How Does Debt Consolidation Work?

If you are juggling multiple debts, owed to different creditors, the option to combine it all into one single repayment each month probably sounds appealing – and this is where debt consolidation comes in.

Consolidating debts can take the hassle out of negotiating with numerous lenders and keeping track of what you owe and to who. However, before you take out a consolidation loan, it’s important you carefully consider the pros and cons, and also understand exactly how the process works.

Debt consolidation is a big decision and we recommend you speak to a financial advisor before going ahead with such a solution. But for now, we have simply provided some information below on what debt consolidation is and how it works and the advantages and risks of debt consolidation:

What is debt consolidation?

Debt consolidation means taking on a new loan that is then used to clear all your existing debts. However, this doesn’t mean the debt is gone, it simply removes the stress of dealing with multiple lenders and you only owe one lender money each month.

It’s very important that you carefully consider how the interest rate on this new loan will affect your ability to make repayments, especially if you have consolidated a large amount of debt. For example, a larger loan with a basic interest rate could mean you pay more over time than two smaller amounts with lower interest, while some people discover that their repayments can lower in cost – if they consolidate with a 0% or low interest loan but this will usually only last for a limited amount of time of the repayment plan.  

Debts that can be included in a consolidation loan include:

  • Credit cards – Many people discover that interest on credit cards increases over time, leading to problem debt when the minimum repayments they can afford barely cover the extra charges.
  • Store cards – Store cards usually offer lots of enticing interest free plans, but if you have not paid off these in time then you’ll discover the interest rate is incredibly high, making it difficult to get out of debt.
  • Personal loans – Whether it’s a bank loan or a payday loan, interest rates and charges can catch people out leading to large amounts of debt that appear impossible to pay off.

How does it work?

When you take on a debt consolidation loan, you move all of your existing debts into one loan and then close all of your existing other debt accounts. The money from your consolidation loan is used to clear these debts.

When might you consider a debt consolidation loan?

For many, a debt consolidation loan is only the preferable choice if the cost of repayments each month are lower than your other loan repayment combined, or the amount owed does not increase. It’s important to remember that there are numerous other debt solutions to also take into consideration before making a decision, such as an IVA, which also moves debts into one agreed single monthly repayment and can even remove the interest paid altogether.

When making repayments on a debt consolidation loan, you should refrain from taking on further credit to ensure you can focus on clearing the only debt you now have. It’s important to carefully check the new interest rate and to work out whether this improves your financial situation in the long run.

While a consolidation loan offers ease when it comes to making repayments, it may push up the interest rate due to a larger amount of money being owed on one product. This could result in you paying back more in the long run, which isn’t preferable when trying to clear outstanding debts.

Debt consolidation should also only be sought out if you no longer require extra credit and can live comfortably while making the new repayments. However, another debt solution may be preferable and should not be counted out – such as a DMP (Debt Management Plan or an IVA (Individual Voluntary Arrangement). Both these alternative options can result in you paying a set monthly amount and not having to worry about multiple repayments to various lenders.

Before taking on debt consolidation, we recommend you speak to an impartial financial advisor. However, if you would now like further information or advice on the other debt solutions, such as IVAs and DMPs as mentioned above, then our in house financial advisors are on hand – get in touch and start living again.
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