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25.05.2017

Can Debt Cure Debt?

Can debt be the answer to your debt problems?

In medicine, sometimes the answer to protecting ourselves from a disease or illness is to be exposed to the disease or illness itself.  A small dose of certain diseases can stimulate the human body into creating the antibodies that are required to protect it from more severe attacks later.

Can the same be true for debt? Can the cure for debt be debt?  Yes, but only if you rephrase the question: can access to affordable credit sometimes be the answer to unmanageable debt?

As a debt solution, we often call this remedy refinancing or Debt Consolidation and although it can come in many forms, such as personal loans, it is often done via second secured loans over homes.

It’s also not surprising that, as the Bank of England express their concerns about the growing level of consumer debts in the UK, one of the three areas they are most concerned about, other than credit cards and car finance, is second secured loans over homes. These increased by 11% in the year up to November 2016, representing the highest level of growth seen in 11 years. Many of these loans will be consolidation loans, which tend to grow in popularity as the levels of consumer debt in society increases.

Case Study

But can consolidation loans ever be a good thing?  If we take the example of a hypothetical consumer, for the purposes of this example, (we will call her Karen), her debts are below.

Type of DebtBalance  Interest      RateMinimum PaymentTotal RepaidTime to Repay
Credit Card£  7,000  18%£   350.00£  8,257.0024 months
Store Card£  4,000  25%£   200.00£  5,062.0026 months
Personal Loan£  5,000  9%£   158.77£  5,715.5836 months
Personal Loan£12,000  7%£   370.53£13,338.9136 months
Total£28,000 £1,079.29£32,373.48 

 

Karen has £28,000 of debt and if she makes the minimum payments each month, her debts cost her £1,079.29 per month. If she maintains all her repayments she will eventually pay back £32,373.48, which includes the interest on her borrowings. It will also take her 3 years in total before all her debts are clear.

Now if Karen cannot maintain her monthly payments, she is going to go into arrears and eventually default on her debts, which will damage her credit rating.

Instead Karen chooses to refinance. That is take out one loan to pay all her debts in full. If she can borrow £28,000 and get a 5% interest rate over 5 years, Karen’s monthly payments will fall to £528.39 per month, saving her £550.90 per month. She will have to pay for two years more, but in total she will only pay back £31,703.67 (£669.81 less than if she didn’t refinance).

So, for Karen this looks like an ideal solution. She is paying significantly less each month and is paying less over the term of her borrowing and her credit rating is not being damaged. The only downside is she will pay for two years longer.

 

So, where’s the catch?

If Karen cannot borrow a sufficient amount to pay off all her debts, she will still have some remaining debt that won’t be consolidated. Also, if she cannot get the interest rate she wants her monthly payments are likely to be higher. If all she can get is 10% her monthly payments will be £594.92 per month and over the term she will pay £3,321.55 more than she would if she hadn’t refinanced. If the interest rate was 15%, the monthly payments would be £666.12 and she would pay £7,593.60  more than if she hadn’t taken the loan for £28,000 out (repaying almost £40,000 in total).

Also as consolidation loans tend to be for larger amounts, most lenders will want them secured over homes. This is an important factor that must be considered when consolidating, as up to this point Karen’s loans are all unsecured, so if she fails to pay them, none of her lenders can repossess her home. However, as is often the case with these types of consolidation loans, consumers do have to secure them, effectively taking out a second mortgage on their home.

This means if Karen struggles at any point in the next 5 years to make the monthly payments, she may be at risk of losing her home.

Another catch is, even if Karen doesn’t need to secure the loan, she now only has one creditor, which means if she tried to use a formal debt remedy later, such as a Protected Trust Deed in Scotland, or an Individual Voluntary Arrangement in England and Wales, this one lender has all the voting rights and could, therefore, veto any proposal. This means the consolidation loan places them in a very powerful position.

The Problem

The problem with consolidation loans is they are usually sought by people who are already over indebted and no longer can maintain their monthly payments. The attraction of the loan is to be able to make just one payment each month, and usually at a far lower repayment amount.

However, if the underlying reason the person accrued such large debts in the first place is not addressed, there will usually be a high risk that instead of reducing someone’s overall indebtedness, the consolidation loan gives someone a false sense of security, as they have disposable income again and this leads them to believing they can afford further credit again. Alternatively, if the level of monthly repayment is still a struggle for someone, the chances are any change in circumstances are likely to push that person back into the red quickly, with little room to address the problem.

It’s for these reasons, that it’s not unusual to find many people who eventually end up bankrupt, have already consolidated their debts at least once, but sometimes several times.

Our advice at Creditfix would be that although consolidation loans can be useful tools, advice should be sought first.  When used wrongly, they can have a catastrophic effect on people’s finances, restrict the options available to them and in the worst-case scenario, result in people losing their homes.

If you need more information about the options available to you in dealing with your debt, you can always speak confidentially with one of our friendly advisors on 0808 2085 198.