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If you find yourself in significant debt with multiple loans to pay off, you might consider a debt consolidation loan. In a nutshell, a debt consolidation loan allows you to pool your debts into a single loan, making it much easier to manage repayments. Here’s how it works:

How does a debt consolidation loan work?

If your application for a debt consolidation loan is approved (you’ll have to meet certain risk criteria), your credit provider will pay off your outstanding loans and pull the collective debt into a single larger loan. This makes repayment easier while also saving you money on admin fees.

A debt consolidation loan will also usually have a loan term longer than those of your original credit accounts. This lowers your monthly instalments, making them more affordable. But it also makes your debt more costly in the long run since it increases the amount of interest you pay. For this reason, you should always aim to pay off your debt as quickly as possible even if you initially use a debt consolidation loan to make monthly repayments more affordable.

When your outstanding debt has been settled, your loan accounts (such as personal loans) are closed, but your store and credit cards remain open (if you’ve had trouble managing your debt, it would be a good idea to close these).

What are the benefits of debt consolidation?

The first obvious benefit to debt consolidation is that it reduces your many creditors to one. This helps you in two ways. It simplifies repayments, and it makes it easier to budget, since you know exactly how much will be debited from your account every month. The other benefit to debt consolidation is that it can reduce your monthly instalments by spreading your repayments over a longer term. Of course, this is only an advantage if you are currently struggling to make minimum repayments.

What are the risks associated with a debt consolidation loan?

Lower monthly instalments might free up some of your budget, but this should not be interpreted as greater spending power. Such an attitude could land you in even more debt. If you have any disposable income, it should go straight into paying off your debt consolidation loan. 

Another risk with debt consolidation is that while it can help you make minimum repayments, it  invites you to stay in debt longer, which, as has already been pointed out, raises the cost of your debt and increases the chances of you accruing more debt. If you take out a debt consolidation loan, your goal should be to pay off your debt as quickly as possible even with the lower minimum repayments.

Who is debt consolidation for?

If you are struggling to make repayments but still have an acceptable credit score, then a debt consolidation loan can give you a little breathing room by lowering your monthly instalments. If you decide to take this route, you’d need to adjust your spending habits so that you are 100 percent sure that you can make minimum repayments. It would actually be better to pay back more than the minimum every month so that you shorten the time that you’re in debt.

If you are in a LOT of debt and have a poor credit score (one so low that you don’t even qualify for a debt consolidation loan), you will have to consider debt review. With debt review, your debt is assessed by a debt counsellor, who then helps you draw up a budget and makes recommendations to your creditors. When all of your debt is settled, you are issued with a clearance certificate.

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