Debt consolidation: Benefit or disadvantages?
Lechedzani Pitso | Monday October 6, 2014 06:59
It would be wonderful if there was a quick fix, a simple and cheap method we could buy that would, in the blink of an eye, resolve the problem. Is debt consolidation that solution? Most of us also know that getting into severe debt didn’t happen overnight. We got ourselves deeper and deeper into trouble over an extended period. Knowing this, we cannot expect “The Solution” to be a quick one. If someone tells you about (or tries to sell you) a “quick and easy” solution, be suspicious. You must ask questions and look at the T&C’s carefully. Beware of schemes that are very costly – if you can’t afford it in the long term, it’s not a solution at all.
What is debt consolidation?
We are increasingly hearing this term “debt consolidation” and some of us have been told it is the solution to all our problems. Is it a wise solution, or just another way to get even deeper in debt? Debt consolidation is a process whereby you find a lender who agrees to take over all of your debts. Your new lender agrees to buy all of your debts, so they pay off all your debts on your behalf, and then you owe them the money instead. This way you only have to worry about one debt, and so only one debt payment each month. That sounds pretty good, and many of us are looking at that as a solution. However, you must be careful - It is up to you to find a lender who will charge you reasonable fees and interest rates for this service.
The upside
Why would you want to owe all your debts to one lender? The reason to consider this consolidation should be in an effort to pay them off - either over a longer period of time, or with a lower interest rate (or perhaps both). For example, if you have paid off half your mortgage, your property is worth more than you still owe. Because you pay your mortgage over a long period of time, the monthly capital repayments are lower (though try not to go for more than a 20 year mortgage) Also, because your mortgage lender has the right to take your home if you don’t repay, they consider the loan to be low risk, and therefore the interest rate is lower. Therefore, if you can extend your mortgage to encompass a bigger loan, (called re-mortgaging) you could use that money to pay off more expensive debts. This might be considered an example of good debt consolidation.
Reasons why debt
consolidation is a disadvantage
The problem with debt consolidation is no lender will give you money for free, they will charge you for this service. This can be expensive and might get you even further into debt. When you are already in too much debt, you should avoid further debt.
The downside
If you are in arrears with your mortgage, or are blacklisted with ITC or CRB, your mortgage lender won’t be able to help you. It’s here where short term lenders might offer to help. Taking out a short term loan to pay off arrears, or pay debts to clear yourself with a credit bureau may be your only option. This is called a bridging loan. However, again you should be cautious. Be aware that, when you are listed as a bad debtor, there will be higher fees associated with lending to you. We’ve come across upfront fees of between 15% and 25%, and ongoing interest rates of 2 percent to 5 percent per month. Even if you pay off your debt to this new lender in one month, you still have to pay a percentage of the debts for their assistance. If you get a bad deal, this can be very costly. In short, you want to borrow as little as possible, and get your bridging loan paid off as quickly as is possible. You should also shop around and get the best deal!
Good debt
Remember, the ONLY good debt is one that buys an asset that appreciates in value and that produces a secure income. Your home qualifies, because it goes up in value over the long term, and you pay the rent on it to yourself – to pay down the mortgage. For good debt, you can pay it down slowly – over a maximum of 20 years.
Bad debt
All other debt is bad debt. What you owe to clothing shops, furniture stores, micro lenders, cash loans, your friends and your family is all bad debt. The money that you owe on your car is bad debt – your car goes down in value at least 10% each year. Even if you have a loan to buy a plot – if that plot isn’t earning you an income then it’s not an asset, and therefore the debt is bad for you because it’s costing you money. For bad debt, pay it off as fast as you can afford. Pay the most expensive (highest interest) debt first, or pay the debt that causes you the most stress first (like the one you owe your poor mother)
Weighing-up debt consolidation
The downside is the cost, and paying off debt more slowly.
You must weigh these costs against the benefits:
l Only one monthly deduction/payment
lOnly one administration charge – if coming off your salary or through a union
lA lower interest rate
lA longer period of time to pay the debt
lA more affordable monthly repayment.
Counselling and guidance
It is best to seek professional debt counselling and get guidance on a debt payment structure. A good debt counsellor will get to know your situation, and then help you work out a plan. You then work on your plan under the counsellors guidance. If a counsellor thinks that debt consolidation is right for you then they will discuss it with you. However, the counsellor might advise that it’s better to avoid debt consolidation if it gets you even further into debt.
Getting debt free is the goal
Remember, the only people that are happy with their finances are the ones without any bad debt. Therefore getting free of all your bad debt is the goal. You can do this. It will take time and effort, but you can do it. You too can be debt free, and happy. Author: Lechedzani Pitso – Financial Wellness Trainer and Debt Counsellor with S.C.I. Training (Pty) Ltd. © S.C.I. Training run financial wellness programmes in Botswana. For help and information contact them on 3180243 or 72309718 or leche@wellness.co.bw