A debt consolidation loan can be a good thing if you get the right terms and if you use it responsibly.
Debt consolidation allows you to switch from having multiple creditors and credit agreements – all with varying terms and interest rates, each one incurring a monthly administration fee and credit life insurance – to having one loan with one set of charges.
The saving on monthly administration fees, credit life insurance premiums and potentially interest could free up much-needed cash.
Freeing up cashflow can help you if you are in a bad financial situation, but to really improve your situation, there are a few things you need to get right.
Critics of debt consolidation loans cynically call them “displacement” loans because they shift or move your debt – they do not extinguish it. You have to do the right thing to get out of debt.
If you are undisciplined and do not rein in your spending, debt consolidation can lead you deeper into debt.
Here are a few things you need to get right.
1. Use the consolidation loan responsibly
Debt consolidation loans are only as effective as the consumer using them. You must be committed to using the debt consolidation loan to pay off all your loans and other credit, and not be tempted to use it for anything else.
Some credit providers remove this temptation by paying all your creditors on your behalf to ensure that the consolidation loan is used for the purpose for which it is intended.
2. Make sure you stop taking on more debt
A debt consolidation loan will be recorded on your credit report and depending on how much you owe, may or may not prevent you accessing more credit.
If you are able to take out more credit or if you already have store accounts or credit cards on which you will be able to continue to spend, you could take yourself further into debt.
Having continued access to credit may be your undoing, especially if over-spending – rather than a cut in earnings or factors beyond your control - is what got you into trouble in the first place.
If you lack financial discipline, you would do well to close all retail accounts and credit card accounts at least until you have repaid the consolidation loan.
3. Make sure you are paying less interest
If you do consolidate, try to avoid repaying the debt over a longer period as it will incur more interest. Depending on your situation, you may need to repay your debt at a lower repayment over a longer term. Use this relief only if you absolutely need to though, as it will cost you more in interest in the end.
For example, if you have 10 creditors to whom you are paying a total of R12 000 a month and get a debt consolidation loan paying one creditor R11 000 a month, it appears to save you R1 000 a month.
However, if your R12 000 a month repayments would have ended in three years, and the consolidation loan is over four years, you will end up paying considerably more after four years.
The longer the term, the lower the monthly instalment but the more you pay in interest.
If you are able to get a loan where the interest is less than the average interest rate you are paying on all your other loans and the term is the same, you score. Paying less interest over the long term can have a huge impact over time.
4. Use the savings to repay the debt faster
If your consolidation loan saves you administration fees, credit life premiums and interest, use the savings to pay off your debt faster than the term, and in so doing save more interest.
When you get an annual increase or any financial windfall, sink as much money as you can into your debt consolidation loan to reduce the term over which you will repay the loan.
The shorter the term, the less you will pay in interest over time.
Then try to start putting aside a small amount every month in an emergency fund, so that you won’t have to use credit for your next unplanned expense. Read more: How do I set up an emergency fund?
A hint for home owners
If you have an access or flexible bond and you are able to borrow against it, you can use your home loan to consolidate your debts.
However, a home loan has a long repayment period and if you consolidate a shorter-term debt into your home loan and repay that debt over a long period, you will incur much more interest.
For example, if you have a car loan over five years that is at a higher interest rate than you are paying on your home loan, you could use funds to which you have access in your home loan to repay your car loan and then make the equivalent repayment into your bond to ensure that debt is repaid within the five years.
 Be careful of consolidating unsecured debt into your home loan and not being able to meet the repayments. You could risk losing your home. |
