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What is debt consolidation and how does it work?

If you are looking to deal with your debts, you will probably have considered debt consolidation. Debt consolidation can help you take control of your borrowings, save you money and simplify your financial arrangements.

But what is debt consolidation? And how does it work? Keep reading to find out.

What is debt consolidation?

Debt consolidation is simply the process of combining lots of smaller debts into one larger debt. For example, if you have several credit cards or store cards you may decide to take out a larger debt in order to repay all these smaller debts.

How does debt consolidation work?

Debt consolidation involves you taking all of your outstanding debts and combining them into a single, more manageable debt. This can either be through secured borrowing against an asset, such as your home, or through further unsecured borrowing, such as a personal loan or a credit card.

Consolidating your debts with a loan

The most common way of consolidating debts is through a debt consolidation loan. This is a loan that you take out to repay your existing debts, thereby ‘consolidating’ these various debts into one larger loan. You may also choose to extend the repayment period of their debts when you take out a debt consolidation loan. This is because it generally reduces your monthly repayments.

Debt consolidation loans can normally be taken on a secured or an unsecured basis. A secured loan is likely to offer a lower rate but the loan will be secured against your home.

The main advantage of a debt consolidation loan is that it can reduce your interest payments and reduce your monthly outgoings. It can also simplify your finances as, instead of having multiple creditors, you just pay one loan to one lender.

However, a debt consolidation loan will normally mean that you are paying your debts off over a longer period of time. If you take out a secured loan then your home may also be at risk if you fail to keep up your repayments.

Consolidating debts with a credit card

If you have debts that you intend to repay over a shorter timescale then an interest-free credit card could be a cost-effective option. Low rate or 0 per cent balance transfer credit cards allow you to transfer debts from other cards, and then repay the combined debt without paying interest. Considering the average credit card rate in the UK in March 2012 was 17.3 per cent, this could save you a lot of money.

You should remember that these deals are time restricted and that the low interest rate period will generally last for only around 12-18 months. So, this option is generally only a good idea if you are confident you can repay your debt before the low/zero interest period expires.

What if I am really struggling with my debts?

As mentioned earlier, the above methods of debt consolidation can`t really help with debts that are causing you severe problems. If you are struggling to repay your debts, you should talk to a debt adviser about more suitable options.

A debt management plan or even an Individual Voluntary Arrangement (IVA) may be more suitable for you, and a specialist debt adviser can help you explore your options.

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