Debt Consolidation Explained

Couple counting coins together

If you are facing financial difficulties and going through challenging financial times, it is of the utmost importance that it be addressed immediately. It may be the case that you need to consider taking out a short-term loan or perhaps a loan for bad credit to tide you over in the immediate term or perhaps you need to seek other measures. Short term loans though, are expensive and cannot serve as a long-term solution for enduring financial troubles.

It may seem that there is simply no way out of the cycle of debt you find yourself in. However, there are companies and charities that can help you manage your debts effectively and in a more affordable way.

Debt consolidation in a nutshell, is when a person with outstanding debts consolidates their existing commitments and debts into a single, more manageable, more affordable monthly payment plan. This is usually the last resort for many people who find themselves at the end of the rod with regards to future credit. It is important however, to inform your creditors as soon as possible that you are seeking debt consolidation, be they an online direct lender, credit card provider or otherwise.

It is often the case that those found in such positions have little choice but to turn to debt consolidation loans, which differ in their nature to bad credit loans. Alternatively, a debt management company may agree with the borrower in debt and their creditors to take on the debt to help them clear what they owe.

What is Debt Consolidation and How does it Work?

According to a report by the Money Advice Service, around 8.3 million people in the UK struggle with ‘problem debt.’ This type of debt is distinctly different from what may be otherwise termed ‘normal’ or ‘everyday’ debt which would include things such as mortgage commitments or credit card bills, which by their very nature mean that the borrower is in a form of debt and must therefore meet their repayment commitments.

Debt in the UK

Many people in the UK are in some form of debt and for most, their debts are not unaffordable. Some debts are necessities such as mortgages, whereas others in some case are less so, such as some forms of car finance. However, according to recent statistics, debt can be separated into the following types

Student Debt

The amount owed by graduates upon graduating university

Household Debt

Average debt owed in total per household

Credit Card Debt

How much the average person in the UK owes their credit card provider (s)

Mortgage Debt

The average amount of outstanding mortgage debt in the UK

Personal Debt

Other debts (car finance and other financial commitments)

Alleviating Chronic Debt

Chronic debt however is very different. Rather than being a normal form of debt, this is where the person in debt has no way out and cannot meet even their minimum requirements, for example interest payments. Being in this position with chronic debt may affect a person’s psychological well-being, relationships and sense of financial security. People in this position often also find themselves with an increased degree of hopelessness which perpetuates the cycle of debt.

People who face chronic debt often have multiple forms of debt rather than one single monthly payment. It may be the case that the borrower has payday loans, credit cards, mortgage repayments, utilities bills and more outstanding all at once. It is difficult to manage just one monthly debt payment, let alone three, four or potentially even more different payments.

Why Am I in Debt?

People often find themselves in the position of untenable debt for a number of reasons including:

  • Starting with one debt that they cannot pay off, so they take out a short term loan they ultimately cannot cover either
  • They have a great deal of monthly commitments and they lose their job
  • Separation from or the death of a partner who was helping to cover expenses, debts and bills
  • Being irresponsible with money and spending
  • Living ‘hand to mouth’ and an emergency arises (such as needing to cover emergency medical bills that are expensive)

In these types of situations, many people will turn to debt consolidation solutions in one guise or another. Debt consolidation is a method of debt management that pools together various debts including credit and store cards, car finance payments and then creates one consolidated loan.

Whether or not consolidating your personal loans is a good choice for you will depend on multiple factors, such as overall debt amount, currently monthly payments required, your total income and your debt management plan.

Why Consolidate My Personal Loans?

Debt consolidation may be a good choice for you for a whole host of reasons. Primarily, debt consolidation can relieve stress and the concerns of you potentially losing your home, vehicle and personal possessions in the worst circumstances.

Rather than having multiple payments to worry about each month, your refinanced loan will allow you to make just one monthly payment. This is much easier to manage, and may even empower you to take greater charge over your finances.

Another reason to consider debt consolidation is to try to improve your credit score as much as you can. Credit ratings are impacted negatively when you miss payments and make late payments as well as should you go bankrupt or require an IVA (read more about IVAs here).

It is easy to miss payments when you have to worry about multiple different payments and commitments as opposed to one consolidated monthly bill to a single debtor. With one bill, it is likely to be easier to pay consistently and on time. This may help you raise your credit score somewhat, which can help your financial future and get you back on your feet for the future.

Debt consolidation may also help you receive a lower interest rate on the plan. If a person has six monthly payments, the interest rates may be very high on some loans. Debt consolidation firms offer lowered interest rates, which may help you lower your overall loan payment with interest.

What Are the Risks of Debt Consolidation?

Despite the benefits of debt consolidation, there are also some risks involved. Debt consolidation is a serious decision and the potential benefits and risks vary from case to case.

Before consolidating your debts in any way, consider the pros and cons of your loan situation to make sure it is a sound financial decision in your specific case. If debts are small enough to be paid quickly, in perhaps less than 6 months, it may be costly and unnecessary to consolidate your debts. If your total debt balances exceed this, consider the risks before committing to a formal consolidation plan:

Debt Consolidation Does Not Address the Root Problem of Debt

Consolidating your debts may feel like you are fixing your debt problem immediately, but you may have to consider your spending habits overall in order to eliminate debt accumulation from your life going forward and to help prevent you falling back into a spiral of debt again. Creating a realistic budget for your day to day spending and financial behaviour may be a more effective way to prevent the accruing of debt in the future.

Debt Consolidation Could Prolong Your Debt by Several Years

People are often drawn into debt consolidation loans by the promise of lower monthly repayments. Debt consolidation firms are able to offer these lower payments by prolonging your payment plan; a four year payment plan with several small debt payments may be consolidated into one plan that will take six years to pay for example.

Additionally, this prolonged payment plan type may increase your overall payment amount by the end of the entire plan. A lower interest rate may end up costing you more money if the debt takes several years longer. Early repayment may be a better and cheaper option.

Additionally, debt consolidators hike up interest rates over time, so if you sign up for a five year debt consolidation plan with an interest rate of 9%, your interest rate may climb to 13% in the third year. This may result in a plan that is more expensive than your previous payment plan.

If you are with a debt consolidation plan provider and for any reason feel that your consolidation loan violates UK law, please consult the Financial Services Register via the Financial Conduct Authority.

What Are the Alternatives?

If debt consolidation is not a good match for your circumstances, there are many other options to consider.

To start, you may want to create a debt management plan yourself. In your plan, consider your current income, your potential income in coming months and years, and your expenses. This will help you build an accurate and realistic timeline for paying back your debts.

Instead of consolidating your debt, consider getting an 0% interest credit card which allows free of charge balance transfers from one card to the card in question to consolidate all credit card debts sensibly. These cards may help you to pay your expenses without accruing interest.

If your financial interests are immediate, a short term loan may help you get out of a pressing financial situation. Short term personal loans are commonly used to help cover an emergency, unexpected expenses, car payments and home repairs. A short-term loan may be a good option for you, rather than debt consolidation in the short term.

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