We hear a lot about debt consolidation loans and why they might be a sensible way for a family with more than one debt to get their finances under control and reduce their monthly payments. But what are debt consolidation loans and do they really make sense for people who are concerned about the amount of interest they are paying on their unsecured debts?
Debt consolidation loans explained
Most families in the UK owe money on more than one card or on more than one unsecured loan. While it can make life difficult keeping track of all of these balances and repayments, it is possible, likely even, that you could be paying more in total interest charges than you have to.
A debt consolidation loan is exactly what it says on the tin: you wrap all of your debts into one balance with one interest rate and once monthly repayment. While this can make household budgeting much simpler, it can also substantially reduce the amount of interest charges you are paying each month, although be careful not to extend the payments too far into the future.
When you take out one of these loans, you are moving all or most of your unsecured debt onto a single, new loan. Once you have done this, you’re then free to close your other credit cards or loans. Be careful, though, some credit agreements include early repayment penalties which may incur a cost if you try to pay off a loan early.
When you are approved for a debt consolidation loan, you’ll find all of your debts are in one place, with a single interest rate to watch and a single monthly repayment to make.
You’ll be able to close your other credit and loan accounts which will mean that your credit rating might improve because it shows potential lenders that you are acting responsibly to manage your debts.
An example of when it works
Take an average family with the average unsecured debt of £16,000. That may be spread over two credit cards and one unsecured loan. The chances are that the family is paying in excess of 15% APR on those credit cards and 8% APR or more on the loan. That might add up to monthly repayments of £500.
Now take a typical debt consolidation loan of £16,000 with an interest rate of 3% APR through Cahoot. This loan is repaid over five years and the repayments would be £269. The total charge for credit over the five years would be £1,155.64 and you would end up repaying a total of £16,155.64.
This is probably substantially lower than you would end up repaying on your credit cards if you simply made the minimum payment each month. You’d also be able to repay your debts much faster with this debt consolidation loan.
The disadvantages of a debt consolidation loan
With some loans and in some circumstances, a debt consolidation loan can end up costing your more. If most of your debt is on credit cards, applying for one or more of those with 0% APRs introductory rates for balance transfers will almost certainly cost you less than rolling these debts into a single loan. This would allow you to pay 0% interest on the balances for, on average, 18 months, allowing you to repay the total balances faster.
Other things to consider
If you’re considering a debt repayment loan, then you should always total up all of your debts and work out how much you owe. This is because the interest rates charged on these kinds of loan are usually lower the more than you borrow.
If you owe, say, £14,000 but can find a loan for £14,500 with a lower interest rate, then it often makes sense to apply for this because you may end up paying less interest over the lifetime of the loan.
If there may be circumstances where you might be able to repay the debt consolidation loan before then end of its term, then check whether the loan you are considering comes with any early redemption penalties. These can be a nasty surprise when you think you are in a good position to pay off the loan early!
Oliver Jones has written for Solution Loans since 2015. His passion for personal finance comes through in the 150+ blog posts he's written since that time. His talent for explaining all things money means he's covered topics as diverse as...Read more about Oliver Jones