Is debt consolidation right for you?

Debt is an issue that many people face as they pay off home loans, credit cards and other forms of credit. But what do you do when it becomes too much to handle?
 
One of the options available to you is debt consolidation. According to DebtBusters, “debt consolidation is another debt management option to consider when you owe a large amount of money to creditors. Debt consolidation involves using new debt to pay off existing debt that’s owed to creditors. When done correctly, debt consolidation can help you get out of debt faster by paying less interest on debts and correctly managing your finances.”
 
There are two ways that you can manage your debt consolidation. You can either apply for a consolidation loan to pay off all your outstanding debts and then pay off that one debt, or you can consolidate your debt into your home loan.
 
Understanding debt consolidation
Gary Green, managing director of Ké Concepts, points out that debt consolidation is similar to applying for a loan, but that in this instance, the credit provider is paying off debt owed “to other credit providers on the behalf of the applicant and creates a single loan.”
 
However, while you already have credit in the form of a loan, credit card, or store card, you are still required to meet the necessary credit risk and affordability assessment criteria to ensure that you will be able to repay your debt consolidation loan. If you do not meet the requirements, you will not be granted the new loan. (See criteria below)
 
Green added: “The intention is to have one loan at a lower interest rate than the individual loans thus lowering the cost of credit. This would only apply if the applicant does not increase the repayment term of the new loan.”
 
According to Green, when considering applying for debt consolidation, you should approach one of the major banks, or a larger micro-lender, as they are more likely to provide this facility.
 
Types of debt consolidation
Theunis Kruger, head of Unsecured Lending at Standard Bank, says: “It is a sad fact that millions of South Africans spend a large part their monthly income to service debt in the form of instalment sales and account-based spending. They have to settle these payments before even thinking about putting food on the table. It is a no-win situation that becomes unbearable when an unexpected expense comes along and destroys what little spending money is left over after monthly commitments are met.
 
“In many instances the solution is debt consolidation. But before the step is taken, the impact of consolidating different debts should be considered.”
 
However, Kruger highlights that there are two types of debt, short term debt such as credit cards and store cards, and long term debt, such as a home loan. When these two types of debts are consolidated into one ‘payment pot’, the cost of debt consolidation can be high.
 
Kruger notes: “The main objective becomes seeing monthly commitments being consolidated into a single manageable payment, but the implications of long repayment periods on personal cash flow is not fully considered.”
 
One way to consolidate your debt, Kruger explains, is to ask your bank to consolidate all your debt into your home loan, meaning that all your short-term loans will be paid-off, while you still have the remaining repayments on your home loan.
 
However, Kruger emphasises that there are several things that you need to be aware of before opting for debt consolidation. He provides the following two examples to illustrate:
 
1.       Consider a personal loan of R 20 000 payable over 48 months at 14.25% interest p.a. The following would apply:

Monthly repayment: R549.04
Total payment over 48 months: R26 353.97
 
With the payment extended to 84 months at a reduced interest rate of 11.25% p.a. The following would apply:

Monthly repayment:  R345.08
Total payment over 84 months: R28 987.00
Additional payment over the longer period: R2 633.03
 
2.       Consider a larger ticket item, say a car on which there is R 150 000 still owing and a term of 48 months outstanding. As this is a major expense and it is being combined with other debt, a repayment period of 10 years is put in place, with the additional payment going on to a home loan. If the same interest rates are applied the following would occur:

Monthly payment over 48 months (14.25%): R4 117.81
Total payment over 48 months: R197 654.76
 
With the payment extended over 120 months (11.25%) the following would apply:             
Monthly repayment: R2 087.53
Total payment over 120 months: R250 504.10
Additional payment over the longer period: R52 849.35
 
The benefits of debt consolidation
One of the benefits of making use of debt consolidation is that instead of paying different creditors, all your debt is bundled under one umbrella, and you make one payment.
 
Green points out that when it is used responsibly, debt consolidation can “reduce the cost of borrowing by having a single larger facility at a lower interest rate than the combined loans.”
 
Furthermore, debt consolidation can also “reduce the credit burden for someone who does not have enough available cash to pay for necessities after paying instalments on all their individual loans.
 
“It can assist the applicant to budget better because a single repayment is easier to manage than several individual repayments. It should reduce bank charges because only a single payment needs to be processed.”
 
Choosing debt consolidation
One of the reasons that people opt for debt consolidation is that “it’s a means to reduce over-indebtedness by freeing up some available cash flow for essential items. The monthly instalment required to service the debt can be brought down if the cost of borrowing is reduced and the new loan has a longer repayment period,” reveals Green.
 
“It can be used as a mechanism to avoid going under debt review because of an inability to repay your debt. Debt review would incur additional charges payable to the debt councillors and prevent the debtor from applying for any additional credit whilst under debt review,” he adds.
 
However, there are risks associated with debt consolidation. For example, Green highlights that as your net cash position is improved through the consolidated loan, you may now qualify for more loans, which could result in your becoming over-indebted. If you do qualify for more loans, the temptation will always be there to borrow more. If you know that you would fall into that trap then debt consolidation may not before you.
 
Furthermore, it is vital to note that converting short term debt into longer term debt through a consolidated loan may ease the monthly repayment burden, but this will also increase the amount of interest repayable over the longer term, stressed Green.
 
“It requires strict self-discipline on behalf of the individual to stick to the repayment of the single loan and not apply for any additional loans,” says Green.
 
It can be difficult to get a loan for debt consolidation. However, DebtBusters stats that “if a credit provider does grant you a debt consolidation loan, they will usually loan you the money with high interest rates attached. High interest rates are not the answer to your situation, as it will make it more difficult for you to pay back your debt.”
 
It adds: “Debt counselling is an alternative debt management solution which can assist you with settling your debt. You will be able to pay off your debt, within a period of five years and less, based on the amount of money you can afford to pay towards your debt each month.”
 
The criteria
DebtBusters provided several recommendations for people to consider when deciding if debt consolidation is the best course of action for them:

• The interest rate of your consolidated debt (the loan to pay off your debt in one payment) is lower than the debts you are consolidating (the various debts that you are paying off).
• Each month, the money needed to pay off your debts should be lower.
• “Don’t trade fixed-rate debt for variable-rate debt. The risk associated with a variable rate is that the rate could start out low, but may move up,” emphasises DebtBusters.
• You should aim to pay off new debt as quickly as possible. DebtBusters points out: “Ideally, apply all the money you save by consolidating to paying off the new debt.”

 
What to consider before choosing debt consolidation
Kruger suggests that before choosing debt consolidation people need to consider the following:

• Understanding the repayment implications of your consolidated long-term loan.
• Compare interest rates across all debts that you owe.
• Only use long-term debt solutions when it is absolutely necessary.
• Consider paying extra into the account every month as soon as possible to reduce the loan period and save you money.

Do not commit to any additional debt until your consolidated debt is paid off. “It is very important to manage your money properly, to avoid landing up in further debt,” highlights DebtBusters.
 
“Remember to not take out any further debt until this loan is paid back, otherwise you may find yourself in the very same situation,” adds Kruger.
 
If you do not qualify for debt consolidation, there are other methods available to help you manage and paying off your debt. These include debt counselling and debt management.
 
For more information on debt counselling, click here.
For more information on debt management, click here.