Debt consolidation, is it a good idea?

WeMoney

If you’re someone struggling to get on top of mounting debts, it might be worth considering consolidating your debts. Debt consolidation is an excellent way to make it easier to manage your payments and ideally, you’ll be paying a lower rate of interest.

However, like anything, there are both advantages and disadvantages of debt consolidation and before going down that path you should ask yourself is debt consolidation a good idea?

Let’s get to the following commonly asked questions:

  • What is debt consolidation?
  • What are the advantages of debt consolidation?
  • What are the disadvantages of debt consolidation?
  • How to consolidate your debt?

Q1. What is debt consolidation?

Debt consolidation is the process of taking out a new loan and using it to pay off one or more smaller loans. Debt consolidation is effective, combining all your debts into a new loan making it both cheaper and easier to manage generally through a balance transfer to a new loan.

Debt consolidation doesn’t get rid of debt, it simply makes it easier and cheaper and therefore possible for you to get on top of. Many people might be struggling with mounting credit card debt for instance that increases each month, while also having something like a car loan or auto loan.

Note: For those struggling with mounting debts, having a way out is just as important as anything else. By rolling all of this debt into one new loan, it can create cheaper repayments and also helps by having a fixed payment schedule with an end in sight.

Q2. What are the advantages of debt consolidation?

For those asking if debt consolidation is a good idea, it’s important that you assess the reasons why it might be an option for you. Here are some of the main advantages of debt consolidation.

Single payment

Debt consolidation means that you take out a new loan and roll your other debts into that new loan product.

You are effectively left with one payment to make each week, fortnight or month and that can dramatically help in simplifying your finances. It also has the added benefit of making it far easier to budget and plan out your finances.

Recommendation: One of the keys to getting out of debt is to have a good understanding of where your money is going each month. By having only one debt or loan repayment makes it easier to keep track of one of your core expenses.

Lower interest rates

Many short-term loans, such as credit cards, come with some of the highest interest rates of any form of loan. A credit card in the current environment will typically be attracting an interest rate somewhere around 20%. Compare that to what you might be paying on a home loan at present, which could even be under 2% and you can see why these short term debts can really start to get out of hard.

Add to that the fact that there are normally additional fees and charges that are applied to you when you don’t make your repayments on time and you can see how a $1000 outstanding credit card balance can quickly balloon into something that can be tough to manage.

One of the major advantages of debt consolation is the ability to roll your small debts and bills that might be attracting high interest rates, into one that is far cheaper. For example, you could roll multiple credit card debts into a personal loan that comes with an interest rate that is around half as much. You will also have an easy payment schedule and with the lower overall repayments, you’ll be able to pay down the loan easier or even faster.

Note: The faster you can pay down the debt the better as you will ultimately pay far less interest, than if you spread it out over many years. Either way, lower interest rates can significantly improve your financial position virtually overnight.

Remove the financial stress that comes with debts

For many people, having debts that are mounting up and past due can be an incredibly stressful thing that can also have serious health benefits. Debt consolidation has a number of financial benefits, but one of the most important is that it can take a huge weight off your mind and reduce your overall stress levels.

Having one simple repayment to make each week or month and being able to budget accordingly, is an incredibly freeing experience for someone who has been weighed down in debt for many years.

Q3. What are the disadvantages of debt consolidation?

If you are considering debt consolidation as a strategy to minimise the total amount of interest you pay, then it is vital to analyse the disadvantages. In that way, this will help you to get a clear picture of what your costs and fees are going to look like when you go through the process or taking out a new loan.  

Fees, charges and costs

When you consolidate debt, there are additional costs that lending providers such as banks may add in their annual and application fees. Plus, there might be other clauses that stipulate the add-ons of additional fees if you pay part of your debt off early.

This is why debt consolidation can feel like a balancing act, between assessing the money that you will save by taking out a new loan and then comparing this to any termination of breaking fees that might be associated when you are exiting your other loans.A good example might be a car loan that comes with significant costs to pay it out early. If your plan was to pay out the car loan with a personal loan, you might find that the money saved on interest is not enough to cover the fees associated with the car loan.

Recommendation: A debt consolidation calculator or budgeting app is a great way to quickly assess your current situation

Interest rates

Debt consolidation is generally going to be a great option for you to get a cheaper interest rate, but it’s not always going to be the case. While it might be possible to roll your debts into a new home loan, that’s not going to be something everyone is able to do. You can do a quick debt assessment which is a good way to see where you stand.

If your only option is to take out an unsecured personal loan, that might not come with an interest rate that makes debt consolidation worthwhile. The first thing to do is always list out your current outstanding debts and their interest rates and repayments and then you have a clear understanding of what type of loan or debt consolidation product you need to make it viable.

Recommendation: If you have had bad credit in the past or a poor credit score then you might not be able to access the very best interest rates. It might be worth considering some form of credit repair to improve your credit prior to looking to consolidate your debts.

Be careful of the loan term

Just because you are able to use a debt consolidation strategy to lower your overall interest rate, you still could find yourself in a worse position if the term of the loan is longer.

It is important to note, not just how much your weekly or monthly repayments are, but how much interest you will be paying over the life of the loan. A high interest rate of around 20%, might be more appealing than a 10% interest rate if you have the ability to pay off the prior debt quickly. A 10% interest rate on a loan over 5 or 10 years can see you paying a significant amount of interest and is not recommended.

Your goal when you look at any debt consolidation strategy should be to not only find the lowest rate but make sure you have a loan product that you can pay down quickly.

Note: Some debts such as student loans, will likely not be easy to consolidate given the way the system works in Australia.

Q4. How to consolidate your debt?

There are a number of ways of debt consolidation and the option to choose depends largely on your personal situation.

Personal loan

The most common way to consolidate debt is to roll them into a personal loan. A personal loan can be either secured or unsecured and the interest rate will vary accordingly. A personal loan is normally the best option for a debt consolidation loan.

Note: If you’ve got credit card debts with high interest rates, a personal loan can be an excellent way to consolidate your debt and minimise the amount of interest that you pay. However, it is important to point out that this debt consolidation strategy only works when you are motivated to pay off your debts.

Home loan equity

If you own your own home and have some spare equity in it, you might be able to refinance your mortgage and use the additional funds to pay out any debts or credit cards. A home loan comes with nearly the lowest interest rates you’ll find anywhere and is a very good debt solution.

Note: The main consideration here is that you need to have a home of your own and more than 20% equity in the home, based on a bank valuation. Otherwise, there can be some significant costs that would far outweigh the benefits of debt consolidation.

Credit card introductory offers

As we know, credit card providers are constantly on the lookout for new customers and one of the ways they attract new business is by offering very enticing deals to new customers.

Some of the types of offers available can be around long interest free periods and bonuses. In this instance, you can effectively do a credit card balance transfer which is a great debt solution and one that can help with managing debt.

Note: It’s possible to take out a new credit card with a long interest free period to consolidate your other credit card debt, however, this can also be a risky strategy and probably considered an alternative to debt consolidation in some ways. Unless you are able to pay down the debt in a timely fashion, you’ll find yourself in the same position as you were in beforehand.

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Disclaimer: The author is not a financial advisor and the information provided is general in nature and was prepared for information purposes only. This article should not be considered to constitute financial advice. Accordingly, reliance should not be placed on this article as the basis for making an investment, financial or other decision. This information does not take into account your investment objectives, particular needs or financial situation.

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