Debt Consolidation: What is it and How Does it Work?

If you’re currently repaying multiple debts to different lenders, you may consider debt consolidation.

Debt consolidation is when you take out credit, such as a loan, to pay off your existing debts. This means you would only have one debt to focus on paying off in place of those being consolidated.

While consolidating your debts can have some benefits, it’s also important to consider the risks to help you understand if it’s suitable for your individual situation.

Read on to find out how debt consolidation works and what factors you need to consider.

How does debt consolidation work?

Debt consolidation works by taking out a form of credit to pay off some, or all, of your existing debts. This may include loans, credit cards and overdrafts.

By consolidating your debts, you would only need to make one payment to one lender, rather than keeping track of multiple payments.

For example, if you owe £2,000 on a credit card and £3,000 on a loan, you may be able to apply for a new loan of £5,000 to pay these off. You would then repay the new £5,000 loan in instalments over the agreed term.

Depending on your situation, consolidating your debts could help you to lower the amount you pay in interest.

It could also allow you to reduce your monthly payments, though this may mean you need to pay more in interest overall if you repay the new loan over a longer period.

If you have credit card debts, you can choose to pay them off with a loan or transfer them to a 0% balance transfer credit card.

By moving credit card debt to a card with a low or 0% interest rate, you could save money on interest (as long as you meet the terms of the card and pay off your balance in full before the lower rate expires). Find out more about consolidating credit card debt.

Bear in mind that debt consolidation is completely different to a debt management plan (DMP), which is an agreement between you and your creditors, and is set up by a debt charity or other DMP provider.

» MORE: Paying off a loan early

What is a debt consolidation loan?

A debt consolidation loan is simply a loan that you take out to pay off, or consolidate, other debts.

Even though it is known as a ‘debt consolidation loan’, it is no different to any standard personal loan or secured loan and works in exactly the same way.

Personal loans and secured loans can both be used for debt consolidation. There isn’t a specialist type of loan that is only designed for debt consolidation.Particular care should be taken when using a secured loan for debt consolidation, especially if you are consolidating currently unsecured debts against your home or other asset, as you could lose the asset if you fail to keep up with repayments.

When you apply for a loan, you will typically be asked what you want to use the loan for. You would just need to choose the option that says ‘debt consolidation’.

» MORE: Using a personal loan for debt consolidation

Types of debt consolidation loan

Depending on your financial circumstances, you can apply for an unsecured or secured debt consolidation loan.

Unsecured loans are personal loans that are used for debt consolidation.

These loans are not secured against any asset, and the rate you get will depend on your credit history, your finances, and the terms and conditions of the lender.

Alternatively, you could apply for a secured loan for debt consolidation.

Secured loans are loans that are secured against a particular asset, usually your home. Because you are using your property as security against the debt, the lender may be more willing to consider larger loans at lower interest rates, as well as applications from people with poorer credit histories.

However, if you miss any repayments, you could potentially lose your home, so it’s important not to make this decision lightly. You should also consider the fact that you may be converting unsecured debt into secured debt by doing this.

» MORE: Secured vs unsecured debt consolidation loans

Pros and cons of debt consolidation loans

Debt consolidation can be useful, but it may not be the right option for everyone. Consider the potential advantages and disadvantages before deciding whether to consolidate your debts.

Benefits of a debt consolidation loan

Potential advantages of consolidating your debts include the following:

• You may be able to get a loan with a lower interest rate.
• It may be easier to manage one debt with one lender rather than multiple debts with different lenders.
• You may be able to reduce your monthly repayments (although you may pay more overall if you repay the loan over a longer period).

Risks of a debt consolidation loan

Potential disadvantages of debt consolidation loans to consider are:

• You could end up paying more overall if the interest rate on your new loan is higher or you repay it over a longer period.
• You need to factor in any early repayment charges on existing loans.
• Applying for a debt consolidation loan involves a hard credit check, which will be recorded on your credit history.
• If you continue to borrow while paying off a debt consolidation loan, you risk getting caught in a cycle of debt.
• If you use a secured loan to consolidate debt, your property or asset is at risk if you can’t keep up with repayments.

Is debt consolidation right for me?

You may want to consider debt consolidation if:

• you have multiple debts
• you are paying a higher interest rate on these debts than you could get by applying for a loan now (if you’ve since improved your credit score, for example)
• any money you would save on interest isn’t outweighed by any early repayment charges
• the total amount you would repay with the new loan is less than the total amount payable on your existing debts
• you prefer to have one monthly repayment to keep track of, instead of multiple payments

If you choose to take out a debt consolidation loan, you need to be disciplined and make sure you stay on top of your payments. Taking out credit to pay off credit can be risky and could make your situation worse if you continue to use your credit cards and borrow more money.

