As a percentage of GDP, Australians have the second largest household debt amount in the developed world (AAP). And according to the ABC's Australia Talks National Survey, 37% of Australians are struggling to pay off their debts. Home loans, car loans, credit card debt – these can all pile up fast. Debt anxiety can push us to overwork ourselves, skimp on necessary purchases, and can contribute to general unhappiness.
But loans don't always have to be a bad thing. After all, loans can help us land our dream homes, secure a means of transport and save us in a bind when money is tight. It's when you take out more loans than you can manage that you start to feel overwhelmed, especially with all the interest rates and different repayment dates and amounts involved.
Fortunately, there are debt consolidation loans – a loan to pay out all your other loans and ease your financial anxieties by leaving you with only one loan to repay, ideally at a lower overall interest rate. If you're unsure about how taking another loan can solve your existing loan problems, read on for more information. In this quick primer, you’ll learn the basics of debt consolidation and find out if it's the right option for you.
Understanding debt consolidation
Debt consolidation is the act of combining multiple loans into a single loan plan. Instead of repaying several loans and credit cards with their own interest rates, late fees and early repayment penalties, taking out a loan for debt consolidation gives you just one loan amount, one interest rate, as well as one set of fees and charges to keep in mind.
So how does debt consolidation work? It's simple. You apply for a debt consolidation loan, borrow enough money to get all your existing debts repaid, and then work towards meeting the monthly repayments for your one new loan. Essentially, you use new debt to take care of your old debt.
Like your typical personal loan, a debt consolidation loan is usually unsecured, meaning your bank or lending party will not require you to assign an asset (such as a piece of property or a car) as collateral. However, some lenders do offer secured debt consolidation loans as well. And while a debt consolidation loan often has a longer term than a regular personal loan – the average is three to five years – the interest rate will likely be lower than the combined interest of all your existing loans.
Types of debt that can be consolidated
Most financiers allow borrowers to consolidate debts from unsecured loans, with some exemptions for certain types of secured debts. It's best to consult with a lender to find out their policies on secured and unsecured debts.
- Credit card debt. Credit card debt is, by far, the most common type of debt. By transferring your credit card debt into a consolidated loan, you can avoid paying the high interest charges usually associated with credit cards. Paying off credit card debts sooner also helps boost your credit rating.
- Home mortgage debt. Home loans are the second most common form of debt, and the largest contributor to our total household debt. While there aren't too many options to consolidate your home loan into a debt consolidation loan, there are some options to consolidate all personal loans into a home loan. Another way to do it is to refinance your existing mortgage.
- Student loan debts. Whether you need to fund your university tuition, pay for equipment, or need an allowance for living expenses, student loans can help you stay focused on your education. The great thing about student loans is that they can be deferred for up to five years, so typically, you can start paying off your loans when you start making money. However, entry-level jobs don't pay very well, so sometimes student loans (and interest!) can pile up fast.
- Other personal loans: Medical, home renovation, wedding, furniture, and car loans are just a few examples of personal loans that can be consolidated into one loan.
Secured vs unsecured loans
What exactly is a secured debt consolidation loan? And is it better than an unsecured loan? There is no right or wrong type of loan – it all depends on what you're looking for.
A secured loan for debt consolidation is a type of personal loan that lets borrowers roll all their debts into one account, as long as they can provide some kind of security against their loan. A "security" is an asset of yours that can be taken into possession by the lender should you be unable to meet the monthly loan repayment. Because the lender gets collateral they can offer a lower interest rate, since they have a little more assurance that their borrower will pay.
An unsecured loan, on the other hand, doesn't require collateral. While this may seem like a better deal than a secured loan, keep in mind that most lenders must impose a higher interest rate for an unsecured loan. This is to offset the risk involved in lending such a large sum of money. Additionally, most lenders will not offer unsecured loans to borrowers with low credit ratings.
Fixed vs variable interest rate
There are two types of interest rates: fixed and variable. A loan with a fixed interest rate is a loan where the amount of interest you have to pay for each periodical repayment remains the same throughout the duration of the loan term. Conversely, a loan with a variable interest rate is one where the amount of interest you're charged changes based on certain factors, such as a change in the Reserve Bank of Australia's cash rate. Rates on a variable interest loan can either increase or decrease over time.
Is either of these a better option? At first glance, a fixed rate seems like the better option – it's predictable and easy to plan for. However, some studies find that borrowers on a variable interest loan end up paying less in interest than those on a fixed rate.
How to qualify for a debt consolidation loan
While each lending body has its own set of qualifications and requirements, here are some things you can prepare before applying for a loan:
- Proof of identity. To prove your identity online or otherwise, you typically need 100 points' worth of federal government or state-issued documents. A birth certificate, a current passport and a certificate of Australian citizenship will get you 70 points each, while an Australian driver's licence or tertiary student card rate 40 points each. Medicare cards and credit cards count for 25 points.
- Proof of income. Your lender needs to be sure you're capable of repaying the loan amount by the end of the loan term. To do so, they'll likely ask for copies of your most recent payslips.
- Proof of residence. Some lenders will require a billing statement, a mortgage agreement, or a rental contract that states your name and current address.
- A good credit score. Some lenders have a minimum requirement on credit scores. Your credit score and the repayment history it represents provide lenders with a snapshot of your ability to handle your finances. Think of it as a report card of your financial activities. Repaying the appropriate amount owed on your existing debts without being late means your score should improve over time. If you do not know what is on your file, then take a few minutes to get your free credit report before applying.
- An asset for security. If you're gunning for a secured loan, you'll need some kind of valuable asset that you can offer up as collateral. Cars and residences are often used as security.
Alternatives to a debt consolidation loan
Consider two other ways of consolidating your debts before you apply for a debt consolidation personal loan:
- Credit card balance transfer. Many credit cards offer 0% interest for long periods on balances transferred when you apply for a new card. You can transfer balances from your existing credit cards – and in some cases from personal loans – to your new card, and benefit from a period of between six months and two years or more in which to get on top of your debt repayments without paying interest. Learn more about the pros and cons of a balance transfer vs. a debt consolidation loan in this guide.
- Refinancing your home. You may want to refinance your home to take advantage of a better interest rate offer, or to access the equity you have built up in your home. In this latter case, the current market value of your home is much higher than your current home loan balance, and you could refinance for a larger loan amount. This converts your home equity into extra cash able to be used for paying off other debts. Think carefully before you do this, however, because you're converting those short-term debts into one with a much longer term.