When is a debt consolidation loan a good idea?

Many South Africans seek debt consolidation loans when they feel their debt burden is too heavy and they need relief.

This type of loan can be a helpful tool. It allows you to take out a new loan to pay off multiple debts, simplifying your monthly repayments.

However, these loans attract a high interest rate, and if you are overindebted, you won’t qualify for any further credit.

We outline the ins and outs of debt consolidation loans, and discuss an alternative debt solution.

What is a debt consolidation loan?

A debt consolidation loan is a new loan you take out to pay off multiple debts, leaving you with a single monthly repayment.

Banks and other credit institutions offer these loans.

Ideally, a consolidation loan should come with a lower interest rate than your individual loans, reducing the total cost of your credit over time.

However, if the new loan has a longer repayment term, this can reduce the effects of a lower interest rate. You may end up paying more in the long run.

Be sure to compare different offerings. Consider loan origination and admin fees, the interest rate, and the loan term, to ensure you choose the best option. Bear in mind that balance transfer fees and early repayment penalties for your existing loans can add up and offset the benefits of a new loan.

Who will benefit most from a debt consolidation loan?

If you are paying high interest rates on your current loans and/or finding it hard to manage your debt effectively, a debt consolidation loan could benefit you.

These types of loans can help simplify, and potentially reduce, your monthly debt repayments.

If, however, you’re already overindebted and you can’t afford your current expenses, you may need to consider consolidating your debt through a process known as debt counselling.

When should you consider a debt consolidation loan?

A debt consolidation loan may be useful if you’re unable to keep track of your monthly debt instalments, and/or you can’t afford your current interest rates.

You should consider a debt consolidation loan if:

• The new credit is used to settle your smaller debts and does not add to your burden.
• The new loan interest rate is lower than your current loans.
• The new loan instalment is lower than the total of your current debt repayments, thereby freeing up cash.
• The consolidation loan is unsecured – for example, your house will not be seized if you fail to repay it.
• By consolidating multiple debts into a single repayment, you will save money on monthly service fees, administration and debit order charges, and insurance costs. This is because you will have only one account to pay instead of many.

However, a debt consolidation loan is not a good option if:

• Your credit score is poor – you may not qualify for a loan as a result, or the interest rate may be high.
• You don’t have enough money to live on every month after repayments. 
• You’ve been unable to make one or more of your current loan repayments -this means you’re overindebted and you will not qualify for a new loan.

The pros and cons of a debt consolidation loan 

Advantages

Provided the loan is used to pay off multiple smaller debts, you’ll enjoy a simpler repayment process, which can reduce stress and anxiety.

You may benefit from a lower interest rate and reduced fees – but this is not a given. You will also pay a single set of loan account fees, saving you money.

You’ll still be able to take out new credit if you qualify for it.

Disadvantages

In most cases, debt consolidation loans come at a very high interest rate, as they are unsecured, meaning there is no asset attached to them, such as a car.

They may also attract a longer repayment period, meaning you will pay more interest over time.

Other potential risks include:

Increased debt. By consolidating many debts into one loan, you may feel a false sense of relief and start using your credit cards or taking out more loans, leading to further financial strain.

Early settlement fees. Lenders may charge penalties for early settlement of any existing loans, which can increase the overall cost.

A damaged credit score. If you’re unable to make your consolidation loan repayments on time, you risk damaging your credit score, and you may face legal action.

How to qualify for a debt consolidation loan

To be eligible for a debt consolidation loan, you’ll typically need to have:

• A good credit score. This will also help you obtain a lower interest rate, because you represent less of a lending risk.
• A stable income. This will show that you can afford to repay the loan you’re applying for.
• A debt-to-income ratio of less than 35%. If 35% or more of your income is used to repay your debt, your consolidation loan application may be rejected.

What effect will a debt consolidation loan have on your credit score?

Taking on an additional loan may lower your credit score. Even applying can affect your score, as when loan providers check your credit score, this is seen as a “hard enquiry”. Having too many of these in a short period of time can make you seem like a credit risk.

However, consolidating your debt can simplify your repayments, making it easier to pay on time. This can have a positive effect on your credit score over time.

Reducing your credit utilisation ratio, meaning, the amount of credit you use compared to the amount of credit available to you, can also boost your credit score in the long term. 

What is the purpose of debt consolidation? 

The purpose of debt consolidation is to combine all of your debt to free up cash flow and gain better control over your accounts.

You should only consider debt consolidation if the new loan instalment is lower than the total of your current debt instalments.

What is the alternative to a debt consolidation loan?

Debt consolidation doesn’t always involve taking out a new loan.

DebtBusters can help you combine your loans into a single, reduced monthly instalment, in a process known as debt counselling. This instalment is paid to your various credit providers by a payment distribution agency.

Your debt counsellor will assess your financial situation, help you create a budget that’s tailored to your needs, negotiate with creditors to reduce your interest rates and repayment amounts, and provide guidance for managing your debt effectively. 

Debt counselling is a legal process, and you won’t be allowed to apply for additional credit. Your debt counsellor will repackage your debt so that you can meet your monthly financial obligations.

You will also be protected against any further legal action your creditors might try to take. Any included assets cannot be seized, and your creditors are disallowed to contact you throughout the process.

Debt counselling allows you to regain control of your debt and, ultimately, become debt-free.

How do you know you need debt consolidation?

If you’re losing track of which credit providers you’re paying every month, or you’re struggling to keep up with instalments because of excessive interest, you may benefit from debt consolidation.

If you can’t afford your debt repayments, and you’re finding it hard to make ends meet, a specific form of debt consolidation known as debt counselling can help you escape the debt trap and get back on your feet.

DebtBusters can help you work out which solution is best for you. Telephone 086 999 06 06 to speak with an expert consultant.

Long-term financial planning after debt consolidation 

Once you’ve paid off your debt, it’s vital to manage your finances effectively to avoid falling back into debt. Here are some strategies to help you build a secure financial future.

Create a budget. Your budget should detail your monthly income, fixed expenses (such as rent and utility bills), and variable expenses (such as groceries and personal spending). The goal is to ensure that your expenses do not exceed your income. Allocate a portion of your income towards savings, to build a buffer for unexpected expenses or emergencies.

Avoid future debts. This means living within your means, avoiding impulse buys, and distinguishing between wants and needs. Avoid accumulating new debt, particularly high-interest debt. If you use a credit card, pay off the total monthly balance to avoid interest charges.

Struggling with unmanageable debt? DebtBusters can help you consolidate your debt without taking out a new loan.