Debt consolidation is a dangerous game

By Annie Shaw, Moneyextra
2008

Debt consolidation can seem like an easy way out when the bills get too much. What could be simpler, after all, than rolling all those fiddly direct debits and standing orders into one handy payment each month, so you know exactly how much is going out and on what date? And, as a bonus, the amount leaving your account each month could be less, leaving you more to spend on other things.
Well, that all may be true. Debt consolidation can help people to cope with their bills and even avoid going bankrupt. And if repayments on the loan are made promptly each month, a consolidation loan can be used to re-establish a good credit record. But it's not the whole story.
Loans that should carry a health warning
Debt consolidation loans should come with a big health warning, because consolidating a lot of little loans into one big one can be a dangerous move. Before you take out a consolidation loan you need to understand two things:

* The difference between secured and unsecured lending

* The power of compound interest

Not all loans are equal
A secured loan, the type usually used for debt consolidation, is one that is linked to your house or, more rarely, another high-value asset. The house is the "security" for the loan so, if you don't make all the repayments, the lender might be able to make you sell your home to force you to pay him back.
That means that a secured loan is much more risky for the borrower than an unsecured loan, which is not linked to anything. The worst penalty you face for defaulting on an unsecured loan is to be taken to court and a judgment to be taken out against you - which would mean that in future you could have trouble getting such things as a credit card, a mortgage or other loan.

* Compare rates on unsecured personal loans

Apply Now For Debt Consolidation


The ever-growing debt
Compound interest is interest which is charged on interest that has already been added to a loan. If you do not make your monthly payments in full, you end up paying interest on interest - and then interest on interest on interest.
How much you pay for a loan in total will be governed by two things: the interest rate (and how often it is compounded) and the length of the loan. If you extend the length of your loan, even if the interest rate remains the same as on your previous loans, you will end up paying more back to your lender in the long run.
Debt consolidation loans usually work by bringing your monthly payments down to a level that you feel you can more comfortably afford. But they do this by extending the period of the loan, and at the same time making you pay more over the period.
This is how compound interest works: if you owe £500 at a rate of interest of 6% a year and you make no repayments for that year, the debt increases to £530 (6% of £530, ie £30, plus the original £500). If you still make no repayments, the interest in the second year will be more than the previous year (6% of £530 - compared with the first year's 6% of £500 - making a total owed now of £561.80). The debt will continue to grow like this, getting bigger all the time.
So, you can see how important it is to meet your repayments, and how the way to get the debt to go down rather than up would be to increase your repayments, not decrease them - which is what a consolidation loan will tend to do.

* Need advice about paying off your debts? Find a financial adviser near your home or office

Other drawbacks to debt consolidation
There are some other drawbacks to consolidating your debts with one lender:

* You will now have only one creditor, which could mean you will have more difficulty in negotiating repayments if you have further financial problems in future.

* The loan will probably be secured against your home, meaning you could lose it if you do not pay.

* Credit card debts and personal loans are unsecured.

* You may pay a higher rate of interest compared with other types of loan, particularly if you have a poor credit history.

* Secured loans are usually offered on a variable rate basis so you could find your repayments soaring if interest rates rise.

* If you are able to repay the loan early thanks to an inheritance, for example there may be hefty penalties payable for early repayment of a secured loan.

* Official government advice about debt, IVAs and bankruptcy

Other debt management options
Before you take out a secured loan you should look at other options, including selling items you don't need, such as valuables or a second car, moving your credit card and store card debt to a card with a lower interest rate, or taking out an unsecured loan just to cover your card debt.

* Credit cards: find the best rates on balance transfers

If you have equity in your home, you could consider remortgaging to release capital to repay your debts. This will also extend your indebtedness over a longer period, but the interest rate on a mortgage tends to be much lower than on secured loans. If switching your mortgage to another lender will result in early repayment penalties, ask your existing lender if they will grant a second mortgage on your property. This could still work out cheaper than a separate secured loan.

* Compare rates on remortgages

Apply Now For Debt Consolidation


The problem for people seeking debt consolidation is that they are often experiencing repayment difficulties and may have a poor payment record, which will close off to them many of the cheaper avenues to rescheduling their finances.
However, using the services of so-called specialist debt consolidation firms can be a route to further problems, not least because they often charge high "administration fees", or "application fees", which are added to the existing debt. You should never pay for debt counselling or debt rescheduling.

Courtesy:
http://money.uk.msn.com/guides/dealing-with-debt/article.aspx?cp-documentid=4750221
 

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