Can a consolidation loan ever be a good thing? Serena Cowdy looks at the pros -- and cons -- of 'tidying up' your debts.
It's the time of year when financial resolutions abound. Millions of us are gritting our teeth, acknowledging the debt gremlins under our beds and trying to squish them once and for all.
Having taken a good hard look at your finances, the chances are you'll want to take action and 'get your house in order' to kick off 2008.
Every year, millions of people choose to do this by consolidating their debts.
I've done it myself. When I left university, my bank account resembled a leaky hosepipe. I was trying to repay several debts at once, and whenever I got my foot on one money leak, another seemed to pop up elsewhere. So I decided to scoop together all my debts (credit card, overdraft, money I owed the parents) and plonk them into one big shiny new loan.
This sort of simplification can be hugely psychologically appealing -- you feel you're 'getting a grip' and 'taking action' - and it does make it easier to track what your debt is doing.
However, does it ever make financial sense, or can it only make a bad debt situation worse?
Here at the Fool, we've made the case against loan consolidation several times. In this article, I'm going to explain how - if you're very careful and determined - you can make consolidation work for you.
What exactly is a consolidation loan?
Let's be clear. 'Consolidation loan' is just a phrase used to explain putting several outstanding debts into one loan. You can consolidate your debts using an unsecured or secured loan, a credit card, or by remortgaging.
In other words, you don't need to choose a 'consolidation loan' as often advertised on TV. Any lender using a 'celeb' to say things like "Apply now and live the dream" or "You really could have that dream holiday" gives me the heebie-jeebies, and doesn't, in my view, encourage responsible borrowing!
In fact, these ads are usually trying to sell secured, or 'homeowner' loans. These can be a very risky proposition. Usually, what the loan is 'secured' against is - you've guessed it - your home. This means you're more likely to lose the roof over your head if you don't make the repayments. (Read more about the pros and cons of secured loans here).
How to make consolidation work
Before you take out any sort of loan, have a look at our top borrowing tips.
In deciding whether to consolidate your debts, you then need to ask yourself two key questions:
1. Will I actually save money? Work out how much you'll save by consolidating -- and only go ahead if it makes financial (not just emotional) sense. Here are two examples:
- You have three debts, and you're being charged interest of 15%, 10% and 5%. You're offered a consolidation loan at a rate of 7%. Transferring the first two debts into the new loan could well save you money. However, don't throw in the debt that's being charged at 5%, just for the sake of simplicity -- this is most unFoolish!
- The monthly repayments on a loan might be less than your combined current debt repayments. However, pay attention to the total amount repayable (TAR).
Spreading payments over a longer period of time will provide financial relief in the short term -- and many people opt for a consolidation loan for this reason. However, if you do so you may end up paying hundreds (or even thousands) more in interest over the total period of the loan.
2. Have I had my `lightbulb moment'? You need to recognise the underlying problem. The The reason you're in debt in the first place is because you've been spending more than you earn. This may have been unavoidable at the time -- educational or medical expenses are just two examples -- but you need to sort it out so you don't get into even more debt.
Fool research has shown that five out of six people who consolidate then go on to amass even more debts to accompany their new loan. Don't consolidate, feel great relief, then continue the spending party. As this Fool's experience shows, that won't solve anything!
SO -- if you do go for a consolidation loan, try also visiting the Fool's Get Out Of Debt centre and the excellent Dealing With Debt discussion board, to make sure your spending never gets out of control again.
Two top loans
Now, to specifics: If you decide you do want to consolidate your debts, here are two loans that could be right for you:
The best loan for you will obviously depend on your circumstances. The following choices work well on the basis that you'd prefer an unsecured (personal) loan, and that you need to borrow £20,000, to be repaid over five years (60 months).
Of course, whether you're eligible for these will also depend on your current credit rating.
Yourpersonalloan.co.uk(financed by the Co-operative Bank) is currently offering unsecured loans at one of the lowest rates in the UK (typical APR 6.7%). There are no arrangement fees.
The main drawback of these loans is that early repayment charges apply. If you decide to pay your loan off early, you're likely to be charged a one month penalty fee (depending on the original loan term and amount).
It's also worth mentioning that all loans from this provider include a compulsory initial payment holiday of one month - during which you will still incur interest on your loan.
If you're looking for a loan with greater repayment flexibility, the AA Online Loan with no Redemption Penaltymight be for you.
It has a higher typical APR (7.8%), but as well as having no arrangement fees, you can pay this loan off early without early repayment charges - and you can make lump sum repayments.
Here's a breakdown of what you'd end up paying for each of the loans above:
Provider | Typical Annual Percentage Rate (APR) | Loan amount and term | Total amount repayable (TAR) | Monthly repayment | Total cost for credit |
|---|---|---|---|---|---|
Yourpersonalloan.co.uk | 6.7% | £20,000 over 5 years | £23,481.00 | £391.35 | £3,481.00 |
AA Online Loan with no Redemption Penalty | 7.8% | £20,000 over 5 years | £24,065.40 | £401.09 | £4,368.40 |
Remember these two loans are good for the circumstances that I outlined above. If your circumstances are different, an alternative loan may be a better fit for you. Visit The Fool's Loan Centre and you can search the whole loan market!
There's also a chance that you may be refused for a loan you apply for. When this happens many lenders pass your details to a secured loan provider who will try and sell you a secured loan. If you don't want this to happen, look for a tick box in the application form saying that you don't wish to be approached by other lenders.
Whatever you decide to do, just don't fall into the trap of letting your debts get the better of you all over again!