How consolidation loans work
Consolidation loans are often offered as a solution to large credit card debts. On the surface they are attractive as the interest rate and repayments are generally lower, but they may not always be the best option.
The sort of borrower who needs a consolidation loan is a borrower with credit card debts that are, or could prove to be, too large to service. It is really important to know whether that person recognizes that the root problem is overspending. If the person does not think that they are overspending, or accepts that they are overspending but does not have a track record of reducing their debts, then a consolidation loan would be a bad idea, as it could make the problem worse.
A consolidation loan can increase the capacity that a borrower has to take on more debt. So if there is an ongoing issue with the credit card spending then it will only be made worse as the credit cards will still be used. In many cases the credit card spending will increase as reaching credit limits has previously slowed down spending. It may also lead to a better credit record as the ratio of debt taken on to debt approved will have gone down, which in turn can lead to credit card limits being increased (although under the Credit Card Act 2009 providers are not allowed to do this without the cardholder’s permission).
The total interest paid can also increase as the term of the loan is longer, even though the interest rate is lower. There is also a danger that a borrower may use their house as security. If payments are missed then the lender has recourse to the house and is far more likely to start proceedings than they would with an unsecured borrower, when then have the same rank as other lenders.
Consolidation loans are useful if the borrower is already on a path to pay down their debts. If a couple of smaller debts have been paid back and a pattern of spending less than the borrower’s income every month is established, than a consolidation loan can be a useful part of the debt reduction as the money can be paid out automatically when a salary is received and the debt reduction can be “pre-programmed”. However it is a good idea to make the loan repayments challenging and to use credit cards sparingly during this time.
Consolidation loans are a good component of a debt reduction program, but they have to be used in the right place.