The pros and cons of debt consolidation

Angelique Ruzicka
2017-11-18 23:28
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 Remember, debt consolidation is still a loan and not the ultimate solution to your debt monster. Picture: iStock

When it comes to addressing your debt problems there are several strategies you can adopt. One of them is debt consolidation, which is a form of refinancing and entails taking out one debt to pay off all the other loans that you have outstanding and are struggling to pay off. 

Typically, mortgages or personal loans are used to consolidate all other forms of debt such as credit card, personal loans, store card and student loans. The advantage of debt consolidation is that all your debts are now placed under one loan and is usually restructured in such a way that the loan is more affordable i.e. the installments are often lower than those that you paid for your previous loans put together.

You often get a better rate of interest too, particularly if you put all your debts under your home loan. This is because home loans are a couple of percent lower or at (if you have have a good credit score and considered a low risk by the bank) the prime lending rate, which at the time of writing is 10.25%*. Meanwhile, personal loan and credit card rates can often be charged at the maximum rate allowed by the National Credit Act (NCA), which is 27/28%. 

But while this may sound like a cheaper way to restructure your debt or like the solution to your debt problems, Rekha Ramcharan, managing executive for personal and business lending at Absa, cautions that it often ends up putting borrowers into further debt. 

She points out that the interest charged on your consolidated debt may not actually be cheaper in the long term.

“Home loans are usually structured over 20 years and sometimes longer. So the amount on which you are charged interest over the longer term, could mean you pay more interest because you are paying off much less of the capital every month. This is one of the reasons why we don’t recommend debt consolidation loans.” 

Debt consolidation will only be a temporary measure for most borrowers, warns Ramcharan.

“If you are not addressing the underlying reason why you took out many loans and got into debt in the first place, consolidating your debt won’t work,” she explains. 

She adds that debt consolidation could work for those who took out a loan as a once off for something that they are unlikely to borrow for again, like paying off hospital bills for a condition that they have now recovered from. It will particularly work out for those that are disciplined about paying off their consolidated loan and who won’t borrow more money until the debt is paid off. 

Ramcharan explains that when it comes to debt, past behavior is the best determinant of future behavior. People who get into debt over frivolous, non-essential items are more likely to repeat the mistake as there’s no rule against borrowing more money after you’ve consolidated debt.

“A borrower will not make a success of debt consolidation if they don’t change their spending behavior,” she says. 

Instead of opting for debt consolidation, she recommends talking to your lenders about your debt concerns.

“Debt consolidation is a loan, it’s not a solution. All banks have teams that are able to help customers if they are under stress even before they have problems with debt and can’t afford to pay. Those teams can help you work out a budget and restructure your loans. If you are further in debt and that process won’t help, then debt review can also help you and all credit providers will participate in this,” she adds. 

*Correct as at November 16 2017

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