How does debt consolidation work?

If you’re struggling to keep up with multiple loan repayments, paying high interest rates, or feeling overwhelmed by debt, consolidating your debt may be a good solution.

We explore what debt consolidation entails, the pros and cons, and the various loan-based options.

Tip: Using a budget calculator can help you understand your monthly financial obligations.

What is debt consolidation? 

Debt consolidation generally refers to a form of debt refinancing that involves taking out one loan to pay off many others.

It can be helpful if you are heavily indebted, struggling to meet your credit and loan repayments, or find yourself left with little to no money left after servicing your debts. 

How does debt consolidation work? 

Debt consolidation entails combining multiple existing debts into a single new loan, with one monthly repayment.

This gives you “breathing room” in your budget, explains Heetal Govindjee, head of personal lending at Standard Bank.

“While debt consolidation won’t erase your debt, it may make it easier to manage,” she explains.

What are your debt consolidation options? 

Consolidating debt isn’t a one-size-fits-all solution, so it’s vital to first evaluate your circumstances and goals. 

You can consolidate your debt through a loan in two ways:

• Once the loan is approved, your bank account is credited with the agreed amount, and you settle the debts yourself.
• Once you've supplied letters from your creditors requesting settlement, your financial institution settles the debts directly with your creditors. 

Secured and unsecured loans 

Debt consolidation falls within the unsecured loan category. Alpheus Legodi, product head at FNB Loans, explains the difference between secured and unsecured debt.

“Secured debt is tied to an asset, such as a house, that serves as collateral the lender can seize if you default on your loan,” he says.

An unsecured loan, on the other hand, requires no collateral, but the borrower must be sufficiently creditworthy in the lender’s eyes, he notes.

Unsecured loans generally attract a higher interest rate than secured loans because the risk to the lender is greater.

When is a debt consolidation loan high risk? 

A debt consolidation loan may be considered high risk if you have a high debt-to-income ratio – meaning, a high percentage of your monthly income is used to service your debt – or a poor credit score.

Banks are unlikely to lend to you under these circumstances as it could be considered reckless lending - which credit regulations disallow. It's also a credit risk to them. 

Lenders who do offer high-risk debt consolidation loans typically attach higher interest rates and fees to these loans, along with strict terms and conditions.

Examples of the best debt consolidation loan options

FNB

FNB offers up to R360,000 in credit, under its “credit switch” option. The loan duration is up to 72 months and is specifically for the purpose of consolidating credit, such as personal loans, credit cards, revolving facilities, student and temporary loans, and retail accounts for clothing or furniture.

The bank also helps manage payments to providers on your behalf.

Personalised interest rates are applied, which means you may qualify for a lower rate, depending on the rates you’re currrently paying, and your credit status. If you’re up to date with repayments, a “payment break” is available every January.

There are no penalty fees for early settlement of consolidation loans. Applications can be made via the FNB banking app, online banking, or in an FNB branch.

Old Mutual

Old Mutual’s debt consolidation loans are based on the total combined value of the accounts to be consolidated, and your credit profile, including your credit score and loan affordability.

Under this option, you can include an unlimited number of accounts, up to a maximum combined debt value of R250,000. Repayment terms vary between three and 72 months.

A once-off initiation fee is payable at the loan's inception, and there is a monthly service fee. The initiation fee is waived if an existing Old Mutual loan is part of the consolidation.

The interest rate applied is based on affordability and your credit profile.

African Bank

African Bank allows customers to consolidate up to five loans with a combined value of no more than R350,000, and earn 1.3% of their loan instalments back in Audacious Rewards points, says Sibongiseni Ngundze, group executive of consumer banking. Repayment terms vary from 12 to 72 months.

“On successful application, the customer is charged a once-off initiation fee for setting up the loan; a monthly service fee for its ongoing administration; fixed interest; and a monthly credit life protection premium for cover against death, disability, and loss of income,” Ngundze notes.

“African Bank has a convenient application process, as customers are not asked to provide settlement quotations for each loan they want to consolidate. This information is accessed directly from the credit bureaus,” he says.

You can also choose a payment break of one month on a fixed-instalment credit agreement, if needed.

Nedbank

Nedbank offers debt consolidation loans of up to R300,000. Costs and interest rates vary depending on your specific circumstances.

