What happens when you consolidate debt?
Consolidating debt is essentially a way of moving all your debt into one place. In doing so, you make managing the repayments (and budgeting) easier. You also reduce multiple interest rates down to one, and you only have a single lender to repay.
In some cases, consolidating your debt can make it more affordable, as you may have a more competitive interest rate than before. As a result, it may even help you pay off the debt quicker.
There are two main ways to consolidate debt:
- balance transfer credit card
- debt consolidation loan
1. Balance transfer credit card
A balance transfer credit card is a way to consolidate credit card debt. It involves moving all your credit card debts to a single credit new card. This means you only have to make one monthly repayment, instead of juggling multiple payments.
Balance transfer credit cards may come with a 0% introductory offer. This interest rate will be fixed for a set period, which can make your debts more affordable. How long the 0% interest period lasts depends on the provider, but one thing you can guarantee is that it will end, and when it does, the interest will likely increase significantly. So, it’s important that you try and clear the balance in full before this happens.
2. Debt consolidation loan
There are two main types of debt consolidation loan: unsecured and secured.
Unsecured debt consolidation loan
Unsecured debt consolidation loans are very similar to personal loans in that they aren’t tied to any assets. You borrow a fixed amount of money from a lender upfront, and then use it to repay your existing debts in full. You then pay back the loan in monthly instalments.
The main difference is that debt consolidation loans are normally taken out for this purpose only – whereas personal loans can be taken out for multiple purposes.
You can consolidate multiple different kinds of debt under one loan (i.e. overdrafts, credit cards and other personal loans). The benefit is you’ll only have one repayment, one interest rate and one lender to think about.
Secured debt consolidation loan
Secured debt consolidation loans are tied to an asset that you own, such as your house. This means that if you can’t repay the loan, your house will be at risk. This added layer of security often gives lenders more confidence to lend larger amounts (compared to unsecured loans) to those with lower credit scores.
Although unsecured debt consolidation loans aren’t secured against asset, failing to make at least the minimum monthly repayments under any type of credit will impact your credit score. This can have a knock-on effect on your ability to get approved for credit in the future.
Is it wise to consolidate debt?
Whether or not consolidating your debt is a good move depends on your personal circumstances. While there can be benefits, it isn’t for everybody and sometimes it can end up costing you more.
Debt consolidation may be a wise move if:
- you want to make budgeting easier, so you never miss a payment
- having multiple debts with different interest rates is making your debt too expensive
- you can commit to the monthly repayments involved in consolidating debt
- you have a good credit history and are likely to be approved for a new line of credit
- you can get a 0% introductory deal on a balance transfer credit card - and you pay off your debt before the deal ends
Debt consolidation may not be a good idea if:
- you’ll end up paying even more through fees and charges for early repayments/transferring your debt
- you don’t know if you can make the monthly repayments on your new line of credit
- you have a poor credit score that means you’ll only be able to get a debt consolidation loan or balance transfer credit card with a high interest rate
- it won’t help make your debt more affordable and/or it’ll keep you in debt for longer
What is the best way to consolidate debt without hurting credit?
As you know, there are two main ways to consolidate debt: you could get a balance transfer credit card or a debt consolidation loan. The best way to consolidate debt depends on your individual financial situation.
Applying for any kind of credit will temporarily lower your score (whether it’s a loan or credit card), due to the lender performing a hard check on your credit report. This helps them to decide how risky it’d be to lend to you, based on your past financial behaviour.
To help you decide which route to go down, consider the following questions.
Which is the most affordable option?
When it comes to your credit score, whichever option you choose, one of the most important things to bear in mind is affordability. As long as you make your payments on time and in full, your credit score should increase over time. Plus, it will show lenders that you are trustworthy to lend to. So, you need to work out if this will be easier to achieve if you consolidate your debts.
By the same token, if you fall behind with your repayments, your credit score will drop and late fees may be applied. Three to six missed payments can lead to a default being applied to your credit report. Further missed payments could lead to a County Court Judgement (CCJ). These negative markers can seriously affect your credit score and your ability to get credit in the future.
Will my credit utilisation ratio be more or less than 30%?
To make sure you keep your credit score in tip-top shape, you want to avoid spending more than 30% of your total available credit limit across all your credit cards and overdrafts. This percentage is known as your ‘credit utilisation ratio’.
So, if debt consolidation means you’re going to max out your new credit card limit, it could potentially have a negative impact on your credit score. In which case, you may want to consider an instalment loan instead. Moving revolving credit card debt to an instalment loan should reduce your credit utilisation ratio – and in turn, boost your credit score.
What other factors should I consider?
When it comes to choosing between a credit card and a loan, there are other factors to consider besides your credit score, such as interest rates, if you prefer fixed or variable payments and how much you need to borrow, for example.
Read on for more information about credit cards versus loans.
Can you still use your credit card after credit card consolidation?
Consolidating your credit card debt doesn’t automatically close those accounts. Instead, it moves the debt from them to another location (either a balance transfer credit card, or a debt consolidation loan). It’s then up to you whether you choose to keep those credit card accounts open or close them.
So, while you can still use your credit card after paying off the debt on it through consolidation, it’s best not to, as it’s so easy to end up with even more debt overall.
Having said that, keeping them open (and not spending on them) can be a good idea if you had a good repayment history – as it will show future lenders that you are a responsible borrower. It also keeps your access to credit open if you ever need it. The risk is that it’s also awfully tempting to have the credit sitting there waiting for you.
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Intelligent Lending Ltd is credit broker, working with a panel of lenders. Homeowner loans are secured against your home.