What is debt consolidation?

21/11/2019
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You’ve heard of debt consolidation or had it suggested as a solution to your debt problems. But what is it, how does it work, and is it right for you?

 

Read more: Fixed vs floating interest: What's the difference?

 

WHAT IS A DEBT CONSOLIDATION LOAN?

A debt consolidation loan is a loan you take out to pay off other loans. This means you only have one loan to pay, with one set of repayments, and one interest rate.

Demonstration of debt consolidation

You are merging all your loans to either reduce interest costs, reduce the length of your loan, or reduce your weekly payments. Consolidation loans can be personal loans, balance transfer credit cards or they can be extensions of mortgages. This blog covers personal loans specifically.

 

WHAT ARE THE BENEFITS OF A DEBT CONSOLIDATION LOAN?

Debt consolidation is attractive for several reasons.

  • Simplicity. A consolidated debt is one loan with one interest rate and one repayment schedule, so it’s easier to manage.
  • Cheaper. A debt consolidation loan can have a lower interest rate than existing loans. This can save significant amounts of money in the long run. However, sometimes it does make financial sense to leave one or more debts alone if they are on a very good interest rate or don’t have long to run.
  • Instant relief. If the new loan has a longer term or has a lower interest rate, the repayments will be more reduced and payments more manageable.
  • Faster debt repayment. If you are able to keep your repayments the same after lowering your interest rate, you’ll pay off your loan faster.

 

WHAT ARE THE RISKS OF A DEBT CONSOLIDATION LOAN?

While debt consolidation is a solution, it might not be the best solution for you. There are several drawbacks.

  • Credit score. Every time you take out a loan, it can impact your credit score.
  • More expense. If your debt consolidation loan has a long term, you might pay more in interest by the end of the loan. This will depend on your agreed interest rate, so make sure to calculate the difference. org.nz has an excellent tool to do that. There may also be early repayment costs when settling the other loans you are consolidating – you need to check what these are. New loans can have added fees too, which only adds to your costs.
  • Cures symptoms, not the problem. If you are struggling to make repayments, a debt consolidation loan may not make a difference.

Because your circumstances are unique to you, your best bet is to speak with a financial adviser first.  If you don’t have a financial adviser, start with asking your friends or family who they use and trust.

 

HOW TO GET A CONSOLIDATION LOAN

If you decide to go for debt consolidation, there are a few simple steps.

1. Check your credit history and correct any errors. The better your history, the better your consolidation offers will be. You can find out how to do this here.

2. Decide on a provider. Go direct or work with a broker to find the right consolidation product and provider for you. Wondering what the benefits of going through a broker are? Read our guide.

3. Apply for the debt consolidation loan. Once you’ve decided on a provider, applying for a consolidation loan is the same as any other loan. You will be asked for some personal information and financial records. This will be used to review and assess your application. Providing any good re-payment statements you have for your existing debts can be helpful.

After applying, you will receive an offer from the lender or broker.  If you like the offer after considering the new interest rate, costs, the new term and the payments, sign the contract, and you’re done! The next few steps will be advised on by your lender.

Lastly, if you’re consolidating because of difficulties with your budget, make sure to mention this. Your adviser will be able to tell you the next steps that ensure you do not have to consolidate regularly.

 

SUMMARY

Consolidation loans can be an effective way to lower your repayments, pay less interest, and simplify your overall budget. But they do have some drawbacks and may not treat the real problem. Make sure to speak with a financial expert before making a decision to consolidate.

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