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Debt consolidation no quick fix

Personal Finance

Most of the banks are offering debt consolidation loans, but they have become more discriminating than ever about who qualifies for these loans.

A debt consolidation loan is a loan used to pay off multiple loans. It has been referred to as “debt displacement”, because it moves debt from many different accounts into one account to save on interest or help with cash flow.

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Nedbank’s debt consolidation loans are granted “primarily” to the bank’s transactional clients and only “best-risk clients” qualify for such loans, Warren Tromp, the head of value analytics at Nedbank Personal Loans, says.

Hannalie Crous, the head of credit at First National Bank (FNB) Retail, says the bank’s debt consolidation offering is restricted to “lower-risk customers” and constitutes a small proportion of the number of loans that the bank grants in a month.

Absa scrapped its debt consolidation product last year in response to misuse of these loans by consumers who don’t use the loans to pay off debt. However, since many of its customers have taken up loans with other lenders at higher interest rates than those offered by Absa, the bank has recently reintroduced a debt consolidation product, Jan Moganwa, the chief executive of customer solutions at Absa Retail and Business Banking, says.

In terms of Absa’s new product, the bank will settle the customer’s existing debt directly “and consequently remove the option of a customer being tempted to draw down on that facility”.

This appears to be a new distinguishing feature of debt consolidation loans. If you are given a loan by African Bank, Capitec, FNB or Old Mutual, they will pay your creditors on your behalf with the proceeds of the loan.

Alfred Ramosedi, the group executive for sales and marketing at African Bank, says the bank will settle your debts with registered credit providers only. In other words, if you have borrowed from a friend or relative, or a loan shark, the bank will not pay them.

According to Crous, when a credit provider grants you a debt consolidation loan, the National Credit Act (NCA) “requires credit providers to take reasonable steps to ensure that other obligations are settled”. This suggests that a credit provider who issues a debt consolidation loan has a responsibility to ensure that the money is used to pay legitimate creditors.

Most consumers visiting the website of the debt counselling company DebtBusters are looking for debt consolidation loans, says Ian Wason, the company’s chief executive.

Shirley Smith, the chief operating officer of Old Mutual Finance, says the demand for debt consolidation loans has increased since Old Mutual introduced its product a few years ago. Ramosedi says African Bank has also seen a significant increase in the demand for these loans over the past year.

According to DebtBusters, 78 percent of South African households are in debt and South Africans are among the most indebted people in the world. Wason says the two key reasons for our rampant debt are financial illiteracy – or a poor understanding of how debt works and how to manage it – and the use, or misuse, of personal loans to pay off existing loans.

Borrowing from one lender to pay another is usually a bad idea and a sign that you could be over-indebted. Debt consolidation isn’t quite the same thing, because you’re borrowing from one lender to pay off all your creditors.

In doing so, you simplify your affairs – because you go from having multiple lenders and debts to just one lender and one debt – and you save on the costs of servicing multiple debts. These costs include monthly administration fees and premiums for credit insurance.

For a debt consolidation loan to be viable, it must attract a lower rate of interest than the rest of your debts and improve your cash flow.

What’s the difference between a personal loan and a debt consolidation loan, you may ask. When you obtain a personal loan, it can be for anything. The lender pays the amount loaned to you and you spend the money as you wish, be it on a holiday, to cover an emergency expense, or to consolidate debt.

If you plan to use a personal loan to consolidate debt, be careful. If you are not disciplined, you could get yourself deeper into debt, so make yourself accountable to someone who will make sure that you use the money to pay off your debts. Also, personal loans tend to be expensive, because they are unsecured loans. The maximum a lender can charge on a personal loan is currently 28 percent a year, though your rate will be determined by your individual risk profile.

Debt consolidation loans are also unsecured loans, so the same maximum applies. This is why it is imperative that you negotiate a favourable interest rate with the lender offering the debt consolidation loan.

With the exception of Capitec, the banks would not be drawn on what you can expect to pay for a debt consolidation loan. Andre du Plessis, the chief financial officer at Capitec, says that, while the rate depends on the risk profile of the client, the bank’s best rate is 12.45 percent.

A mortgage bond, which is a secured loan, is generally the cheapest form of credit – 19 percent is currently the most a lender can charge you for a home loan. However, most people pay prime (10.50 percent) plus one or two percent. For this reason, debt consolidation using a home loan is preferable to a debt consolidation loan or a personal loan.

Using your home loan

There has been a “material” increase in the number of clients looking at using their home loans to consolidate their debt, Kevin Penwarden, the chief executive of SA Home Loans, says.

“Interestingly, it has not been a sudden or sharp ‘spike’, but rather a slow but steady increase – indicative of and consistent with the increasing financial squeeze faced by so many consumers and borrowers,” he says.

In order to use your home loan to consolidate your debt, there needs to be equity in your property – that is, the difference between the value of the property and the amount owing. If you have equity in your property, you may be eligible for a further loan against the property. You could do this with the bank that issued the home loan, or by switching home loan providers.

When you use a home loan to consolidate debt (lenders often refer to this as “refinancing”), the key is to pay off the amount borrowed as soon as possible. You don’t want to stretch the debt over the life of the bond, because that would result in you paying a great deal more in interest.

When you apply for a further bond to consolidate debt, Penwarden says the lender will look at all household income and expenses – including the costs of servicing existing debt. If your budget is stretched to the limit by existing debt commitments, the lender is unlikely to grant the application.

“However, if the client can demonstrate that the debt consolidation exercise will improve the household’s cash flow and hence make the mortgage loan comfortably affordable, that may be taken into consideration in our credit decision,” Penwarden says.

Beware the extra burden

Whichever way you look at it, a debt consolidation loan is a loan, so you must approach the product with caution. The experts agree that it’s no quick fix; it will cost you in the long run. Once you’ve obtained one of these loans, don’t take on more credit.

“Think carefully before taking on any additional debt, including a debt consolidation loan,” Hannalie Crous, the head of credit at First National Bank Retail, says. While consolidation can improve affordability, it is only advantageous if you use the additional cash flow to improve and consolidate your financial position, and if you refrain from borrowing after consolidation, she says.

Jan Moganwa, the chief executive of customer solutions at Absa Retail and Business Banking, says that while debt consolidation may look like a quick fix, you must remember that it usually means longer repayment periods and invariably, higher effective interest payments over the entire term of the loan.

“And, if debt consolidation is in response to financial stress, you need to exercise prudent financial discipline to sort out the problem,” Moganwa says.

Alfred Ramosedi, the group executive for sales and marketing at African Bank, says consumers need to guard against running up additional debt while paying off their debt consolidation loan. Similarly, if you agree to a consolidation plan but fail to meet your monthly repayments, the result will be “credit damage” [an impaired credit report] and penalties, he says.

Over-indebted?

When a debt counsellor has found you to be over-indebted and taken you into debt counselling, you are prohibited (in terms of the National Credit Act) from taking on any new debt, with the exception of a debt consolidation loan for the specific purpose of settling other debts.

Ian Wason, the chief executive of the debt counselling company DebtBusters, says that, to his knowledge, debt consolidation loans to over-indebted consumers “have never been done or tested”, suggesting that the market is reluctant to offer such a product to over-indebted consumers.

Wason says the average consumer with debt has five credit agreements and many could benefit from consolidating their multiple monthly payments into one monthly payment, if only from an administrative point of view. “It also means that consumers have a much better handle on how much money they owe in total,” he says.

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