Debt is easily acquired, but hard to get rid of. It happens gradually. You may open a credit card account or two, and take out a personal loan. Add on your student loan and a lease payment, and before you know it, you have more debt commitments than you can afford.
It's easy to get frustrated, but thankfully there's a potential solution: debt consolidation.
How debt consolidation loans work
If you have lots of different debts and are unable to keep up with repayments, you can bundle them into one loan to reduce the monthly payments.
Debt consolidation happens when you borrow enough money to pay back all of your existing loans, and then owe only one debt to a new lender. When loans are combined, you only have a single payment to make every month. You pay one interest rate, which can be fixed or variable based on the type of loan you choose. If you don't add to your debt until you have paid off your new combined loan, consolidating is a clever tactic that will help you get ahead financially.
Lower interest, less stress
Debt consolidation is a straightforward method of converting existing high-cost unsecured loans into one loan at a lower interest rate. This is designed to help you pay off debts quickly and without stress. You can combine the debt into a home equity loan, a credit card balance transfer or a personal loan.
It basically covers all unsecured personal debt – credit cards, store cards and bank loans. When you are paying a variety of high interest rates, a debt consolidation loan can save you thousands over your repayment period.
For example, if you have a $5,000 credit card balance at 21% p.a., a $6,000 personal loan at 15% p.a. and a $3,000 store card balance at 22% p.a., you can apply for a debt consolidation loan of $14,000 that comes at a single interest rate, lower overall than what you are currently paying. This helps you pay down the total debt more quickly because you are paying less interest.
Debt consolidation, however, is not a magic bullet to solve your debt problems. It won't help change your purchasing habits, which generated your debt in the first place. It would also not help if you're at such a stage of financial trouble that you don't yet have the resources to borrow at a lower interest rate.
Types of debt consolidation loan
There are two types of debt consolidation loan:
- Secured. This type of consolidation loan is where an asset, usually your home, secures the money you borrow. Be aware, however, that if you fail to make repayments you may lose your property.
- Unsecured. In this case the consolidation loan is not covered by any security or collateral, but approved based on your credit profile.
Alternatives to a debt consolidation loan
A debt consolidation loan is not the only way of dealing with your debts. Depending on the severity of your situation, you could consider a balance transfer credit card, home loan refinancing, or a debt agreement.
- Balance transfer credit card: A balance transfer credit card is a form of credit card that allows you to transfer your current credit or store card debt from one or more existing cards to a new one, and repay your transferred debt within a set term of six to 12 months (sometimes longer) at a rate as low as 0%. This is typically offered by card companies to attract new customers and could be a good way to stay ahead of your credit card debts. However, it may be difficult to be approved for a balance transfer credit card if you have a poor credit score, so plan to apply before your debt situation gets so bad that you are missing repayments.
- Home loan refinancing: If you have equity in your current home, you might be able release some of the equity by refinancing your home for a larger amount than your current home loan balance, using the funds to pay off your other debts.
- Debt agreement: This is a possible solution for anyone who is very deeply in debt or actually insolvent. It could take the form of a court-approved Debt Management Plan, a Debt Repayment Order, or, as a last resort, bankruptcy. A credit counsellor or insolvency practitioner can advise on your options.
