Are debt consolidation loans a smart financial move?

By Marianne Curphey

If you're juggling multiple credit card and other loan debts, rolling them all together into a debt consolidation loan with a fixed interest rate and single payment may ease your stress.

However, debt charities say, without proper planning, debt consolidation can be dangerous.

What are debt consolidation loans?
Offered by banks, debt consolidation loans allow you to bundle together various debts (such as credit card debts and overdraft debts) into a single loan with a single payment. Sometimes, the interest rate on the consolidation loan will be lower than the combined interest rate of all the separate debts.

Unlike unsecured debts (such as  credit cards, overdrafts and personal loans), debt consolidation loans are often secured against an asset, such as a house, according to the Money Advice Service. This could mean that your home would be at risk if you don't keep up repayments.

For this reason, debt consolidation loans are not usually available to tenants or people who do not own their own property, although some loan providers do offer unsecured loans for lower sums.

Debt consolidation risks
While getting a consolidation loan can reduce your interest payments, this is not always the case. If you are already struggling financially or have gone into arrears with your debts, it could be difficult to find a competitive interest rate from a provider. debt-consolidation

"If you have a poor credit rating, you may not be able to take out a consolidation loan, or you may be offered one on worse terms and conditions, for example at a higher interest rate," says Paul Crayston, spokesman for the Money Advice Trust.

Crayston also warns that the interest rate may change over the loan period, making it impossible to work out what the total cost of the loan will be. So check to see if the loan rate is "fixed" or "variable," Crayston suggests. Also make note of the repayment period. A lower interest rate, but a longer repayment period, could mean that you end up paying more over the life of the loan.

Another risk may stem from your own behaviour. Used correctly, consolidation loans can help you eliminate your debt. However, that's unlikely to work if you don't cut down on your spending. The temptation with a consolidation loan is that you start to use credit cards again when you should be concentrating on clearing the loan itself.

If you end up taking on a debt consolidation loan without first resolving the problems that necessitated it, "it will just add to your debt burden," says Una Farrell, spokesperson for StepChange Debt Charity.

"These types of loans are particularly unsuitable for people who are unable to repay what they owe and who probably need to opt for one of the insolvency solutions," Farrell says.

Before trying to merge your debts, look at your finances as a whole with the help of a debt counsellor, Farrell recommends.

"You should always seek free debt advice if you are struggling with your debts, or even if you are just worried about managing your debts," Farrell says. "There are a range of debt solutions which debt charities such as StepChange Debt Charity, National Debtline and your local Citizens Advice Bureau will advise you on."

When debt consolidation loans might make sense
Crayston says it's "always vital to seek advice" before getting a debt consolidation loan, as there are often better solutions available.

Still, consolidating debts might be an option if you are looking to make your monthly instalments toward debts more affordable without impacting your credit rating (consolidation loans won't hurt your credit unless you fall behind on payments), and without having to negotiate repayment plans with all your individual creditors.

"You will be making one monthly payment on one loan, rather than many payments to different creditors," Crayston says. "Your new monthly payment should be lower, but you must check that you can afford the new payments."

Debt consolidation alternatives

There are a number of alternatives to consolidation loans, such as a debt management plan drawn up for you by a debt counsellor, or an informal negotiation with creditors that allows you to pay back your debt over a longer period of time.

Other possibilities are:

  • An Individual Voluntary Agreement (IVA), which is a legally binding agreement between you and your creditors. It freezes your debts and allows you to pay them back over a set period, usually five years.
  • A debt relief order, which freezes your debts for a year and allows you to repay them in instalments over six months
  • Bankruptcy, whereby your assets are used to pay off as much of your debt as possible, and the rest is written off.

See related: A 0% card for damaged credit -- too good to be true?, Personal loans v credit cards: What's the best way to borrow?

Published: 8 March 2013