While consolidation takes immediate pressure off, it does not erase the debt owed. Unchanged financial habits will see that pressure mount again, writes Mapalo Makhu.
WHAT IS DEBT CONSOLIDATION?
Debt consolidation is when you take out a new loan to pay off a number of existing debts, normally unsecured debts such as a credit card, an overdraft, personal loans or store clothing accounts.
The advantage of debt consolidation is that you end up paying one creditor instead of multiple providers. This allows you to get a grip of who you are paying and it gives you peace of mind knowing that you can focus on one loan repayment, especially if you were battling to keep up with the different payment dates.
A consolidation does not mean that you become debt-free, it simply means that instead of paying a lot of creditors, which can be overwhelming, you replace all the debts with one manageable debt that you can hopefully tackle.
It can be challenging to keep track of multiple loans and if you have several credit cards, store accounts or personal loans then you’re probably paying more fees than you really need to.
A debt consolidation loan can solve both problems by pulling all your debts into a single loan. This reduces the amount of fees you pay and makes repayment simpler.
So, for example, you have the following debts:
Personal loans = R85 000
Credit cards = R60 000
Overdraft = R50 000
Clothing accounts = R25 000
Total debt = R220 000
Understandably, if you are already not coping with just how much debt you are in, having different debit order dates and different amounts going off your account can be stressful.
When you consolidate your debt, a creditor – a person or company that lends money or extends credit to another party – extends you a consolidation loan with which to pay off all your debts, leaving you with only one loan.
In the example above, the creditor would give you R220 000 to pay off the various debts you have, but in the end you would still need to make payment towards the R220 000 consolidation loan.
While the benefit of a consolidation loan is evident, there could be disadvantages. As the old adage goes: There ain’t no such thing as a free lunch.
Although a consolidation loan can provide some well-needed relief from dealing with numerous creditors and lowers your monthly instalments, this can come at a price. The loan can present a double whammy in the form of higher interest rates and/or a longer payment period, making this “solution” an even more expensive alternative to paying off your debts.
Remember that the higher the interest rate and the longer the repayment period, the more expensive the overall debt becomes.
Unfortunately, one does not have much negotiating power with creditors when going for an option such as a debt consolidation loan. In most cases you simply take what is put on the table depending on how risky they think you are.
This brings me to your credit score. It is a history of your past financial behaviour with credit – how well or poorly you have handled credit.
Most people opt for a consolidation loan when their finances have turned for the worst, instead of being proactive by speaking to their creditors to perhaps pay less on their debt until they get back on their feet.
Instead of working out a plan that will provide some sort of financial relief people wait until their only resort is a consolidation loan or, worse, debt relief.
If you have missed some payments or you did not pay on the agreed date it reflects badly on your credit score. That is why making an arrangement with your creditor is always advisable before things escalate.
As a personal finance coach, I often talk to people who think that a debt consolidation loan is a magic wand that will make all their financial woes go away. However, often consolidation does not work because people never fix the bad habits that got them into the financial mess in the first place.
Yes, a consolidation loan has its advantages but if your habits remain the same you will most likely find yourself in distress again.
Change your habits, change your life.