Debt consolidation is when you have more than one debt to pay off, so you decide to combine your debts to pay them off together, rather than repaying them separately. In order to do this, most people will decide to take out a debt consolidation loan.
With a debt consolidation loan, you get a single, larger loan which is used to pay off all of the smaller loans you have taken out after combining them, thereby avoiding having to pay multiple interest rates on multiple products.
Debt consolidation loans are great for people who have borrowed from various sources and are looking to get a handle on their finances whilst potentially making substantial savings on interest rates.
How Does Debt Consolidation Work?
Debt consolidation involves applying for a new, single loan product, using that money to repay your outstanding debts, and then finally repaying your consolidation loan. The amount of money that you borrow must be enough to pay off the amount of money that you owe when all of your debts are combined.
The repayments are usually made monthly by the borrower to a single lender in the form of a lump sum; therefore the interest paid is only on one transaction, rather than many. Debt consolidation means that you are paying one larger sum on the same day each month, rather than smaller ones throughout the month. If paying a single, sizeable amount works better for you, then debt consolidation may be a viable option.
The incentive for taking out a Debt Consolidation Loan is that, even if you end up paying for an extended term, you may save on the amount of interest you pay. Interest rates on small loans (such as payday loans) are oftentimes higher than the rates on larger loans.
This does not mean that you will definitely end up paying less on interest in the long run, however. Because debt consolidation loans are usually a significant amount of money, it is likely that your repayment period will be longer than what it would be if you did not consolidate your debts. The longer the repayment period, the more interest you will be paying.
It is best that you try to work out whether or not you will save on overall interest payments before consolidating your debts, with both repayment terms and individual interest rates in mind.
Secured Debt Consolidation Loans
You will typically find that most debt consolidation products take the form of secured loans, which are when the loan is secured against a valuable asset of yours. The asset is usually your come or your car, which will then be used as collateral if the loan is not repaid.
Because the loan is secured against an asset with a secured loan, the lender’s risk of approving you as a customer is greatly reduced, which means that the rate of interest offered by the lender can be much more competitive than that offered in unsecured loans products.
Most debt consolidation loans are used to pay off multiple unsecured loans products that themselves come with relatively high interest rates.
Unsecured Debt Consolidation Loans
If you do not have an asset to secure your loan against, or if you simply do not want to take the risk of having collateral, then you may still be able to get a debt consolidation loan in the form of an unsecured loan.
Student loans, credit card debts, and other loans can sometimes be combined into an unsecured product, although the interest rates will not be as competitive as with a secured loan. As someone who already has multiple debts, it could be harder to get an unsecured debt consolidation loan than a secured one.
Is a Debt Consolidation Loan Right for Me?
A debt consolidation loan is a good option for you if you have a number of debts to repay (such as multiple credit cards), and are looking to repay them in a convenient monthly sum which may allow you to save on interest rates.
If you have trouble keeping up with multiple repayments from an organisational point of view, then a debt consolidation loan may be the product for you. Although the term of your repayment period will likely increase, you will be able to avoid the risk of forgetting to make one of your individual payments, which could result in an expensive fine.
Many loans providers will have individual terms and conditions with regards to repaying your debts with them. You could be charged early repayment fees for having used a debt consolidation loan to pay off your existing debts before your final repayment which you had previously agreed upon.
If your credit score is not perfect, payday loans for bad credit may be one way to get access to finance but also an expensive form of debt.
Debt consolidation loans do not reduce the initial amount of debt that you owe, but they may be able to make that debt more easily repayable by potentially offering you improved repayment terms and lower interest charges.