How Does Debt Consolidation Work?

Debt consolidation can be a lifeline when multiple debts become overwhelming, especially with high interest rates and looming deadlines. It simplifies your finances by combining several debts into a single monthly payment, often with a lower interest rate. If you’re in the UK struggling to keep up with repayments, several debt solutions are available to help you regain control of your finances. Here, we’ll explain different debt consolidation methods and debt relief options, including Individual Voluntary Arrangements (IVAs), Debt Management Plans (DMPs), and Debt Relief Orders (DROs), so you can choose the best route for your circumstances.

What is Debt Consolidation?

Debt consolidation involves taking out a new loan or entering into a formal arrangement to pay off multiple debts, leaving you with just one monthly payment. The idea is to simplify your financial obligations, reduce interest rates, and spread costs over a more extended period to make them more manageable.

Debt Consolidation Loans

A debt consolidation loan is one of the most common ways to consolidate debt. You use these personal loans to pay off all your debts, such as credit cards, store cards, or other personal loans. You repay the new loan in fixed monthly instalments over an agreed period.

Pros:

• Simplifies payments into one manageable monthly instalment.
• Can reduce overall interest if the loan has a lower rate than your current debts.
• Fixed repayment schedule makes budgeting easier.

Cons:

• Good credit may be required to access favourable rates.
• You could pay more in the long run if the repayment term is extended.
• Risk of losing collateral (if secured against assets like your home).

We’ve discussed how debt consolidation loans in the UK work further on our website.

Individual Voluntary Arrangements (IVAs)

An Individual Voluntary Arrangement (IVA) is a formal, legally binding agreement between you and your creditors to repay your debts over a fixed period, typically five or six years. You make one affordable monthly payment, which is distributed to your creditors. At the end of the IVA, any remaining debt is written off.

Pros:

• Creditors are legally bound to accept the arrangement and freeze interest.
• You only pay what you can afford.
• Once the IVA is completed, any remaining debt is written off.

Cons:

• Your credit rating will be affected.
• An IVA is recorded on a public register, and some employers may view it negatively.
• Failure to keep up with payments can result in bankruptcy.

Money Advice specialises in IVAs, and we’re always available to help – read more on IVA Pros and Cons on our website.

Debt Management Plans (DMPs)

A Debt Management Plan (DMP) is an informal arrangement where you work with a debt management company to repay your unsecured debts, like credit cards and loans, at a reduced rate over time. The company negotiates with your creditors to reduce payments and interest rates, consolidating your debts into a single payment to the debt management company, which then distributes it to your creditors.

Pros:

• Lower monthly payments can make repayments more affordable.
• Helps consolidate payments into one monthly instalment.
• Interest and charges may be frozen, depending on negotiations with creditors.

Cons:

• An informal agreement means creditors are not legally bound to freeze interest.
• DMPs can take a long time to clear debts.
• May impact your credit score for several years.

If you’re deciding between solutions, we have further information on the differences between IVAs and DMPs.

Debt Relief Orders (DROs)

A Debt Relief Order (DRO) is a solution for individuals with low income and minimal assets who cannot afford to pay off their debts. A DRO freezes your debts for 12 months, and if your financial situation hasn’t improved by the end of that period, the debts are written off. To qualify, your debts must be less than £30,000, and you must have less than £75 in monthly disposable income.

Pros:

• Offers a way out for low-income people with no significant assets.
• Debts are written off after 12 months if your circumstances remain unchanged.

Cons:

• Limited to those with debts under £30,000 and very little disposable income.
• Your credit rating will be severely impacted.
• A DRO will stay on your credit file for six years.

Balance Transfer Credit Cards

If your primary debt is from high-interest credit cards, you might consider using a balance transfer credit card to consolidate debt. These cards allow you to move debt from multiple cards onto a new card, often with a 0% introductory interest rate for a set period.

Pros:

• An interest-free period (typically 6 to 24 months) can help you pay off debt faster.
• You can save money on interest if it is paid off during the interest-free period.

Cons:

• A balance transfer fee (around 1-3% of the debt) is often charged.
• After the introductory period, the interest rate can increase significantly.
• You need a good credit score to qualify for the best deals.

Is Debt Consolidation Right for You?

Debt consolidation can be an effective solution for managing debt, but assessing whether it’s the right option for your situation is essential. If your credit is good enough to access a low-interest loan or balance transfer card, or if you can manage payments under a DMP, consolidation may help simplify your finances. However, if you’re struggling with significant debt and can’t see a way out, formal solutions like an IVA or DRO might offer the relief you need.

Taking the Next Step…

In the UK, several debt solutions can help you regain control of your finances. Whether it’s a debt consolidation loan, a balance transfer card, or formal arrangements like an IVA or DRO, there is a solution for almost every situation. The key is understanding your financial circumstances and selecting the right approach to manage your debts effectively. If you’re unsure where to start, Money Advice can help you make those first steps.