A Debt Consolidation Primer

By Martin Sumner

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Debt consolidation is one of the most widespread reasons for taking out a personal loan, and while it can be a very effective way out of financial distress for some people, it can also be a bad choice which makes a poor situation even worse. If you've been considering taking out a loan for this purpose, it's vital that you know exactly what you're getting into and what the possible benefits and drawbacks can be.

The basic point of debt consolidation is to take out a loan large enough to repay all your existing debts, such as credit card balances, overdrafts, expensive store card accounts and so on. By taking out one loan at a lower rate than your current borrowings, and clearing your debts with the funds you obtain, you should be left paying a single monthly repayment that is less than the combined total of all your previous debts.

Even if you can't secure credit at a more beneficial interest rate than that which you are currently paying, you can still take advantage of consolidation by spreading your repayments over a longer term. This can mean that your monthly repayments will be lowered, albeit at the expense of paying more in interest charges over the extended term of your borrowing.

At this basic level, debt consolidation seems like a sensible idea, especially if your debt burden is starting to become unmanageable - after all, who would refuse paying out less each month to service their debts? There are however a few points to consider before taking the plunge.

Firstly, as already mentioned, spreading out your debt over a longer term will almost inevitably mean you'll end up paying more interest in total than if you instead cleared the debt as quickly as possible. While this might not seem a major concern if you're genuinely in dire straits financially, the numbers involved aren't trivial: a typical long term loan could see you having to repay sometimes twice as much as you've borrowed.

Also, the most common choice for debt consolidation is a secured loan, where your home is potentially at risk of repossession should you fail to keep up your repayments. Transferring unsecured debt such as credit card balances into secured debt might make sense financially in the short to medium term, as you're likely to save in interest charges, but you need to be aware of the possible risks if your financial circumstances take a turn for the worse.

Finally, consolidating your debt will only work out if you have the discipline to avoid building up new debts. You should ideally cancel all the credit cards that you pay off as part of the process, along with closing any overdraft facilities or other lines of credit that you have available to you. If you don't do this, the temptation will inevitably arrive to begin borrowing again, and you could end up reaching the same debt levels as previously, but with the added burden of your consolidation loan on top - and that way lies only insolvency in most cases.

This is not to say that you should be overly wary of taking out a debt consolidation loan, but it will be a major decision that will effect your financial status for many years to come, and so you should make your choice fully aware of both the positive and negative aspects.

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