Debt consolidation loans

A debt consolidation loan is a single new loan taken out to pay off several existing debts. You work out how much you need to borrow to clear everything, apply for a loan of that amount, and if approved, use the money to repay each of your creditors. You are then left with one monthly repayment to the new lender instead of several payments to several lenders¹. Banks and building societies may offer personal loans for this purpose².

The appeal is simple: one payment instead of many, a lower monthly amount if the interest rate is lower or the term is longer, and a known end date. But consolidation does not reduce what you owe. Interest is added to the amount you borrow, and if the new loan runs for longer than your original debts, or the rate is higher, you can end up paying more in total than you would have done³. Where the loan is secured on your home, falling behind on payments can lead to repossession⁴.

How a debt consolidation loan works

The process starts with adding up what you owe. You work out how much you need to borrow to pay off all your debts, then apply for a debt consolidation loan for that amount. If the lender approves you, you use the money to pay back each of your creditors, and from then on you make one monthly repayment to the loan lender until the loan is paid off¹. In the case of credit card debt, the loan money pays off the card balances and you then repay the loan instead of the cards⁸.

Debt consolidation joins all your debts together, usually by taking out a loan and using the money to pay back the people you owe⁹. The ni direct guidance for Northern Ireland consumers describes it in the same terms: consolidating debt is when you take out a single, new loan to pay off several existing debts².

The benefit most people notice first is budgeting. After consolidating, you only have one monthly repayment to make, which can make budgeting easier to manage¹. Consolidation may also help make the debt more affordable by lowering the monthly payment you need to make⁶. The rationale behind it is to secure a lower rate of interest, so that the borrower has only one, lower monthly repayment¹⁰. Other advantages listed in official guidance include a known end date, dealing with only one lender, and avoiding the damage to your credit record that missed payments on the old debts would cause².

Interest and charges are added to your repayments, so the monthly payment is not simply the old debts divided by the number of months¹¹. How that interest is worked out is covered in how loan interest is calculated, and the mechanics of borrowing in general in how personal loans work.

Which debts you can combine into one loan

Consolidating your debts means you get one single loan to pay off all, or some, of your other debts¹². You do not have to include everything: a partial consolidation, clearing the most expensive debts only, is also possible.

What you can include comes down to what the lender allows. National Debtline's guidance is blunt on this point: any debts that your lender allows you to include can go into the loan¹³. In practice that usually means unsecured debts such as credit cards, store cards, personal loans, overdrafts and catalogue accounts. Credit card consolidation specifically means merging debts so you only have one bill to pay, and the two usual routes are taking out a personal or consolidation loan, or transferring balances onto a low interest credit card⁸.

Two limits are worth knowing. First, unsecured loans of this kind are not allowed for certain purposes: lenders will say you cannot use them for things like buying property or making mortgage payments⁴. Second, some debts carry consequences of their own if they are left unpaid, such as priority debts like council tax or energy arrears, and these are normally dealt with differently rather than rolled into a loan. A debt adviser can look at which of your debts a loan could sensibly cover. The wider set of borrowing types is covered in types of loan.

Secured or unsecured: what puts your home at risk

A consolidation loan may be an unsecured personal loan. However, if you are a homeowner, it may be secured against your home¹². The difference between the two is the single most important thing to understand before signing anything.

Unsecured means the loan is not linked to your home⁹. With unsecured loans, lenders look at your credit history and affordability to check whether they should lend to you¹⁴. If you do not pay, you can be taken to court and risk having a county court judgment (CCJ) against you, because an unsecured consolidation loan is classified as a non-priority debt¹².

Secured means the money you borrow is financially linked to your home¹⁴. A secured debt consolidation loan works like a second mortgage: the loan becomes a second mortgage on your home and puts it at risk. If you fall behind or cannot afford the payments, the lender can repossess your home and sell it⁵. The lender can take and sell your property, and your credit rating will be affected⁴. This applies to loans secured on your home or business assets¹⁵.

Many secured loans are offered specifically as a way to consolidate debts. Their interest rates are lower than unsecured personal loans because the risk to the lender is reduced: if you do not pay, the lender has your home to fall back on¹⁶. That lower rate is the trade for the much bigger risk you take on. Some secured lenders will lend to people with a bad credit history who would not get an unsecured personal loan at all¹⁶.

The regulator has paid close attention to this market. An FCA consultation proposed extending its requirements to all second charge debt consolidation mortgages, and not just those made to credit-impaired consumers¹⁷. In plain terms, loans that consolidate debts and sit behind your first mortgage are treated as a category with specific rules, because of the risk to the borrower's home. The comparison is set out in more detail in secured or unsecured borrowing compared, and what happens when payments are missed in missing secured loan repayments and your home.

What it costs: interest, fees and a £6,000 worked example

The cost of a consolidation loan has three parts: the interest rate, the length of the term, and any fees. Interest and charges are added to your repayments¹¹, and there may be other charges like set-up fees or early repayment fees⁹. A loan described as having no fees to set it up still has interest added to the amount you borrow³.

