A debt consolidation loan essentially combines all your different debts (such as credit card debt and personal loan debt) into one loan with one repayment. This makes it easier to manage your debt, but before consolidating your debt there are a few things you need to consider first.
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What is a debt consolidation loan?
A debt consolidation loan is a type of personal loan that allows you to consolidate many types of debt (such as credit card debt, personal loan debt, etc.) into one loan so that you don’t have to only one monthly repayment to be retained with a potentially lower rate. interest rate.
While this method can make it easier to manage multiple debts, it can also backfire if you end up stretching your debts with a longer loan term and therefore end up paying more interest than if you just repaid. your debts in the initial term(s) of the loan. This is more often the case if you consolidate your debts into a home loan, but it can also happen with personal loans if the term of the new debt consolidation loan is longer than the original term of the loan.
Advantages of consolidating your debts with a personal loan
Consolidating all your debts into a single loan makes it easier to manage your debt because you only have one monthly repayment to make.
You could potentially get a lower interest rate.
Consolidating all your debts into one loan means you may have fewer account maintenance fees to worry about.
Disadvantages of consolidating your debts with a personal loan
If you fail to make the repayments on time, you could end up increasing your debt amount due to additional late fees and interest.
You may have to pay a termination fee to get out of any existing loan.
If you don’t meet your repayments, you could hurt your credit score.
The Dos and Don’ts of Debt Consolidation Loans
- TO DO shop around and compare debt consolidation loans to find one with a competitive interest rate and terms that work for you. Remember to look at the comparison rate when comparing loans, as it often better reflects the cost of the loan as it factors in fees.
- TO DO look for a debt consolidation loan with flexible features, such as the ability to make additional repayments without being financially penalized and a flexible repayment frequency.
- TO DO remember to consider all costs before consolidating your debt into one loan. There are set-up fees, prepayment fees, loan application fees, potential breakage fees for existing loans, and other fees. You may even find that it is not financially prudent to consolidate your debts, as it could cost you more than if you continued to repay your current loans.
- TO DO set up direct debits so you never forget your monthly or fortnightly repayment. You can easily set up automatic transfers through your online banking app to your lender. You can time your automatic payments to coincide with payday, so your debt is paid off in the background and you don’t even have to think about it.
- NOT include your debts in your mortgage (at least think VERY carefully before doing so). Mortgage repayments have very long loan terms (25-30 years) and stretching your short-term debt over such a long loan term could result in you paying thousands of additional dollars in interest and fees.
- NOT move to a longer loan term without considering the financial implications. While this may reduce your monthly repayments, you could end up paying significantly more interest and fees over the term of the loan than if you had just paid off the debt within the original time frame.
- NOT take on more debt. If you already have credit card debt or personal loan debt, don’t ask for more credit cards or payday loans to get out of it. Going into even more debt to pay off your existing debt may sound like a “stopgap solution,” but it can trap you in a spiral of debt. If you are really struggling to settle your debts, there are other options which we will discuss later.
Other Ways to Consolidate Your Debt
Besides consolidating your debts through a personal loan, there are two other common methods of debt consolidation:
Credit card balance transfer
For those of you who have credit card debt on multiple cards, you can consolidate all of that debt onto one card using a balance transfer.
Under this method, your credit card debts will be transferred to a card with a lower interest rate or even 0% interest rate for a limited time (the promotional or honeymoon period) which can be between three and 26 months. In theory, you should aim to pay off all your debts without incurring any additional interest for this honeymoon period.
But if you fail to repay all the debt before the end of this period, any debt that has not been repaid will then be charged at a rate of return, which is generally much higher than most interest rates. credit cards. For example, most credit card interest rates are around 17%, while the average return rate is 20% and can even reach 24% in some cases. A review by ASIC found that 30% of balance transfer users ended up increasing their debts by 10% or more because of it – not really the ideal outcome when the purpose of a balance transfer balance is to get rid of your debt, not to go any further. this.
Debt consolidation in your home loan
The other popular method of debt consolidation is to consolidate all of your debts into your mortgage. To consolidate all of their existing debt into their mortgage, many homeowners refinance their home loan into a larger loan or request an increase to their existing home loan. In this way, all their debts are gradually paid off thanks to the regular repayment of their mortgage.
One of the advantages of this strategy is that most home loans today have very low interest rates, between 1 and 3%, compared to interest rates on personal loans and credit cards. , which are around 17%. While it may seem obvious to consolidate your credit card and personal loan debt into your low rate home loan, it can backfire because mortgages have very long loan terms, typically between 25 and 30 years. . Spreading short-term credit card and personal loan debt over such a long loan term means you could end up paying thousands in additional interest and fees over the life of the loan.
If none of these methods appeal to you and you prefer to tackle your debt without consolidating it, there are other debt reduction strategies such as the “snowball strategy” or the “avalanche strategy”.
The two cents from Savings.com.au
Debt consolidation has its merits as it can make managing your debt much easier as there is only one loan repayment to worry about, rather than juggling multiple loan repayments on different debts. If debt consolidation isn’t for you, there are other debt reduction strategies you can try, such as the snowball method or the avalanche method discussed above.
If you don’t see any of these options working, don’t be afraid to contact your current lender and ask what financial hardship options they offer. Don’t take on more debt trying to manage your current debt. Payday loans and credit cards may seem like a “stop-gap solution”, but taking on even more debt to manage your current debt will only lead you into a spiral of debt – it’s just a recipe for a desaster.
Once you have managed to get yourself out of debt, it is extremely important to sit down and analyze what led you to this debt so that you do not fall back into the same situation. Set a budget and consider reducing your credit cards so that you are not tempted to pay future expenses with your card. If you’re the type of person who has trouble controlling impulse spending, cutting your cards is probably a good idea.