You may have heard of the phrase “debt consolation loan” – this is where you take out another loan to pay off all your existing loans or a large portion of them.
When you're debts start spiralling out of control it can seem like a hopeless situation but the only truth is that the sooner you start taking action the better off you'll be. It can be tempting to ignore all the calls and letters from your creditors – but this is the worst possible thing that you can do.
Control your debt
If you don't take control of your debt you'll simply let things spiral out of control. From student loans, car loans and mortgages to credit cards and household utility bills – debt piles up and before you know it your in over your head.
To get out of debt and remain as debt free as possible you have to understand the real reason that you got so far into debt in the first place. One of the main reasons that people get into expensive debt is because they get into the bad habit of spending irresponsibly – mostly in the form of purchasing luxury goods and funding expensive outings and holidays.
If this is the reason that you got into serious debt then you have to cut back on everything – immediately.
Stop spending & start repaying your debts.
This may be a very uncomfortable change because once you’ve become accustomed to being in and accumulating debt it can be very hard to put a stop to the spending. Another common problem that delay action is that people simply don't know how or where to start – and in such cases it’s very important that some time be spent on increasing your financial education – you simply can’t fix what you don't understand.
If you’ve never created and stuck to a budget then this would be the time to do so. A budget will not only help you control your spending but it will help you figure out exactly how you're going to pay your debts.
If you’ve been spending a lot on luxury items – most that you have no real use for – you are going to have to consider selling them and using the money to repay some of the most critical debts. In addition, any salary increase or bonus from your employer must immediately be to repay debts.
The second thing is that you need to do is sit down and list all your creditors, how much you owe each one and what the interest rates are.
If you're married, you need to do this with your spouse so that your combined income can be split up as efficiently as possible. You need to prioritise them from those which are the most essential to those with the highest interest. Essential debts are your mortgage, utility bills, tax debts and very high interest debts.
You then need to contact each creditor and explain your situation – they will be more willing to help you if you're honest and show them that you're willing to take responsibility then if you ignore them and let things get out of hand.
What is debt consolidation?
Essentially you will be exchanging many smaller loans for one bigger loan – which may seem like a dream come true to many people but, there can be a downside. Some debt consolation loans may actually make your situation worse because you'll owe money for a longer period of time, have your “cheaper” debts convert to the higher interest rate of the consolidation loan and may also be subject to additional fees.
The obvious benefit is that you will be less likely to miss payments simply because you're struggling to keep up with all the different creditors you owe. You'll also be able to cancel out most of the debts that are cluttering your credit report and making your credit score suffer. The major downside is that if you consolidate some relatively low interest debts, like that on a low interest credit card you will move that balance over to the larger loan where it will be subject to a higher interest rate.
If you put your home up as collateral you may even get a lower interest rate – which may save you from complete financial ruin but at the same time may cause you to lose your home if you don't keep up with the repayments. Most debt consolidation loans are however, unsecured so you won’t risk losing your home and this is the type of debt consolidation loan that I believe to be the best.
If you're really looking to become debt-free you may want find a debt consolidation loan that allows for early repayments without penalty – you may find yourself paying it off in 4 years instead of 5 or even 2 instead of 3 depending on how much debt you're in.
Debt consolidation loans will certainly make your debt more manageable since you'll be making one simple and fixed payment each month. If you can shop around for a lower interest rate then you will definitely benefit even further. By keeping up with repayments you'll also limit damage to your credit score and possibly even improve it. Once one creditor has been paid off the remainders will receive a larger amount and this will help shorten the time within which your debts are repaid. If you run into some additional cash or get an increase in your salary at work and would like to help speed up the debt repayment process, you could allocate this money to the loan as well – just make sure there are no fees for doing this beforehand.
If you make your monthly repayments and don't take on any additional debt till the term of the consolidation is over - you will be debt free. Debt consolidation works best for those who have the majority of their debts in the form of unsecured loans like credit card debts and short-term personal loans. It will not work for overdue bills, parking and speeding tickets or tax debts. If you contact a non-profit debt advisory agency they will be able to help you determine if a debt consolidation loan will be beneficial to your personal financial situation – or if it would do more harm.
