Consolidation loans are tempting. They help members cut the interest rates they are paying. Monthly repayments can be reduced. The convenience of one combined monthly payment helps people budget better.
But they are not without risk. One-off credit card consolidation may be a better option.
Consolidation loans can be relatively large. Ideally all creditors need to be repaid, otherwise the problem isn’t fully addressed. A member wishing to pay off a credit card, might just run up to the limit again, reducing the likelihood that any consolidation loan is repaid. Importantly, a debt consolidation loan is only one step from a Debt Management Plan.
What’s the risk of debt consolidation?
We took a look at the data behind 100 debt consolidation loans taken out between April and October this year.
Applicants had lower credit scores, suggesting bad rates could be as high as 10%. The average request was for £3,000 but only in a few cases did this cover the entire debt. Applications were driven by credit union lending limits rather than achieving a borrower’s goal to repay everything. This is despite most borrowers being at, or near to, revolving credit limits.
Applicant’s average income was £1,300. Worryingly 4 in ten applicants had a default on their credit record.
Credit card consolidation is less risky
Members applying to pay off just one credit card had the second highest credit score of any loan type between April and October this year. The bad rate could be half that of multiple debt consolidation loans. Most applicants had only one credit card so the average loan request of £1,900 would repay the debt in its entirety.
20% of applicants had a default on their credit record – half the frequency of those seeking full consolidation loans.
There’s plenty of scope, in terms of pricing, to help offset an example 5% bad rate. In July, the average credit card interest rate passed 20% for the first time in two decades. Rates for adverse credit history credit cards were just under 40% APR.
Consolidating can improve credit score
There’s some evidence from the USA that consolidating credit card debt can improve credit scores. Published in CUTimes, New data from TransUnion finds that most people who consolidate credit card loans see improved credit scores after a year.
The key question with debt consolidation loans is whether borrowers “pay off most of their credit cards then run up their credit card balance right away, and get themselves deeper and deeper in debt?” says Liz Pagel, SVP at TransUnion. “Or, does it do what the consumer advocates hope that it would do, which is to get them into a more steady payment schedule that’s more predictable and help them chip away at their debt?”
It would appear that the latter is the case. In this study, over half of subprime borrowers saw their credit score increase.
This makes sense. Scores fall if a borrower is at a revolving credit limit. They would tumble further if a payment is missed. A consolidation loan reduces both these risks. If the card remains open and hardly utilised then the credit score should improve.