A rough guide to debt consolidation

We pride ourselves on being a responsible lender. We do not want our clients to struggle with debt repayment, and we have achieved the lowest arrears rates in the industry. As with any other credit facility, debt consolidation loans can be used wisely or unwisely; but there are many tangible advantages which debt consolidation offers when used sensibly.

roughguidetodebtconsolidation

A debt consolidation loan is a loan taken out to pay off several other smaller loans. A reason to consolidate smaller loans into one larger loan is usually to secure a lower overall average interest rate. Typically debt consolidation involves replacing high-interest short term debt (such as credit cards, store cards, personal loans) with a lower interest rate loan which usually has a longer term – typically your home loan. If you own property, you can apply for additional funds on your existing bond; of course that’s as long as there is positive equity in the property (i.e. the value of the property exceeds the current outstanding loan amount). Debt consolidation also allows you to make a ‘clean start’, by converting your various existing commitments into a single, manageable monthly loan payment. This also saves on multiple fees, service charges and debit order charges on the various loans.

The result of such consolidation is that the monthly repayment will be lower on the consolidated loan compared to the combined monthly repayments of the smaller loans, which will improve cash flow. So if you’re battling to afford your monthly repayments on your debt, this can be a practical solution to avoid events such as foreclosures and repossessions.

However, benefiting from debt consolidation requires financial discipline, without which it can actually make your financial situation worse.

Read on to find out why:

Let’s illustrate the concept of debt consolidation through an example. Let’s say you currently have a variety of debts as indicated below:

Home loan Vehicle finance Credit card Personal loan
Amount due R600 000 R120 000 R25 000 R45 000
Repayment period 240 months 60 months On-going 48 months
Interest rate 9% 16% 20% 18%
Monthly payment R5 398 R2 920 R1 000 R1 320

Debt consolidation means that you would take a further advance on your Home Loan for R190 000 and use this cash out to settle and close all the other accounts. After consolidation you would have a single home loan of R790 000, and the instalment would be approximately R7 110 pm (excluding fees, charges and insurances).

Hence, in this scenario, your monthly cash flow saving would be approximately R3 528 pm. The interest saving per month would be approximately R1 260 (R15 200 pa).

(The above example is merely to illustrate the concept of a debt consolidation exercise. Actual savings will differ according to personal circumstances and the applicable interest rates).

At a glance, it seems a great idea, giving both interest savings and better cash flow: so what are the risks?

Fact: despite the material interest saving per month, the bigger reason that you pay R3 500 less each month is that instead of repaying your debts over 3, 4 or 5 years, you are now extending that same debt up to 20 years (the notional period of your bond) - which means that in the long run you will pay much more interest on that debt. Also, for example, you could still be paying off your vehicle long after you have disposed of it.

What can you do to prevent this? The best advice is to pay as much of the ‘extra’ R3 500 into your bond every month as soon as you can afford to. For example, if you were to redirect the payments you would have made on your short term debt into your (increased) bond, this would allow you to pay off your entire home loan in under 10 years (instead of 20), and you would save a whopping R540 000 in interest expense.

As a general principle, one should not pay short term expenses with long term finance (debt). However, this may be one of the only immediate options open to you. If you are currently in danger of defaulting on your loan repayments, you will need the breathing space from this cash flow improvement to stave off any defaults.

Certainly debt consolidation can be a lifeline and is preferable to a judgment or a repossession of your house or car. However, we do recommend that the short-term debt should be repaid as soon as your circumstances permit.

The big danger is that if you suddenly find yourself with a “spare” few thousand rands every month, you may be tempted to spend the “extra” money. If you do so, in no time at all you may be back in trouble, with no options left. You must avoid falling in to the same spending patterns that originally created the predicament of over-indebtedness. We do not advocate using long term debt to finance your current consumption expenditure. You should therefore use debt consolidation to save on interest expense, not to reduce your longer term monthly debt repayments.

In conclusion, as with any other credit facility, this can be used wisely or unwisely; but there are many tangible advantages which debt consolidation offers when used sensibly.