Your home for a loan: how debt consolidation works

mortgage application©iStock.com/BrianAJackson

When the stress of debt feels too much rolling up outstanding arrears on household bills, loans and credit card repayments into just one - a debt consolidation loan - can start to look tempting.

Providers promise the ease of a single monthly payment and, often, a lower repayment each month.

But debt consolidation loans aren't always the helping hand they claim to be.

What is a debt consolidation loan?

A debt consolidation loan is a way of rearranging multiple existing debts down to a single loan offering a lower monthly payment and - usually - a longer repayment schedule.

Many lenders provide debt consolidation loans to borrowers with equity in their homes when those borrowers' household budgets show that there is a surplus available each month to service the new loan repayments.

And don't forget that the consolidation loan isn't interest free: it will bring its own interest rate which will continue to inflate the new, consolidated balance.

Turning unsecured debts secured

Debt consolidation is often sold as a good way of safeguarding valuable assets (like a home) when dealing with creditors threatening bankruptcy.

On the other hand, though, it's vital to know that failing to make repayments on a secured loan can lead to loss of home through possession proceedings in the county court.

That's because, as we mentioned above, a debt consolidation loan takes a number of unsecured debts and not only turns them into one debt but, often, ties that one debt to an asset such as a property.

Credit cards, overdrafts and most personal loans are unsecured debts - that is, the borrowing isn't tied into any asset.

Although it's not unknown for those with serious unsecured debt problems to lose property - through charging orders, for example - it is far less common than with a secured debt. Under a secure debt agreement the lender has a right to repossess the asset if the loan goes unpaid.

That makes it a much more risky form of borrowing, especially for those who already have a problem with debt.

Longer to repay

In addition, as we noted above, a debt consolidation loan will generally take longer to repay than the original loans as payments will be spread out over an increased period.

These fixed payments mean that although the monthly payment on a consolidated loan is generally less than the total of all the debt payments which would have been made on multiple debts the total amount to be repaid will be more.

The prospect of actually paying more for borrowing is bad enough. Possibly worse is the prospect of paying that amount over a very long period: a Motley Fool study from 2007 found that the average consolidation loan takes eight years to pay off in full.

Doesn't 'write off' debt

It's also important to realise that a debt consolidation loan doesn't 'write off' debt (be suspicious of anyone that claims to do that).

Although some providers can negotiate with lenders there's no guarantee of those negotiations' success and, in addition, the new loan agreement will have to cover any costs of leaving an existing loan early.

That can often include existing contractual interest and any early settlement penalties as our guide to early loan repayment sets out in more detail.

Doesn't tackle the root cause

Finally, those with problem debts often find that taking out a consolidation loan doesn't tackle the root cause of their debt problem - and, therefore, debt problems simply continue.

The same Motley Fool study from 2007 mentioned above also found that 60% those who had taken out consolidation loans ended up getting deeper into debt shortly afterwards.

The personal finance site speculated that this was a psychological effect: after being consolidated debts feel 'done', freeing individuals to borrow again.

It could also be the case the lack of access to revolving credit such as credit cards after the consolidation leads consumers to take out these products again and, again, fall into unmanageable debt.

The Fool survey was also pessimistic about consolidation loans' ability to change borrowing behaviour.

It found that just 25% of those that took out a consolidation loan actually managed to clear their debts early, although those that did were then less likely to continue accumulating debts.

Alternatives to debt consolidation

All in all, it's clear that debt consolidation loans occupy a really odd place in the personal loans market: they claim to help those struggling with multiple debts but the way they're structured often actually makes borrowing more risky.

In addition, save the promise of just one repayment, there seems to be little return on that additional risk.

So, for those juggling multiple debts, what's the alternative?

Seeking expert advice

When a serious debt problem feels like it's getting on top of you, it could be worth getting in touch with an advice charity.

They can help you talk through the formal options - including debt consolidation loans but also more serious options such as individual voluntary arrangements (IVA) and bankruptcy.

Some also offer advice and guidance on repaying and negotiating with creditors yourself (see last section) and this is often preferable since leaving the standard repayment system can have long-term consequences.

The following are four well known national charities which offer support to millions of people with problem debts every year:

The difference between charities that offer debt advice and private debt management companies is complex. See our charity vs private debt help guide for more information on this.

Debt repayment techniques

The other option for many consumers with multiple debts is simply not to consolidate and just concentrate on paying back the debts as they are.

There are several techniques that can help ordinary consumers in this situation.

'Highest to lowest'

Just taking a budget to the problem of multiple debts can be a much cheaper way of solving the problem when the problem hasn't, so far, become completely unmanageable.

Cutting expenses drastically and starting to repay as much as possible, usually starting with the borrowing at the highest interest rate and ending with the one accruing interest at the lowest rate, is possible - millions of Britons manage to become debt free this way.

'The snowball'

As above, conventional wisdom states that it'd be wisest to pay off the debts with the highest interest balances first, then move on to the next.

However, some personal finance bloggers and even some researchers talk about the 'snowball' effect of paying off the smallest debts first, even if they're not attracting the highest rate of interest.

Paying off the most easily repaid debt first is a huge psychological boost, they say, making it easier to go on to repay other debts.

That certainly seems likely in the case of, say, a long-standing overdraft which places an everyday depressant effect on finances.

Balance transfers and money transfers

Another option is to take out a credit card that has an introductory 0% or low rate APR either on balance transfers (for credit card debt) or money transfers/super balance transfers (for overdraft or personal loan debt).

These credit cards allow cardholders to transfer multiple debts to the card and then pay them off at the low interest rate during a set period.

Generally these are available as offers for new applicants but note that they are also available less formally through negotiation with a pre-existing financial provider.

Just as with debt consolidation loans, however, these facilities aren't charitable: they're money-making exercises on the part of the card providers.

As such, they also need careful consideration before application.

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