Pros and cons of debt consolidation loans

Debt consolidation is a process whereby a consumer takes out a loan in order to pay off two or more existing debts. The idea is to simply amalgamate what we owe on credit cards, HP, bank loans etc by getting a new loan which will pay off all current outstanding debts and cost less each month in repayments.

Taking out a loan for debt consolidation is very popular. A study by the Office of Fair Trading found that in 2002, up to a half of secured personal loans and up to 40% of unsecured loans were taken out with debt consolidation as the reason. They estimate that, in 2002, 32 billion of unsecured lending and 8.8 billion of secured personal lending was used for debt consolidation.

Types of debt consolidation

1. Borrowing a sum of money to pay off all other debts through an unsecured personal loan, from a bank or another lender. Because the loan is unsecured, you won't risk losing your home in the event of any problems repaying.

2. Adding more to your mortgage from your existing mortgage lender based on the rising equity in your house. You are simply borrowing more money form the same lender and your home is as much at risk as it was before.

3. A secured loan on a property, from a lender other than your mortgage provider. This is known as a second charge, and in the event of a borrower defaulting on repayments, the secured loan lender will have a claim on the property after the first charge holder (mortgage lender) has had all their liabilities settled.

Advantages

Many people benefit from consolidating their debts on better interest terms with the advantages of debt consolidation over multiple credit agreements including:

  • Lower interest rates - Some credit and store cards charge over 20% APR in interest whereas a debt consolidation loan should be considerably lower than this.

  • Lower monthly payments - This can make the repayment of debts more manageable and make it easier to budget.
  • Having to deal with only one lender - Rather than receiving numerous statements and demands each month from a number of companies, you now have only one company to deal with.



Disadvantages

  • Some lenders charge a penalty fee (early repayment charge) if a loan if repaid early. These charges can be significant and need to be taken into consideration when deciding whether to pay off your existing debt with a consolidation loan.

  • When you take out a debt consolidation loan you might have to pay a broker fee.

  • Lower monthly payments are normally because the debt is repaid over a longer period of time. Borrowers are therefore likely to pay more in interest charges in the longer term and have the debt for a longer period.

  • If unsecured debts such as credit cards are consolidated with a secured loan, the risk to the borrower is greater. If they encounter repayment problems they would risk losing their property.

  • Many lenders add payment protection insurance (PPI) on their loans, sometimes without borrowers fully understanding what it is. Payment protection insurance cover is usually expensive.



Shop around before applying

The research by the Office of Fair Trading found that most consumers do not shop around for debt consolidation. Around 66% of borrowers who consolidated their debts in 2002 failed to shop around, contacting only one lender.

However is very important to shop around, as the interest charges (APR), the price of payment protection insurance (PPI) and additional costs such as early repayment charges vary significantly from lender to lender.

Be careful of borrowing more than you need

The study by the Office of Fair Trading found that just over half of those surveyed borrowed extra cash when consolidating debts to pay for a new car, home improvements etc. This is not advisable for people currently experiencing serious financial difficulties as it is likely to exacerbate problems.