The effect of the interest rate and the term together is stark. StepChange gives worked examples for consolidation loans aimed at people with bad credit. Borrowing £5,000 over five years at an example rate of 30% means 60 monthly payments of £151, plus £4,076 in interest. Borrowing £2,000 over five years at 99% interest means paying an extra £5,317 in interest. Stretch the same £2,000 over 10 years at 99% and the extra interest rises to £12,180¹⁴.

Those examples are at the extreme end of the market, but they show the two levers clearly. A high rate multiplies the cost, and a long term multiplies it again, because interest is charged for longer. Secured loan repayment terms are often a lot longer than unsecured loans, which is one reason a secured loan can work out more expensive overall despite a lower monthly payment⁴.

Before taking out a loan, official guidance suggests checking the repayment length and total cost, whether the interest rate can change, the monthly repayments and any penalties for missing one, any penalties or costs for repaying early, and what happens if the loan is secured on your home and you cannot keep up repayments². How the rate is expressed matters too: loan APR, representative APR and personal APR explained covers why the rate you are advertised may not be the rate you are offered, and loan fees and charges covers the other costs to check.

Consolidating does not reduce what you owe

This is the point most easily missed. A consolidation loan moves your debts, it does not shrink them. Even a loan with no set-up fees still has interest added to the amount you borrow³. A debt consolidation program increases the amount that you owe, because the amount you borrow has to cover your existing debts plus an amount for the interest and charges¹⁵.

Debt Advice Foundation puts the underlying problem plainly: debt consolidation is rarely the solution to a serious debt problem, because in practice the borrower is simply increasing their borrowing¹⁰. If the reason the debts built up in the first place has not changed, for example spending that regularly exceeds income, the new loan adds a layer of cost rather than fixing anything.

There are ways to get some of your debt written off, but these options have strict rules to meet and are not ideal for everyone¹. They are debt solutions rather than loans, and they are covered later in this page. The point here is narrower: a consolidation loan is a refinancing tool. It can lower your monthly payment and simplify your finances, and it can lower the total cost if the rate is genuinely lower and the term is no longer. What it cannot do is reduce the balance itself.

Who can get one: credit history and affordability checks

There is no minimum or maximum level of debt for consolidation. It depends on what the lender is prepared to lend²⁰. What the lender decides rests on two things: your credit history and an affordability check, which is the process covered in loan affordability checks.

A lender's advertised headline rates are usually only available to people with the highest credit ratings⁶. Having a low credit score or a less-than-ideal credit history can make it harder to get approved for consolidation loans, and may mean being offered higher interest rates than you pay now, or higher risk secured loans¹. Consolidation loans for people with poor credit exist, but they are likely to come with higher interest rates, and the lowest rates may not be open to you if you already have poor credit⁹.

If you have a poor credit rating, you may only be able to get a loan at a high interest rate or secured against your home². Secured consolidation loans are easier to get approved for in this situation, but they carry much higher risks if you cannot repay²⁰. Debt Advice Foundation's view is that consolidation loans should generally only be considered by people with good credit histories and a relatively high proportion of high interest debt, such as store and credit cards¹⁰. It also notes that with lending criteria tightened, it is very difficult to get a consolidation loan at a reasonable rate of interest¹⁰.

Multiple applications can make things worse. Several applications for debt consolidation loans can affect your credit file, because lots of searches can make it harder to take out credit¹⁸. The options for borrowing with a weak credit record, and the lenders that serve that market, are covered in getting a loan with a poor credit history and near-prime and subprime lenders explained.

Applying: documents, checks and how existing lenders are paid

The practical steps are straightforward. First, shop around for the best terms from a reputable lender; building societies and banks may be able to offer a personal loan². Second, work out the total you need, including any early repayment charges on the debts you are clearing. Third, apply, and if approved, use the money to pay each existing creditor back, then close or reduce those accounts so the debts are genuinely gone rather than available to be run up again.

What you need to have ready is modest. Debt advice services typically ask for bank statements for the past 3 months, along with details of what you owe and to whom¹⁴. Debt consolidation loans come with affordability checks, and whether your application is accepted depends on the lender and your personal situation⁹. The documents and process are covered in more detail in how to apply for a loan.

Two things to check before you sign. First, ask each existing lender for a settlement figure, the exact amount needed to clear the debt on a given day, and whether any early repayment charge applies; there may be set-up fees or early repayment fees on the new loan as well⁹. Settlement figures are explained in paying off a loan early and settlement figures. Second, once the loan money arrives, make sure it actually goes to the old creditors. The danger of a consolidation loan is that cleared credit cards and overdrafts stay open, and the balances build up again on top of the new loan.

You may be encouraged to take out insurance with the loan. If so, make sure you need it and that you can claim on it². Payment protection insurance was an insurance product sold alongside credit cards, loans and many other finance agreements, and it was mis-sold on a large scale in the past⁷. If you believe you were mis-sold insurance or a loan, complaining about a lender or finance company sets out the route.

Where a consolidation loan can make things worse

The risks fall into four groups, and each one turns a supposed benefit into a cost.

Higher interest. The added interest may not be cheaper than you are paying now¹. Interest could be higher than what you are paying now, and a poor credit score may mean higher interest, so the loan could cost you more overall⁷.