The bank discusses various financial relief options on its website. Once a loan is in place, reminder messages help you to keep up with your repayments.

Example of how debt consolidation works

With debt consolidation, you’ll pay one monthly fee and, depending on the terms, a reduced monthly repayment, potentially, at a personalised interest rate. Your bank will manage the switching process for you.

Legodi provides the following example of debt repayments across three credit accounts with three different monthly fees and varying interest rates:

If you consolidate the total amount of R55,000 into one loan over five years, at an interest rate of 22.25%, the repayment amount will be roughly R1,660 a month, depending on monthly fees. 

However, the total repayment amount will be roughly R99,600 over the five years, as opposed to the R85,176 you would have paid under the original loan terms (R3,549 repaid over a 24-month period). 

“Debt consolidation helps your cash flow, but you will end up paying more in the long term due to the extended loan period,” says Sylvia Walker, a financial planner and author of Smartwoman: How to Gain Financial Independence and Create Wealth.

Applying for debt consolidation 

In order to qualify for a debt consolidation loan, the following criteria must be met:

• You must be a permanent resident of South Africa
• You should be employed full-time, or self-employed with a regular income
• You cannot be declared insolvent, or under formal debt review or administration
• You must be 18 years or older
• Your salary must be paid directly into your bank account

To apply, you will need:

• A South African green bar-coded ID book or smart ID card
• Proof of residence not older than three months
• Proof of income (your latest three months’ payslips, three months’ bank statements, or a South African Revenue Services ITA34 notice of assessment)

What are the risks or disadvantages of debt consolidation loans? 

There are several points to consider before you apply.

Firstly, understand the potential new interest rate and whether additional fees are involved, advise Govindjee and Legodi. Make sure you have a plan for repaying the loan. Will you be able to keep up with the repayments?

Walker explains that, although your new interest rate may be lower than other loans, it will not be low, because a debt consolidation loan is unsecured.

Further, a longer loan term means that you will accrue more interest over the life of the loan. You should therefore aim to pay off your debt as quickly as possible, even if you use a debt consolidation loan to make your monthly repayments more affordable.

Finally, the option is not suitable for customers who are overindebted, have debt across multiple credit providers, cannot agree to repayment terms with their credit providers for a reduced instalment, or have a poor credit score, says Nohamba.

In this case, debt counselling is the recommended approach, although it is essential to fully understand the implications and costs before undertaking this formal legislative process.

Debt consolidation vs debt settlement

Debt consolidation and debt settlement are two distinct financial solutions. 

“Debt consolidation combines all existing credit obligations into a single credit product, and typically extends the repayment period to reduce the monthly instalments,” says Francois Viviers, group executive of marketing and communications at Capitec. Interest rates vary based on individual risk profiles, he adds.

By contrast, debt settlement involves negotiating with creditors to pay a lump sum amount that’s less than the total amount owed. This provides an alternative for those in good financial standing.

The simplicity of a single payment at a potentially lower interest rate could contribute to a reduction in the total cost of credit, Viviers notes.

What will happen to your credit score if you consolidate your debt? 

Govindjee warns that applying for loans from multiple lenders will reflect negatively, and might lower your credit score.

“It could initially affect your credit score because you’re taking on more debt. However, your credit score might improve once you pay off your debt and continue repaying your consolidated loan on time and in full. This is because your payment history accounts for 35% of your credit score,” Govindjee says.

Should you consolidate your debt? 

Consolidating your loans may be a good idea if you meet the criteria to refinance your debt and see no other way to cover all of your instalments.

“Debt consolidation creates an opportunity for consumers to make one loan repayment, which may include a lower interest rate on the total combined debt; only one service fee; and one credit insurance premium on the consolidated loan,” points out Vuyo Nohamba, head of product development, consumer lending at Absa Everyday Banking.

“The total amount consumers will save will vary based on their outstanding debt and the number of loans combined.”

Be aware, however, that you’ll need self-discipline and commitment to stick to the plan.

A debt consolidation loan may not be viable or sufficient if your debt exceeds 30% to 35% of your gross monthly income, your credit score is poor, you can’t cover your living expenses, or you’re already in payment default. Under these circumstances, you may also be tempted to use the loan to meet your monthly expenses, rather than repaying your existing loans.

Tip: Keep your credit score healthy by paying your loan instalments regularly and on time.