and more so with remortgages because the lenders have more restrictive terms.
If you are going to use your home as security for debt consolidation, your advisor should consider a remortgage as part of the whole advice process. So only go to an advisor who’s going to look at both – a remortgage and a secured loan and compare them side by side.
There is another alternative. This is really aimed at people who perhaps have got into a little bit of a problem with their credit. Not everybody who wants a consolidation loan is in trouble, and a debt management plan doesn’t involve borrowing It involves approaching your creditors and agreeing on reduced payments with them.
You’re essentially agreeing to reduced payments because you can’t afford to pay your debts. You’d have to give evidence to them that you can’t afford it. You’re paying less, so it gets your outgoings down but it does mean you’re paying for longer. This is because you’re just making reduced payments then essentially catch up on them later.
However, there is another big impact on this. If you’ve got good credit history right now and you go into debt management, then all of those loans that you’ve got are going to show on your credit search as an arrangement. That’s going to make it very difficult for you to borrow in the future. If you’re on a debt management plan now, many lenders are not going to lend to you. You need to be very careful before you go on to debt management and take advice.
Debt management does have a place but if you’ve got a good credit history, it’s probably not one to consider too strongly. If you’ve already got a bad credit history, then you’ve probably not got so much to lose by using debt management. But again, speak to an advisor and they’ll help you.
Factors that are really important
Talk to your advisor. Look at whether you can actually leave some of of your credit outstanding. If you can afford to leave some of it in place, it may make sense just to pay it down as quickly as you can.
Don’t automatically consolidate everything, talk to an advisor and don’t automatically take it over the longest term, just to keep your repayments down. All you’re doing in this scenario is taking longer to pay it back. If you can afford to pay it back sooner, take a shorter term.
Or ideally, take a loan that allows you to make extra payments every month to reduce the balance. Don’t fall into the trap of getting used to having that extra disposable income. Use it to pay the debt down.
What not to do
Don’t think of debt consolidation as something that you just do because you can. We see repeat offenders who consolidate their debt, get their debts right down and then rack up a whole load more on their credit cards. That isn’t the way to do it. If you’re going to consolidate your debt, think about it very seriously, as a credit repair tool. But also a tool to help you manage your outgoings in the future and maintain a higher level of disposable income for luxuries and emergencies.
Don’t automatically go and get more credit, because if interest rates go up, you need to be able to afford all of your priority payments. You need to be able to afford your mortgage or your secured loan, or your rent. It’s really an area where people need to be very responsible and don’t fall for the “buy now pay later” gimmicks that a lot of retailers use to sell you products. Your advisor is going to help you with this. What the advisor will do when they arrange a secured loan or a remortgage for you, is to factor in increases in rates to make sure that it’s affordable both now and in the future.
With that being said, if all of a sudden you go out and you get more credit, then come back and think you now need to consolidate this, you might not meet the criteria required for that secured loan lender. This is because, if you’ve already maxed out on your last loan, you can’t expect to get another one. It all comes down to responsible borrowing and more information is available from Citizens Advice.
In summary, debt consolidation is a good solution for many people. It’s part of a strategy to help you manage your debt. It will reduce your outgoings, but you could be paying more over the longer term, depending on the term you take and the interest rates you were on and you’re moving to.
Don’t borrow more just because you can, don’t borrow for longer and don’t borrow more after you’ve taken out the debt consolidation loan just because you can. Because if rates go up it could leave you in a stressed position where you actually can’t afford your priority debts.
There are more options if you are a homeowner and you’ve got equity in your home. The key message is always get advice, because if the loan is secured on your home, your home is at risk. It’s a regulated loan so you need to speak to an advisor. Your adviser should deal with both secured loans and re-mortgages and know their way around debt consolidation.
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