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A debt consolidation loan is a loan taken out to settle several other, smaller loans. The reason why smaller loans are consolidated into one larger loan is usually to ensure a lower overall average interest rate. Typically, debt consolidation involves replacing high-interest rate short-term debt (such as credit cards, store cards, personal loans) with a lower interest rate loan that usually extends over the longer term – for example, your home loan.
If you own property, you can apply for additional funds on your existing mortgage; This is of course as long as there is positive equity in the property (ie the value of the property is more than the current outstanding loan amount). Debt consolidation also allows you to “get started” by converting your various existing obligations into a single, manageable monthly loan payment. It also saves on multiple fees, service charges, and debit order charges on the various loans.
The result of such consolidation is that the monthly repayment on the consolidated loan will be lower compared to the combined monthly repayments of the smaller loans, which will improve cash flow. Therefore, if you are struggling to bring your monthly repayments to your debt, this can be a practical solution to avoid contingencies such as calls and seizures.
To benefit from debt consolidation requires financial discipline, which can actually worsen your financial situation.
Read on to find out why:
Let’s illustrate the concept of debt consolidation with an example. Imagine you currently have a variety of debt as shown below:
- Home loan (R600 000 over 240 months at 9% interest rate: R5 398 pm)
- Motor financing (R120 000 over 60 months at 16%: R2 920)
- Credit card (R25 000 ongoing at 20%: R1 000 pm)
- Personal loan (R45 000 over 48 months at 18%: R1 320 pm)
Debt consolidation means that you would take a further advance on your home loan for R190 000 and use this cash payment to close all other accounts. After consolidation, you would have a single home loan of R790 000, and the installment would be around R7 110 pm (fees, charges, and insurance excluded).
With this scenario, your monthly cash flow savings would be around R3 528 pm. The interest saving per month would be around R1 260 (R15 200 pa).
(The example above is merely to illustrate the concept of a debt consolidation exercise. Actual savings will vary based on personal circumstances and the appropriate interest rates).
At first glance, this seems like a great idea, given both interest savings and better cash flow: so what are the risks?
Fact: Despite material interest savings each month, the biggest reason you pay R3,500 less each month instead of repaying your debts over three, four or five years is that you now extend the same debt for as much as 20 years (the imaginary period of your mortgage) – which means that in the long run, you will pay much more interest on that debt. For example, you will still pay off your vehicle long after you get rid of it.
What can you do to prevent this?
The best advice is to pay off the extra R3 500 on your mortgage as much as possible each month as soon as you can afford it. For example, referring the payments that you would have made to your (increased) mortgage on your short-term debt will allow you to pay off your entire home loan in less than 10 years (instead of 20), and you will also save a whopping R540 000 in interest expense.
As a general principle, you should not pay short-term expenses with long-term financing (debt). However, it may be one of the only immediate options available to you. If you are currently in danger of defaulting on your loan repayments, you will need room to repay any defaults.
Debt consolidation can certainly be a lifebuoy and preferably over a condemnation or attachment to your home or vehicle. However, we recommend that the short-term debt be repaid as soon as your circumstances allow.
The big danger is that if you suddenly find yourself with a few thousand “savings” rand each month, you may be tempted to spend the “extra” money. If you do, you will soon be in trouble again, with no options left. You should avoid falling into the same spending patterns that caused the predicament of too much debt in the first place. We do not advocate the use of long-term debt to finance your current consumer spending. You should, therefore, use debt consolidation to save on interest expenses, not to reduce your longer-term monthly debt repayments.
Finally, as with any other credit facility, this one can be used wisely or unwise, but there are many tangible benefits that debt consolidation offers if used wisely.