When is debt consolidation a good or bad idea?

Debt consolidation involves rolling all of your current debts into one. This can be a useful strategy to reduce fees and interest, but it may not be the best course of action in some cases.

We explain when debt consolidation may be a good strategy and speak to a financial counsellor about the potential pros and cons.

What is debt consolidation?

Debt consolidation is the process of consolidating your existing debts (such as credit cards and personal loans) into one debt, such as by combining your debts into one debt consolidation loan or increasing your home loan to pay out existing debts.

When is debt consolidation a good idea?

Debt consolidation may make good sense if you are able to get a lower interest rate and fees on the consolidated loan than the rate and fees of your current debts. This could help you save money and get rid of your debts more quickly. But you’ll need to make sure that the new loan is actually cheaper than your existing debts, when you consider overall fees, charges and interest.

Debt consolidation could also help make your repayments more manageable as you’ll typically only be making one repayment during the month, rather than multiple. If you are able to get lower repayments on the new loan, this may also help you manage your finances in the short-term.

Additionally, unlike credit cards, debt consolidation loans are repaid over a set period of time. This may be helpful as it can give you a clear timeframe to clear your debts (provided you make your repayments on time).

Consider the total cost of consolidating

It’s important to make sure that the new consolidation loan is actually cheaper than your existing debts. Look at the interest rate and fees of the new loan, plus the cost of exiting your current loans.

“When people consolidate they may only look at what they are trying to achieve, such as getting lower repayments, and they may not see that they are paying a lot more,” explained Rob Benton, a financial counsellor at the National Debt Helpline.

Mr Benton noted that you may incur fees to take out the new consolidated loan and fees to end your current loans. For example, if you break a fixed-rate loan you will typically be charged a penalty fee for paying out the loan early.

It’s also important to consider the term of the new loan as it may work out to be more expensive than your existing debts in the long run, even with a lower interest rate.

It can be helpful to read the fine print of your existing products and any new products you are considering before you make a decision – such as the Product Disclosure Statement (PDS) and Target Market Determination (TMD).

Be careful of turning unsecured debt into secured debt

You may be able to get a lower interest rate by consolidating unsecured debt (such as credit cards and personal loans) into secured debt (such as a home loan). But this can be risky.

“Some people see the current home loan rates as a good reason to consolidate fairly expensive unsecured debt into their home loan,” said Mr Benton.

“A mortgage is fundamentally different as the lender has more power over you because they can take your security [which would be your home] if you default.”

A home loan is also a long-term debt and if you don’t increase your repayments to pay off the consolidated amount, it may be costly.

“People often don’t increase their repayments and they don’t factor in what the real cost would be over time,” he said.

By leaving your repayments the same, you will essentially defer the consolidated amount to the end of the loan and would be paying interest on it over a number of years, he added.

When is debt consolidation a bad idea?

Debt consolidation may not be a good idea if you are already having difficulty making your repayments.

“There are a lot more options that you could look at first, like deferring repayments or varying a loan under hardship,” said Mr Benton.

Also, be aware of debt consolidation solutions that are actually ‘debt agreements’ – known as a Part IX (9) debt agreement under the Bankruptcy Act. These are acts of bankruptcy and will appear on your credit report for five years.

“Unfortunately some players in the market put this as an option that people can consolidate their debts through,” said Mr Benton.

“Professionally I believe that there are very few instances where you would take a Part IX.”

If you apply for any credit or loan product, including a debt consolidation loan, this will also be noted on your credit report. If you make multiple applications for credit within a short space of time, this can negatively affect your credit score and impact your chances of getting approved for credit in the future.

If you are considering debt consolidation, Mr Benton recommends talking to a financial counsellor first. It is free to speak to a financial counsellor and they are independent.

“A five minute chat or an initial appointment would be time well spent to get to know exactly what the cost is against the benefit, because it’s not always easy or apparent to see that,” said Mr Benton.

“There may be other cheaper options that you should consider, particularly if you are in hardship and finding it difficult to afford your loans.”

You can speak to a financial counsellor by calling the National Debt Helpline on 1800 007 007. The National Debt Helpline also offers a live chat, and you can send them a message online. If required, you can access an interpreter by calling the Translating and Interpreting Service (TIS) on 131 450 or call via the National Relay Service (NRS) too.

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