Debt consolidation loans: Are they really worth it?

If you have debt in multiple places, consolidating that debt into one loan can make it much easier to manage and potentially save you money too.

But before you apply for a debt consolidation loan, it’s important to understand how they work and what to be aware of.

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What is a debt consolidation loan?

A debt consolidation loan lets you combine existing debts into one place. Let’s say you’ve borrowed money on a store card, a credit card and a personal loan. This means you have three separate monthly repayments to make – which will likely all be different amounts – and potentially three different lenders to deal with.

By consolidating that debt into one new loan, you make a single monthly payment to one lender. This can make it much easier to keep track of how much you owe and if your new loan has a lower interest rate, it could work out cheaper too.

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Types of debt consolidation loans

There are two main types of debt consolidation loans – secured and unsecured.

A secured debt consolidation loan is secured against an asset, often your home. Because of this security, you can typically borrow a larger sum of money over a longer term (up to 25 years or more), and interest rates tend to be lower too. You may find it easier to get accepted for a secured debt consolidation loan if you have poor credit.

However, because you’re securing the loan against an asset, that asset is at risk if you fail to keep up with your repayments. So, you need to consider this type of loan carefully. If you can’t meet your repayments, the lender has the right to take ownership of your home and sell it to recoup its money – though this is usually a last resort.

An unsecured loan, on the other hand, is lower risk as you don’t need to use an asset as security. However, this means you typically can’t borrow as much as with a secured loan and rates tend to be higher. You can usually borrow over a term of between one and seven years.

With an unsecured loan, the amount you can borrow and the interest rate you are offered usually depend on your credit history - the higher your credit score, the better your chances of securing a competitive deal.

How does a debt consolidation loan work?

If you apply for a debt consolidation loan, your first step is to work out how much you need to borrow by calculating the total cost of your existing debts.

Once you have this figure ready, you can apply for a loan for that amount. If the lender agrees to let you borrow, you receive the loan funds and use those to pay off your existing debts. You won’t reduce the amount of borrowing you have, but you’ll now have one repayment to make each month, rather than several.

You’ll start making your new monthly repayments as soon as your new loan is in place. It’s important to make these on time, so it can be worth setting up a monthly direct debit to ensure you don’t miss any.

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What debts can you consolidate using a loan?

You can consolidate a range of existing debts into one loan, such as:

·   Personal loans

·   Credit cards

·   Store cards

·   Overdrafts

·   Payday loans

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What are the benefits of using a debt consolidation loan?

Some of the main benefits of using a debt consolidation loan are as follows:

·   Easier to manage: You only have one monthly repayment to make to one lender, so it’s easier to keep track.

·   Potentially cheaper: If your loan has a lower interest rate, you could save money on your debt repayments.

·   You could pay off your loan faster: Reducing your interest rate could help you pay off your debts faster.

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What are the potential drawbacks?

Before deciding whether a debt consolidation loan is right for you, you should also consider the downsides:

·   You could end up paying more: If your new loan has a higher interest rate, or you choose a longer repayment term, your debt could become more expensive.

·   Fees may apply: You may need to pay an early repayment charge to pay off an existing loan early, and your new loan may come with an arrangement fee.

·   You’ll need to undergo a credit check: When you apply for a loan, you’ll need to undergo a hard credit check which will be noted on your credit file.

·   Secured loans come with risk: If you use an asset as security, it could be at risk if you fail to repay the loan.

·   You could get trapped in a debt cycle: If you continue to borrow while repaying your debt consolidation loan, you could get into financial difficulties.

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How much does a debt consolidation loan cost?

The cost of your debt consolidation loan depends on several factors, including:

·   The annual percentage rate (APR): This refers to the total cost of your borrowing for a year, including interest and fees. The lower this is, the less it will cost you.

·   The term of the loan: Borrowing over a longer term lowers your monthly repayments but you end up paying more in interest.

·   Your borrowing amount: Naturally, the more you borrow, the more the loan will cost.

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Should I apply for a debt consolidation loan?

Before applying for a debt consolidation loan, consider whether doing so will save you money overall.

To do this, you need to first check if any early repayment charges apply to your existing debts. You should be able to find this information in the terms and conditions of your loan or give the lender a ring to ask.

If you do need to pay early repayment charges, be aware these may outweigh any savings you’d make by consolidating your debt.

Next, add up the total cost of your current debts, including early repayment charges, to calculate how much you need to borrow. Then start comparing loans to see whether you’re likely to be able to borrow that amount.

You also need to consider how long you need to repay the amount borrowed. You may need to borrow over a longer term to make your monthly repayments more affordable. But this means you’ll pay more in interest overall, making your debt more expensive.

If you work out that consolidating your debts into one new loan will result in more manageable monthly repayments, and the total amount you’ll repay with the new loan is less than the total amount payable on your existing debts, it could be worth taking the plunge.

But if you’ll end up paying more than if you kept the debt where it is, or you don’t think you would be able to afford your new monthly repayments, a debt consolidation loan is unlikely to be a good choice. It may not be the best decision if you’re close to settling your existing debts either.

If you are struggling to keep up with your existing debt repayments, it’s important to speak to your lenders as soon as possible. They may be able to come up with a more manageable repayment plan to help you, without the need to take out a new loan.

You can also seek free advice from debt charities, such as National Debtline, StepChange and Citizens Advice.

Can I get a debt consolidation loan with bad credit?

If you have poor credit, you’ll likely find it harder to get accepted for a debt consolidation loan. But it is still possible. Just be warned that the interest rate you pay will be higher, making the loan more expensive. You might not be able to borrow as much as you’d hoped either.

If you have bad credit, you may find it easier to get accepted for a secured loan – but remember this means using an asset, such as your home or car, as security. Should you fail to repay your loan, that asset could be at risk.

For these reasons, you should think carefully about consolidating your debt if you have poor credit. Taking out a new loan could cause your credit score to dip further, and you may find that it ends up working out more expensive if you’re paying a higher interest rate.

Crucially, you need to be confident that you could comfortably afford to meet your new monthly repayments. If you can’t, you risk doing further damage to your credit rating, and you could end up making your debt situation worse.

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How to compare debt consolidation loans

If you’ve decided to apply for a debt consolidation loan, we can help you compare your options from over 30 credit providers and banks.

You can select how much you need to borrow and for how long, then start your free search to receive personalised offers without affecting your credit score. We’ll only carry out a soft credit check which won’t leave a mark on your credit record and enables you to see how likely you are to be approved for a loan.

Be sure to compare factors such as the interest rate, fees, the length of the loan and the amount you can borrow to help you decide which option is right for you.

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