Beware the Flaws of debt consolidation

THE adverts make debt consolidation seem very attractive. Wipe out your big loan repayments and replace them with lower monthly repayments. You may even save 50pc on all your repayments by bundling all your debts into one loan, the adverts scream.

But what the adverts don't tell you is that debt consolidation is a dangerous game.

Also called 'wrapping up your debt', debt consolidation means that you take out one single loan, often a mortgage, to pay off individual, smaller, loans.

Mortgages are some of the cheapest forms of credit available because the loan is secured on your home.

If you roll all your expensive credit card debt and personal loans into your mortgage, you will be able to pay off these loans using the much lower interest rate attached to the mortgage.

But that is not the whole story.

You pay a lower rate of interest on the consolidated loan, but you can end up paying more because the new loan lasts much longer than the original loans.

For instance, a typical car or personal loan is repaid over a three to five-year period.

If you consolidate this into a 20-year mortgage, the longer term means that although your monthly repayments are lower, you will pay far more in interest over the life of the loan.

Some lenders offer flexible repayment arrangements so that the personal loan part of the new consolidated loan can be paid off within the original term, but at the lower rate of interest. This is known as a split term loan.

However, it is essential to remember that the new, larger loan is secured on your home and if you fail to make payments, your home could be at risk.

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.

If this happens to you, it would mean that in future you could have trouble getting such things as a credit card, a mortgage or other loan.

Danger

The other danger comes from compound interest, which is interest 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.

Doubtless, many of the 60,000 people that research conducted by IIB Homeloans has found are under severe financial strain from higher interest rates, are currently considering debt consolidation as a solution.

However, it is a solution that people need to think long and hard about before embarking on.