A consolidation loan lowers the rate and usually the payment; the rate saves money, and the longer term can take all of it back.
It is worth it when the loan's total cost, interest plus fee, is below the interest you would pay on the debts at the same monthly payment. Moving £7,000 of card debt averaging 24.9 per cent into a 12.9 per cent loan with a 4 per cent fee, and still paying £300 a month, costs £1,481 against £2,419: £938 saved and three months sooner. Stretch the same loan over 60 months to lower the payment and it costs £497 more than the cards.
Worked in full in Personal Finance for Beginners by Julian R. Sterling, with every figure reproduced in a free workbook.See the book on Amazon →
A consolidation loan changes two things at once: the rate and the payment. The lower rate is what saves money. The lower payment is what most offers advertise, and it is usually what takes the saving away. The calculation below separates the two.
| Debt | Balance | APR | First month's interest |
|---|---|---|---|
| Store card | £1,500 | 29.9% | £37.38 |
| Card A | £3,000 | 24.9% | £62.25 |
| Card B | £2,500 | 21.9% | £45.62 |
| Total | £7,000 | 24.90% | £145.25 |
The loan: 12.9 per cent APR, a 4 per cent arrangement fee added to the amount borrowed, so £280 and a loan of £7,280. The budget can pay £300 a month. Interest is taken as balance × APR ÷ 12 each month, the same simple method used in how a loan's monthly payment is calculated.
Pay £300 a month across the three, highest rate first, as in the avalanche method. In the first month £145.25 of the £300 is interest. Run forward month by month and the debts clear in 32 months with £2,419 of interest.
Loan = debts × (1 + fee) = 7,000 × 1.04 = £7,280
Payment = loan × r ÷ (1 − (1 + r)−n), r = APR ÷ 12
Cost of consolidating = loan interest + fee
In Excel: =PMT(12.9%/12, 36, -7280) for the payment, and =NPER(12.9%/12, -300, 7280) for the months at £300.
The first month's interest on the loan is £78.26, against £145.25 on the cards. What happens next depends on the payment you choose.
| Plan | Monthly payment | Months | Interest | Interest + fee | Against the cards |
|---|---|---|---|---|---|
| Keep the cards | £300.00 | 32 | £2,419 | £2,419 | |
| Loan, keep paying £300 | £300.00 | 29 | £1,201 | £1,481 | −£938 |
| Loan over 36 months | £244.94 | 36 | £1,538 | £1,818 | −£601 |
| Loan over 60 months | £165.27 | 60 | £2,636 | £2,916 | +£497 |
Paid at the same £300, the loan saves £938 and finishes in 29 months instead of 32. Taken over 36 months it still saves £601, and the payment falls by £55.06, but it ends four months later than the cards would have. Over 60 months the payment drops to £165.27, which feels like relief, and the total repaid rises to £9,916: £497 more than simply keeping the cards and paying them off. The rate halved; the term nearly doubled; the term won.
The test before signing: will you keep paying what you pay now? If yes, compare total costs at that payment. If the point of the loan is a smaller payment, the extra months are the price, and they can cost more than the rate saves.
| Loan APR | No fee | 2% fee | 4% fee | 6% fee |
|---|---|---|---|---|
| 7.9% | £625 | £791 | £958 | £1,126 |
| 12.9% | £1,103 | £1,291 | £1,481 | £1,672 |
| 17.9% | £1,668 | £1,886 | £2,106 | £2,328 |
With a 4 per cent fee and £300 a month, the loan stops saving money at an APR of 20.08 per cent, about five points below the cards' average. A loan advertised at a rate close to your cards' is usually not worth the fee. If the loan's fee is taken out of the money you receive rather than added, borrow enough to clear the cards in full and compare on that larger amount.
Some offers aimed at people in debt are expensive or predatory. If the payments are already more than you can manage, seek free, reputable debt advice where you live before taking on a new loan. This is education, not advice.
A consolidation offer on the five debts of the book's example, with a blank sheet for your own debts, is worked in the free workbook and cases for this book.
Only if you keep paying about what you paid before. In the example, £7,000 of cards at an average 24.9 per cent cost £2,419 of interest at £300 a month. A 12.9 per cent loan with a £280 fee costs £1,481 at the same £300, but £2,916 over 60 months at £165.27 a month.
Solve for the loan rate at which interest plus fee equals the cards' interest at your payment. For £7,000 of cards averaging 24.9 per cent, paid at £300 a month with a 4 per cent fee, the break-even is 20.08 per cent. Any loan above that costs more than keeping the cards.
Often, for balances you can clear within the 0 per cent period, because the fee is then the whole cost. A consolidation loan suits larger balances that need several years, at a fixed rate and payment. Compare the total cost of each at the payment you will actually make.
This article is one calculation from Personal Finance for Beginners. The book takes the same case from first principles to the decision, chapter by chapter, and every figure it prints is a live formula in the free companion workbooks.
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