How debt consolidation works
One of the most common reasons people are struggling to buy their own home is juggling existing debt while trying to finance a home loan. Emergencies or accidentally spending more than you earn on a credit card can easily lead to accumulating debt. Nowadays, it is even typical to be repaying multiple debts at the same time, which can feel very stressful. Research has shown people with multiple credit cards are especially vulnerable to accumulating persistent debt. This is where debt consolidation comes in.
In this article we explain how debt consolidation works and what are the benefits and risks of choosing it as a financial strategy.
What is Debt Consolidation?
Intrinsically, debt consolidation is a financial strategy that can be helpful for people who have multiple individual debts that they are currently struggling to pay. It is a method where multiple individual debts are consolidated into a single debt.
The most common way of consolidating debt is taking a personal loan to pay off the other, smaller debts in one go. There are alternatives to the personal loan strategy, for example borrowing from friends and family to cover your debt. As there is no interest involved, this is a great strategy, but one that is not available for everyone. That is why personal loans are the most common way to consolidate debt.
So, what is debt consolidation through a personal loan? For example, you might have three different debts from three different credit cards. All these debts might be different in amount and have different interest rates. The core problem with this type of situation is that juggling three monthly repayments is much more to worry about than just one repayment. Besides, the different interest rates could lead to you paying plenty of money just to cover the interest, rather than paying off the debt.
Therefore, debt consolidation can be a powerful tool for regaining control over your finances and becoming debt-free. While it is a useful way of simplifying your money situation and setting goals, it comes with a few upsides and downsides.
Benefits of Debt Consolidation
Consolidating your debt with a personal loan has many benefits that make it a lucrative option. These benefits include but are not limited to:
It goes without saying that making one repayment weekly or monthly is easier to manage than multiple repayments. To reduce debt and improve your credit score, it is important to make your repayments consistently and on time. If you desire easier repayment management, debt consolidation could help.
The problem with multiple smaller debts is the variation in interest rates and the accumulating fees from different lenders. Sure, it is possible to make calculations and tackle them in an order where you pay the least amount possible in interest overall, but if you are able to secure a debt consolidation loan with a lower interest rate and less fees, it could save you money.
Motivation is key to sticking to any budget and financial goal. Having one debt to pay off rather than many gives you a clear timeline to when you can expect to reach your goal and be debt-free.
Consolidating debt to one loan could make it easier to live within your means and budget the maximal amount possible towards repayments.
To put it briefly, debt consolidation is a way to simplify your financial situation. It is a helpful strategy to regain control and set goals for financial freedom, but it does have its downsides. Now let’s get cover what those potential downsides are.
The Downsides of Debt Consolidation Loans
While it is a good and tempting strategy, debt consolidation does come with a few downsides. First and foremost, keep in mind that a personal loan is a new debt. There is no point consolidating debt with a loan unless you are truly prepared to make changes to your money spending. Debt consolidation is only a viable strategy if you are motivated to tackle your debt in a consistent manner. A loan won’t fix anyone’s finances without a clear action plan.
Ideally, debt consolidation should help you pay off your debt at a lower interest rate. If the interest rate of a debt consolidation loan is higher than your individual loans, think twice before going for it. It might not be worth it to consolidate your debts to one if it means you’ll have more debt to pay overall.
It is also wise to consider whether the type of debt you have is suitable for consolidation. For example, if you’re paying for an asset that you will use for a limited time, don’t cover that debt with a loan that will be paid back years or decades later. You wouldn’t want to consolidate repayments for a car that you will only use for 10 years with a loan that you will be paying back for over 15 years.
Does Debt Consolidation Hurt Your Credit Score?
Another aspect that people tend to worry about is whether debt consolidation could hurt their credit score. How much debt consolidation affects your credit score really depends on your arrangement and circumstances, but there are some factors to be aware of beforehand.
In Australia, the major banks and credit providers have been including additional information about the credit products you hold on your credit report since September 2018. A debt consolidation loan will show as unpaid debt on your credit score, just like any other loan or credit you have taken. However, debt consolidation can help improve your credit score in the long run, as you eliminate multiple smaller debts with it.
When considering debt consolidation, bear in mind that late repayments affect credit scores negatively. If you’re currently struggling to make multiple repayments regularly, debt consolidation could help you improve your credit score. If making just one repayment helps you stay on top of things, it could be a solid plan to improve your score in the long run.
Having a few different debts where interest keeps eating away the money you put in can make you feel like you’ll never be debt free. Whether debt consolidation is a suitable method for you or not depends on your circumstances. We can’t stress enough that taking out another loan to improve your finances is only advisable if you are motivated to start living within your means. However, if you are feeling prepared and motivated to make some changes, debt consolidation can be a great way to get back on top of your finances.
Are you worried about whether you’ll ever be able to enter the housing market because of debt? Saving up for a deposit can take years even with no debt at all, which can feel quite discouraging. If you’re looking at options for getting a home loan with little savings, why not book a call with one of our consultants to discuss your options?