Consolidating your debts can be a great way to reduce debt and improve your overall financial health, but there are a few things to look out for when considering a debt consolidation.
A debt consolidation involves rolling some or all of your debts into one single debt. The aim of the consolidation is to lower your overall interest rate and reduce your total fees.
Generally speaking, debt consolidation can definitely improve your financial situation, be here are a couple things you need to look out for to ensure your consolidation is a success:
Watch out for break costs and establishment fees
Depending on the type of debts you are paying out, there may be break costs charged if you are paying out the facility early. This isn’t an issue with credit cards, but with some personal loans and other forms of finance they may hit you with early repayment or break fees.
When taking out your new loan you will also likely be charged an application fee or establishment fee. The fee can vary from one lender to the next, so it is worth taking this into account when searching for your consolidation loan.
Now here’s the important part – you need to ensure that the savings you will make by consolidating your debts will outweigh the costs of putting the consolidation in place.
If the total costs are going to be $2,000 and your interest saving will be $20 per month, then it’s going to take you 100 months to recoup that money, which is over eight years. In this case it could be argued that you’re better off using the $2,000 to reduce the debt rather than consolidating.
Don’t get locked into bad loan
When consolidating your debts your overall aim should be to get out of debt completely. It may take many years, but with planning and discipline you can get there.
Your new loan must be flexible enough to allow you to make additional repayments as well as more frequent payments. If the loan locks you into a certain repayment rate and you cannot pay it off sooner, you may be doing yourself more harm than good.
Look at the interest amount, not the repayment amount
Often when consolidating debts you will be rolling a number of shorter term debts into a single longer term debt.
For example you may have a personal loan with two years remaining, a car loan with three years remaining plus two credit cards. The debt consolidation loan may have a term of seven years.
At first glance it may appear that your monthly repayments have reduced by a large amount, but this will likely have less to do with lower interest rates, and more to do with the simple fact that you are now spreading your debt over a longer period of time.
When doing the sums on whether or not a debt consolidation is right for you, ensure you are comparing the monthly interest payable on your debts rather than the overall monthly repayment.
Don’t extend your loan term and pay the minimum payment
As detailed in the previous point, often when consolidating debts you will be rolling short term debts into a longer term debt. This is especially true when you are consolidating your debts into a home loan which can run for up to thirty years.
When you roll short term debts into a longer term debt, naturally the repayment amount will reduce because you have longer to repay the balance. By paying the new minimum monthly payment you may think you are saving money, but instead you will simply be paying interest over a much longer period.
There’s no point halving your interest rate if you’re going to repay it over a two or three times longer period.
Cancel your old credit cards
One of the biggest mistakes that people make when consolidating debts is the failure to cancel their old credit cards and store cards.
You may have the best intentions when you first pay out the card, but unless you cancel the card there will always be the temptation to use the card again now that the full balance is available.
When consolidating your debts, it is vital that you cancel the original debt. This includes credit cards, store cards, lines of credit and any other form of revolving credit.
If you require a credit card for convenience and online shopping, keep just one card and reduce the balance to a manageable amount like $500 that won’t allow you to get into too much trouble. Alternatively you can get a Visa debit card and escape the credit card trap forever.
Consolidate for the right reasons
When consolidating your debts you need to be doing it for the right reasons.
By committing to the consolidation process and concentrating on reducing the new debt you can make a dramatic improvement to your overall financial health.
About Shane MooreShane is a former financial adviser who has been in the finance and insurance industry for over a decade. Shane holds numerous industry qualifications and is a Senior Associate of the Australian and New Zealand Institute of Insurance and Finance.