It’s worth noting that some lenders – particularly mainstream lenders will view a debt consolidation as a negative thing because it indicates you have trouble managing and paying your own bills - so you will certainly only be considered for any other loan once your completely debt free. It may take you quite some time to get used to sticking to a budget and not spending as much as you’ve become used to – so go into it with the right mindset and goals.
I can't consolidate, my debt is too big.
What if you can’t get a debt consolidation loan big enough to cover your existing loans? In such a case you may have to prioritise the debts and choose to apply for a smaller loan that will cover only the most critical debts. These would once again be those that carry the highest interest rates and penalty fees. Longer term debts that carry a low interest rate will be cheaper to keep as they are anyway so you'll actually save money by prioritising like this.
Consider a Debt Management Plan.
If you're really having a hard time coping with your debt than you may want to consider a Debt Management Plan (DMP) and there are several different charity organisations that will set one up for you without charging any fees. A DMP is basically an arrangement made with all your creditors to make a reduced payment and possibly to even freeze interest on your debts for a certain period of time. You can set up a DMP yourself but we do recommend that you get a third party such as a charity to act on your behalf. This will ensure that the best and most professional arrangements are made both for your own monthly budget and in the allocation of income amongst creditors.
The organisation will help you organise a monthly household budget and will allocate any surplus to paying off your creditors. The amount they pay to each creditor will be predetermined and communicated with them beforehand – some creditors may even agree to freeze interest on your debts so that any payments you make can go directly to repaying the debt. A DMP will negatively affect your credit score because you'll most likely be making smaller payments and unlike with the IVA previously discussed, creditors may still contact you.
If your debt problem has escalated to the point where neither of the options discussed here has the potential to improve your situation then you may have to consider an Individual Voluntary Arrangement (IVA) which will help make your debts more manageable and get the creditors off your back. IVA’s are only suited to a very small number of people – many of whom are overstressed and can no longer take the pressure that mounting debts have put on them.
By getting an IVA creditors may not contact you or continue to charge interest on your existing debts. If you were considering filing for bankruptcy an IVA may save your home and help you get out of debt – one little step at a time. You will make one single payment to the agency representing you and they will allocate the funds to your creditors just as is done with a DMP.
In addition there is something known as a Debt Relief Order which can help those who have no assets, less that £50 left over after all monthly expenses are paid, a debt of no more than £15,000 and meet a few other requirements.
If a DRO is granted you will not be required to make payments to any debts included in your DRO and at the end of the 12 month period the debts will be written off. Debts that may be included in a DRO include personal loans, credit card debts, utility bills, income tax debts and even business debts. There are some very severe consequences of having a DRO as the DRO will appear in your credit report and will restrict your ability to access credit, rent property and even open a new bank account – you will also not be allowed to legally borrow more than £500 without informing the lender that you have a DRO among a number of other restriction for the 12 month time period that the DRO is in effect.
Bankruptcy – Worst case scenario
Finally let’s discuss the worst case scenario – filing for bankruptcy.
Declaring bankruptcy is definitely one of the hardest things for anyone to do because it means that all of your assets including your home and car will be sold to repay your creditors. This will be done by an assigned by an insolvency practitioner who will be assigned to your case.
Essentially you will lose everything you have but it may be the only way to clear the debt that has overwhelmed you. You have to file a bankruptcy petition and the court may declare you bankrupt by passing a bankruptcy order. You will have to pay for the court fees and a deposit for the administration of your bankruptcy.
This is a very serious matter that comes with a list of restrictions and consequences and should only be considered in the most sever of cases. Creditors are not allowed to contact you or take any action to try and recover their money once a bankruptcy order has been passed.
Since there are a range of options for those who are struggling to manage their debts – it’s always advisable to speak to a professional, non-profit organisation that can provide you objective advice on how to best handle your personal financial situation.
The Citizens Advice Bureaux is one such organisation that will provide you with free advisory service – and it’s definitely a good place to start. Step Change is a charity that will also help you in dealing with debt problems.
It’s crucial to remember that the longer you leave debts and creditors hanging the worse the situation will get so take action without delay and never ignore creditors – you'll only end up with more serious action being taken against you.
Creditors may even work with you to make a more suitable arrangement to pay your debt so do communicate with them.