What is a debt consolidation loan?
Between home, personal and car loans, having to pay back multiple loans may make you wonder if debt consolidation loans are worth it based on your current situation. Debt consolidation loans give users the opportunity to simplify their finances, as well as potentially allow people to increase their borrowing capacity. Let’s look at debt consolidation loans in more detail and how they can benefit you.
How does it work?
Essentially, debt consolidation is bringing all your existing debts together into one new debt, which can help you manage your repayments and give you a clearer picture of your financial future. Managing multiple loans can be a struggle when it comes to payment schedules, conditions and interest rates – especially if you have one interest rate that is significantly higher than the other ones. If you have loans with fluctuating interest rates, this may also be frustrating to manage.
Debt consolidation loans can be used in several different situations. Studies show that around 1 in 4 people aged 35-54 hold more than three credit cards! Those with multiple cards may wish to consolidate all their credit card debt into one single loan. They may also choose to go one step further and consolidate these cards with their home loan, car loan and other personal loans.
Consolidating your loans takes the stress out of managing different repayments, and gives you one loan, one interest rate and one repayment amount. This allows you to budget better as well as gives you an end date for the loan when everything will be paid off!
Why should I do it?
While consolidating your debt into one loan may be appealing, there are some who may be a bit hesitant about taking this step. It’s natural for someone to worry whether they can control their spending when they change their current loan conditions, or they may have the idea in their head that it seems ‘too good to be true’. There are many positives to opting into a debt consolidation loan though, including:
- One repayment schedule – It’s been touched on briefly but consolidating your loans means you will only have one repayment on your schedule instead of multiple. This will help you budget smarter, and some lenders may even allow you to choose the frequency of your repayments to suit your schedule. Inovayt General Manager, Jordan Morieson, says, “With multiple loans and repayment dates, quite often people can get confused with what money is coming out on what date and day and quite often what that leads to is people missing payments because they’re unable to manage their money.”
- A clear end date – Another benefit of consolidating debt is having a clear end date in sight of when you’ll be completely debt-free. With multiple loans, you’ll have multiple ‘end dates’ so it can feel as though you’ll be drowning in debt forever. A debt consolidation loan gives you one date you can work towards.
- Potential for a better interest rate – Depending on your loan situation, lenders may offer you a better interest rate than the one you are currently getting. As a debt consolidation loan is usually achieved through a home or personal loan, these often have lower interest rates than many other credit options, so you could pay less interest over the life of the loan. Jordan mentions, “If people can consolidate their debt from a high-interest rate to a low-interest rate, it could save them interest and (in theory) they should be able to pay their debt off quicker than what they would be doing in the past.”
- The ability to increase borrowing capacity – One reason many people choose to consolidate their debt is for the chance to increase their borrowing capacity by reducing their monthly personal commitments so they can achieve goals, such as purchasing an investment property. “The reason the loan would give you greater borrowing capacity is that you’re servicing that car loan or personal loan over a 30-year loan term – which is a typical term for a home loan – rather than a car or personal loan term which is usually five years,” Jordan says.
“You’re paying your debt off over a longer period which means your monthly commitment is lower and essentially means you’ve got more free cash at the end of each month so you could then borrow more money, potentially for investing.”
How does a lender assess your borrowing power?
When any lender assesses your mortgage application, the first thing they’ll want to know is your capacity to repay that loan. As part of this, they’ll factor in your ongoing monthly repayments on any debt you owe. Having only one repayment may be more appealing to lenders, as your ability to pay one repayment is easier than having to pay multiple. It’s for this reason that potential investors should consider debt consolidation to give them the best chance at purchasing an investment property that is right for them. If you can consolidate your debt to leverage your borrowing power, it’s worth looking into.
Are there any pitfalls?
We’ve spoken about the benefits of consolidating debt, but it’s important to discuss the risks involved too, so you can make an informed decision.
- It may cost more in the long run – When choosing to consolidate your debt, there is the possibility you may spend more. Your loan term may be longer and depending on your interest rate, you may end up paying more interest throughout this long term. Pair this with potential added costs like balance transfer fees, closing costs and annual fees, and it may cost more than originally anticipated.
- Can negatively impact your credit score – Just like with any loan, if you constantly miss repayments on your loan, your credit score is going to take a negative turn, meaning you may find it difficult to apply for and be granted loans in the future.
- May encourage increased spending – By consolidating your loans, you may be tricked into thinking you have ‘extra’ money due to your reduced payments. This misconception can encourage spending money you don’t have – especially on credit cards that have been cleared – which may in turn put you into more debt.
Who should I speak with about a debt consolidation loan?
When considering whether debt consolidation loans are worth it for you, it’s important to keep your personal circumstances in mind as to why you think you’ll benefit from a debt consolidation loan. If you need advice, reach out to one of our financial advisors or mortgage brokers for assistance.