Critics of debt consolidation say it’s a “con” because it dupes you into thinking you’ve done something about your debt. In fact, your debt is still there – you’ve just moved it, they say. And the habits that landed you in debt probably haven’t disappeared either.
That may seem harsh, and it wouldn’t apply to people who have landed in debt due to retrenchment or reckless lending. But it would be true for many people in debt, and the remedy for them is behaviour change – such as learning to live on less – not more debt.
People who apply for a debt consolidation loan are either already financially stressed or in danger of going that way. And too many mistakenly expect debt consolidation to be a panacea for all their ills – when it’s more like putting a plaster on a serious wound.
“It’s a short-term fix, not a remedy for the underlying problem,” says Paul Slot, the president of the Debt Counsellors’ Association of South Africa.
The underlying problem is debt. And you can’t borrow your way out of debt. While that is true, it’s also true that there are savvy ways to deal with debt.
For example, your home loan is usually your cheapest form of credit. Depending on your credit profile, your rate is a little above or below the prime rate (currently 8.5 percent). On the other hand, credit cards, store cards and short-term loans incur interest of anything from 21 percent a year to 32 percent over six months.
For this reason, many people use their home loans to finance big-ticket items such as appliances or furniture, making sure they don’t stretch the repayments for such depreciating assets over the term of their bond. It would be foolish to take money out of your home loan to buy a R15 000 television set and spend the next 10 or 15 years paying it off. That would defeat the purpose of using such a cheap form of credit. Had you bought the TV from a furniture store, you’d be charged, for example, 21 percent interest over 36 months. So you score by using your home loan only if you use it wisely – and the same can be said for debt consolidation loans.
The appeal of debt consolidation is that it lets you simplify your affairs by using one large loan to pay off all your smaller debts. In this way, you go from having numerous creditors and credit agreements, with various terms, interest rates and monthly fees, to having one loan with one creditor and being liable for one monthly fee. Typically, your debt consolidation loan would provide you with a lower overall average interest rate over a longer loan term. This reduces your monthly debt repayment and eases your financial burden by giving you more cash in hand at the end of each month.
However, benefiting from debt consolidation requires financial discipline. “Without it, debt consolidation can actually make your financial situation worse,” warns Kevin Penwarden, the chief executive of SA Home Loans.
Consider this example from SA Home Loans. Let’s say you have a home loan of R600 000, a car loan of R120 000, credit card debt of R25 000 and a personal loan of R45 000. (See the table for the terms, interest rates, and monthly instalments applicable to each – link at the end of the article.)
You could use your home loan to consolidate your debt, provided you have sufficient equity in your property (the difference between the value of your home and what you owe on it). Assuming you do, you could take out an additional bond of R190 000 (the sum total of all your debts, excluding your home loan) and use it to settle your car loan, credit card and personal loan.
This would leave you with a single home loan of R790 000 and a monthly instalment of about R7 110, excluding fees, charges and insurance.
In this scenario, your monthly cash flow saving would be about R3 500 (the difference between what you were paying to service all your debt before consolidating it and what it would cost you after doing so). The interest saving would be about R1 260 a month – or R15 200 a year.
At a glance, it seems a great idea, giving both interest savings and better cash flow. So what are the risks?
Penwarden says despite the interest saving each month, the reason you pay R3 500 less each month is that, instead of repaying your debts over three, four or five years, you are now extending that same debt to 20 years (the notional period of your bond). This means that in the long run you will pay much more interest on that debt. In this case, an extra R150 000 in interest.
“The only way to prevent this is to pay as much of the ‘extra’ R3 500 into your bond every month as soon as you can afford to,” Penwarden says. The big danger, he says, is that if you suddenly find yourself with a “spare” few thousand rands every month, you may be tempted to spend the money. If you do, in no time you will be back in trouble, with no options left.
“You must avoid falling into the same spending patterns that originally created the predicament of over-indebtedness. We do not advocate using long-term debt (your home loan) to finance consumption expenditure (such as on food, which is often bought on credit).
“You should therefore use debt consolidation to save on interest, and not to reduce your longer-term monthly debt repayments,” he says.
The other big danger of using a home loan to consolidate your debt is the risk of losing your home if you default.
