Consolidation Loans

Published: 06 November 2008

The total personal debt in the United Kingdom at the end of September stood at more than £1,000 billion – an increase of just over 5% in a 12-month – so if you are feeling the effects of the credit crunch, and juggling monthly repayments on credit cards, loans, etc., you are certainly not alone. One possible solution to this ongoing problem may be to simplify your finances by taking out a consolidation, or "debt consolidation", loan. As the name suggests, this type of loan is designed to pay off existing borrowing, and replace multiple monthly repayments with a single, affordable repayment. This may not only provide what is effectively a "fresh start", financially, but may also reduce the amount of interest payable on your debt. Similarly, fixed monthly repayments – as opposed to minimum payments on credit cards, for example – can allow you to pay off a reasonable proportion of the debt each month, and thereby reduce the length of time required to repay the total amount.

Pros & Cons of Consolidation Loans

The effectiveness of a consolidation loan depends, obviously, on the interest rate available; there is no advantage to be gained by replacing multiple repayments with a single repayment if this means paying the same, or more, interest on your debt, but if you have one, or more, credit cards – whose typical APR ("Annual Percentage Rate") is 17.5%, or more – for example, a consolidation loan may provide a significant benefit in this respect. You should, of course, choose the lowest APR available; APR represents the true cost of borrowing (including any fees, charges, etc., which may not be immediately apparent) in a year.

Do bear in mind, however, that many lenders may you offer a more competitive interest rate if you borrow more money – possibly more than you actually need to repay your existing debt – so you need to exercise a degree of self-discipline. The prospect of further spending a holiday, or some other "luxury" item, may be appealing, but remember that the purpose of a consolidation loan is to improve your financial situation in the long-term, not to make it worse.

You should also calculate a repayment term that is suited to your own financial circumstances; too short a repayment term may place you in the position of being unable to meet monthly repayments, whilst too long a term may cause you to lose your initial enthusiasm for improving your financial situation, because you cannot see any real reduction in the total amount of your debt. Lenders may actually ask you to complete a statement of your outgoings – mortgage, or rent, payments, utility bills, other credit commitments, etc. – so that you, and they, can make a realistic assessment of an affordable monthly repayment.

On receipt of a consolidation loan, it may feel, psychologically, that your financial situation has improved – which, indeed, it may well have, in the long-term – even though you may not have actually reduced the total amount of your debt, at all. This can be a potentially hazardous situation, because it presents the illusion of available funds – possibly large amounts – from previous sources of credit. It is a unfortunate fact that up to 80% of borrowers who take out a consolidation loan actually run up further debts, so be careful with credit cards, in particular, once the balance has been paid off. A credit card with a high credit limit and a zero balance can be almost irresistible, so it may be necessary to close any accounts and/or cut up cards, themselves, unless your level of self-control is above average. The solution to any debt problem is either to spend less, or earn more, in the long-term; in the absence of a forthcoming lucrative career move, or promotion, this typically requires a definite change in attitude towards spending.

The issue of PPI, or "Payment Protection Insurance", has always been a thorny one in relation to consolidation loans, or loans of any kind. PPI is designed, in theory, at least, to protect a borrower from unforeseen circumstances, such as accident, illness, or redundancy, which may prevent him, or her, from making repayments on a loan, or other credit agreement. In practice, however, the number of borrowers who actually claim on this form of insurance policy is small compared to the number of policies sold, and if bought alongside a loan, PPI is typically very expensive. It is obviously up to individual borrowers to decide whether PPI is necessary, or not, but even if it is, it may be available from an alternative provider at a fraction of the cost.

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