Lots of people want to consolidate their debt into one loan. Making just one monthly payment and paying lower interest sounds simpler and cheaper – a big improvement, surely?
Consolidating can be a good way to reduce the interest you are paying, but you have to be careful to get it right. Most debt advisors have seen this go badly wrong for too many of their clients… so here are the five big pitfalls that you need to avoid:
1) DON’T leave credit cards open
If you do this, then at some point it is likely you will use the cards again. Perhaps you mean to pay it all off quickly, but other urgent problems may arise and soon your credit card debt is rising again and you also have the large loan to pay off… and this time round you probably won’t be able to consolidate as the loan required would be too large.
This is the biggest mistake and also the most common. Don’t let it happen to you! Perhaps keep one card for emergencies, but reduce its credit limit to less than £1,000 and set it up to repay in full automatically each month.
2) DON’T borrow more than you need to clear debt
Don’t think It’s only 5% so we may as well borrow another £2,000 and be able to take the kids to Disneyland“. This year’holiday needs to be paid for this year in full, out of this year’s income –
This year’holiday needs to be paid for this year in full, out of this year’s income – otherwise, you can’t afford it! Putting holidays on credit cards may well have been one of the reasons your debt problems have got so big.
You may feel that you can afford the larger loan now, but if your mortgage rate goes up, or your income drops you may be struggling, in which case you will really regret making this loan bigger than it has to be.
3) DON’T borrow for longer than you have to
If you borrow for a longer term the loan may feel “cheaper” because the monthly repayments will be lower. But overall a lot more interest will be charged. If you borrow £9000 over four years at 8% then the monthly repayments will be £219. If you stretch the term to six years, the monthly repayments fall to £158 but the interest total goes up by over £800.
Not only will you be paying more interest, but you will be stuck with the loan for longer. If you want to save up for a house deposit or increase your pension contributions or start a family, you are postponing the time you can get on with the rest of your life. New mortgage-lending rules have made it much harder for you to get a mortgage if you have debts.
4) DON’T consolidate cheap debt
The main gain from consolidation comes from reducing the interest. So if some of your debt is already cheap, don’t include it in the consolidation just to get one payment a month. That simplicity isn’t worth the fact that you will be paying more interest! Also if you have a current large loan that is costing you a lot each month but only has a few months to go, don’t re-finance this as you will then be paying interest on it for a lot longer.
Look at your expensive credit card debt and think how you could tackle that. One option might be to get a 0% balance transfer for it. You couldn’t get a 0% deal for all of your debt, but you may be able to get a smaller offer that will really cut the interest you are paying. There are some very good offers around at the moment, see MoneySavingExpert’s best balance-transfer table.
5) DON’T get a secured loan
If you need to borrow a lot of money, then the only way you may be able to do this is with a secured loan. Don’t do this! It is almost always a big mistake:
- if you have financial problems in a year or two – perhaps one of you loses their job or becomes ill – then there are ways of handling unsecured debts. If you have turned your unsecured debts into secured loans, then you may lose your house.
- if you have to claim benefits for a period, you will get help with mortgage interest after a few months, but you will not get any help with secured loan repayments.
- if the only secured loan you can get is from a sub-prime lender, it will usually be a variable rate. These lenders have a nasty habit of increasing this rate a lot.
Conclusion – be a savvy borrower
If you avoid all these traps, then a consolidation loan may help reduce your interest. If making a few cutbacks now will reduce your expenditure (ditch Sky? fewer takeaways?) then you may be able to afford to borrow the money over a short period, which will mean you pay less interest and get debt-free sooner. Cheap debt is better than expensive debt – but no debt at all is even better!