For people who are in danger of defaulting on their loan repayments, Penwarden says debt consolidation may be their only option.
“Certainly debt consolidation can be a lifeline and is preferable to a judgment or a repossession of your house or car. But, as with any other credit facility, this can be used wisely or unwisely,” he says.
* Debt consolidation. This is a process of “debt displacement” – the moving of debt from many different accounts into one account to save on interest paid or to help with cash flow. Savvy debt consolidation and debt management is all about reducing the amount of interest and monthly charges you are paying on your debts. (Source: www.bondbusters.co.za)
A debt consolidation loan can be secured (for example, a second mortgage) or unsecured (for example, a personal loan).
* Secured loan. A secured loan is one that is secured by an asset – be it your house or car – which can be repossessed and sold if you are not able to repay the loan. For this reason, you pose less of a risk to the credit provider, and therefore more favourable interest rates apply than those offered on unsecured loans.
WHO OFFERS CONSOLIDATION LOANS?
With the National Credit Regulator “on the warpath” and the threat of a R300-million fine hanging over African Bank for alleged reckless lending, credit providers have lost their appetite for debt consolidation, Ian Wason, the chief executive of Intelligent Debt Management (IDM), says.
The IDM group includes Bond Busters, which used to deal in debt consolidation loans. Wason says the company now refers consumers directly to the banks and mortgage finance providers such as SA Home Loans.
None of the big four banks offers a debt consolidation product as such. But all are major players in secured loans and increasingly in unsecured loans. So, if you have a good relationship with one of the big banks and your credit record is clean, you may qualify for a personal loan or an advance on your home loan, either of which can be used to consolidate debt.
Gavin Payne, the managing executive of retail risk at Nedbank, says Nedbank offers debt consolidation only via personal loans to consumers with good risk profiles and who pass the affordability criteria. “This is on request and not a product offering nor a service that is advertised,” he says.
Payne says Nedbank is of the view that debt consolidation is high risk because of the high levels of consumer indebtedness, “although it can be an effective tool for disciplined consumers to manage their debt and potentially reduce their borrowing costs”.
Kevin Penwarden, the chief executive of SA Home Loans, says there’s no reason to believe that people looking for debt consolidation constitute a high-risk group. “We help clients who have a credible debt consolidation proposition. Although we are unlikely to grant [a loan] where the client is not servicing existing debts or has defaults or judgments.”
Arrie Rautenbach, the head of retail banking at Absa, says the bank offers debt consolidation through “standard personal loan products”.
But Wason says debt consolidation loans are “almost impossible” to get because of the stringent affordability criteria and the interest rates offered by credit providers.
“If you’re paying 15 percent interest on your credit card debt, it doesn’t make sense to move that debt into a consolidation loan that charges 31 percent interest over 60 months,” Wason says.
“The other problem I have with debt consolidation is that, in these times, very few credit providers are settling the debt on behalf of the consumer.” (In other words, settling all the consumer’s debts with the various credit providers.) “And, unfortunately,” he says, “consumers can’t be trusted to settle the debts themselves.”
Penwarden says SA Home Loans used to offer clients a service whereby it paid your creditors directly. Instead of paying all the money to you, it would obtain your authority to settle your debts on your behalf. “However, this is not our standard practice. Primarily, we simply offer clients the ability to access the equity in their property via a further loan or switch loan,” he says.
DEBT CONSOLIDATION CHECKLIST
Before you opt for a debt consolidation loan, Paul Slot, the president of the Debt Counsellors Association of South Africa, says you need to first make sure that:
* It enables you to settle all your debts;
* It reduces your overall average interest rate;
* It reduces your monthly repayment – and that this repayment is reasonable, as a percentage of your income;
* The credit life insurance on the loan covers you for death, disability and retrenchment;
* The credit life insurance does not cost you more, and that the fees and costs of the debt consolidation loan (such as bond registration costs) don’t offset any interest rate advantage; and
* By taking out the loan you make provision for your financial needs for the next three to five years (for example, for school fees).
Slot says it is imperative that you use the consolidation loan to settle all of your smaller debts and refrain from ratcheting them up again. You may need to close some or all of those accounts.