Longer term. Some consolidation loans may take you a longer time to pay back than your original debt, which can make them more expensive in the long term than your current debt⁶. A longer loan, even on better terms, can mean you pay more in the end¹⁰. These loans can actually add to your debt or take longer to pay off⁸.

Inflexibility. Repayment terms are not flexible if you cannot afford them anymore¹¹. Official guidance also warns that with a single lender it can be harder to renegotiate if you get into difficulties, compared with dealing with several creditors who may each accept an arrangement².

Missed payments. Missed or late payments can create more problems, so you need to be really sure you can keep up with the repayments¹. If you miss payments on a consolidation loan, the lender could ask you to repay the loan in full, including all the interest that would have been paid by the end of the agreement⁶. Late payment fees could be added to the amount you owe, and interest added will only increase the amount you owe; you will receive a default notice on your credit file, and county court judgments are possible⁴. A personal loan will usually default after two or three missed payments if you do not take steps to deal with the debt²¹.

Consolidating credit card debt by moving balances onto a low interest card, rather than by loan, carries its own version of these risks: it can take longer to pay off and can actually add to your debt, especially if you only pay the minimum repayment each month¹. If you are already struggling, what to do if you can't repay a loan covers the immediate steps.

Alternatives: talking to lenders, debt management plans and other debt solutions

A consolidation loan is one option among several, and it is not usually the first one a debt adviser would suggest for someone in difficulty. The alternatives range from informal arrangements to formal insolvency solutions.

Talking to your existing lenders. You can try to make new arrangements with your existing lenders². Creditors have more room than people expect: when you use a debt adviser, you can ask your other creditors to stop interest and charges, stop collection agencies recovering the debt, accept token payments, or write off the debts²². Creditors may also let you pay through an agreement like a debt management plan, agree breathing space, give a payment holiday, or accept a settlement including a partial settlement²³. Informal debt solutions often involve reaching an agreement with the people you owe money to²⁴.

Debt management plan (DMP). A DMP is similar to consolidation but has different processes and benefits¹. It is an agreement with your creditors, usually arranged through a provider, to pay back what you owe at a rate you can afford. Before setting up a plan, get advice: free and independent advice is available from organisations like Advice NI²⁵. The provider should discuss all the possible options available to you to deal with your debt problem²⁵. A DMP is not without consequences: creditors can still pass your debt to a collection agency, start court action, or continue to contact you²⁶. How a DMP affects you is covered in the debt section.

Formal debt solutions. The main options are debt management plans, debt relief orders (DROs), individual voluntary arrangements (IVAs), bankruptcy, and in Scotland the Debt Arrangement Scheme¹. Lots of companies advertise these solutions, so it is worth knowing the full list before speaking to anyone²⁷. These routes can involve some debt being written off, but they have strict rules to meet and are not ideal for everyone¹. A debt adviser may recommend better budgeting, a debt solution, or using assets to pay back or write off debt²⁸.

Cheaper credit options. Depending on your circumstances, alternatives include making best use of existing credit options such as an overdraft, credit or store cards, a personal loan or mortgage extension, or borrowing from relatives². For persistent credit card debt, the options include increasing monthly repayments, moving the balance to a card with a lower interest rate, or getting a loan you can afford to repay²⁹. A credit card payment holiday may be an alternative to a consolidation loan, or finding a card with a better deal to transfer your balance to³⁰. Credit unions and community lenders offer smaller, cheaper loans, covered in credit union loans and community lenders (CDFIs) and affordable credit.

Support with specific bills. Some debts are better handled through support schemes than through borrowing. For example, if you have water arrears, a supplier's hardship scheme may suggest a payment plan, or funding you can apply for to pay off your debt³¹. If you receive Universal Credit, you can ask about an affordable repayment plan and other options like reduced repayments for deductions from your benefit³².

The choice between a loan and free advice is set out side by side in consolidation loan or free debt advice.

Free debt advice before you borrow

Free debt advice is widely available, and it does not affect your credit score, though some debt solutions will⁷. Getting advice before borrowing is the single most useful step in this whole process, because an adviser can tell you whether a consolidation loan would actually help in your circumstances or whether another route fits better.

There are free advice services that can help across Scotland³³, and equivalent services across the UK. StepChange offers free debt advice online³⁴, and free help and advice is widely available for people affected by debt or the debt collection process³⁵. The FSCS signposts people struggling to repay money they owe to free debt advice from StepChange, Which? and Citizens Advice³⁶. In Northern Ireland, Advice NI provides a range of debt solutions including debt management plans, bankruptcy, IVAs and DROs, and free advice is available on informal arrangements too²⁵.

What happens in a session is practical, not judgmental. You will be asked for bank statements for the past 3 months and details of your debts¹⁴, and the adviser will go through your options: better budgeting, a debt solution, using assets to pay back or write off debt, or a consolidation loan if it genuinely suits²⁸. Because the advice is free and independent, it has no stake in which option you choose, which is the difference between it and a lender or broker selling a loan. If money is tight and you are considering any form of credit, the alternatives in cheaper alternatives to a payday loan may also be relevant.