It’s important to calculate exactly how much you can realistically afford to repay each month, to make sure you don’t borrow beyond your means. You can use our loan calculator to help with this.

If you’re struggling with your existing loan payments, then taking out more credit is unlikely to be the best option for you. You should contact your current lenders to see if you can come to an alternative payment arrangement.

It may also be worth contacting a debt charity for advice on your situation. Asking for advice is free and won’t affect your credit score.

Can I get a debt consolidation loan with bad credit?

You may be able to get a debt consolidation loan if you have a bad credit history. However, people with bad credit are likely to be charged a higher rate of interest than those with better credit histories, so it may not make financial sense to consolidate your debts.

If the interest rate on a consolidation loan is higher than the rate on your existing debts, then it will probably cost you more to consolidate your debts.

You may find it easier to get a secured loan if you have a bad credit score, but this comes with the risk that the lender could repossess your property if you fall behind with payments.

Having bad credit may indicate that you have had trouble making repayments previously. Debt consolidation may offer help if you can minimise your repayments. Even with this in mind, if you are struggling with debt you should seriously consider whether debt consolidation is right for you. Instead, you may be better off seeking debt advice or contacting your lenders to explain that you’re finding it hard to repay them and see if they can come up with alternative solutions.

Before applying for a loan, work out all the costs involved to see if you could save money by consolidating your debts and, crucially, if you would be able to afford the repayments.

» COMPARE: Debt consolidation loans for bad credit

Will consolidating my debt save me money?

It’s important to understand and compare the cost of your existing loans compared to the new single loan.

To work out whether debt consolidation could save you money, you need to know:

• how much you are set to repay overall on your existing debts
• how much it would cost to pay off your debts early
• how much you would pay overall on the new loan

If the interest rate on the debt consolidation loan is lower than the rates on your existing loans, and the money you would save isn’t cancelled out by early repayment charges, consolidating your debts could save you money.

Bear in mind that your credit score will affect the interest rate you qualify for – those with better scores are likely to access lower rates of interest.

It’s also important to consider the length of the repayment term on your debt consolidation loan. A longer repayment term may reduce your monthly payments, but you could end up paying more in interest, which wouldn’t save you any money overall.

How to get a debt consolidation loan

Before doing anything, you need to work out how much you owe across all your debts. Ask your lenders for a settlement figure (the amount you need to pay to clear your debt, including any early repayment charges).

Once you have these figures, you know how much you need to borrow to pay off your debts.

You would then need to apply for a large enough loan to pay off these debts.

When you choose a lender, double-check that it will allow you to use the personal loan for debt consolidation before applying.

Lenders will need to know your personal details and information about your income, employment status and expenses. They will use this information, and the findings from a credit check, to decide whether to offer you a loan.

If your application is accepted, you can use the loan to pay off some or all of your existing debts. You would then repay this new loan as specified in your loan agreement.

You may be able to check your eligibility for a loan before formally applying. This won’t affect your credit score and it can help you see your chances of approval.

» COMPARE: Personal loan eligibility checker

Does debt consolidation affect your credit score?

Because debt consolidation involves an application for a loan, lenders will need to conduct a hard credit check that will be recorded on your credit history.

Multiple hard credit checks in a short space of time could affect your credit score. As a result, you should aim to minimise the number of applications for credit you make.

However, as long as you make all the repayments on your debt consolidation loan, as well as meeting all your other credit commitments, your credit score should start to improve.

Bear in mind that if you decide to close a credit card after paying off the balance, this could also affect your score. Even though closing a credit card can stop you from building up debt on it, it also means you have less available credit and a higher credit utilisation ratio.

What is a credit utilisation ratio?

A credit utilisation ratio tells you how much of your total available credit you are currently using.

You might have an overall credit limit of £8,000 across all your accounts, including an unused credit card with a £2,000 limit. If your total debt is £4,000, you are using half of your available credit. However, if you close the credit card, you would still have £4,000 of debt but your overall limit would drop to £6,000, which means you would be using two thirds of your available credit.

A lower credit utilisation ratio is typically better for your credit score.

Alternatives to a debt consolidation loan

Instead of taking out a debt consolidation loan, there are a few options you might consider. The right choice for you will depend on your situation, but some possible alternatives include:

• speaking to your lenders and debt charities to get help with your situation
• using any available savings to pay off some of your debts
• seeing if you could borrow from friends or family to pay off your existing debts
• consolidating any credit card debt with a 0% balance transfer credit card

Image source: Getty Images