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When I was in my twenties, juggling a number of credit cards with different interest rates, a bank manager suggested I do the smart thing and consolidate.
They pointed out that if I took out a personal loan, at a lower interest rate than what I was paying on my credit cards, I could use those funds to clear my credit card debt and have just one monthly loan repayment for a period of five years.
Essentially, what that bank manager was suggesting was debt consolidation. I didn’t have a car loan or a mortgage at that point so the personal loan I took out wasn’t that large, and as I progressed in my career, and my salary increased, I was able to pay it off sooner and probably ended up better-off overall.
While some companies may offer specific debt consolidation loans, any personal loan that advances you the proceeds at a low interest rate can be used to pay off existing debt.
These kinds of loans are generally unsecured loans—i.e. You don’t have to put up collateral against them—and will have a higher interest rate than a secured loan because the risk to the lender is greater.
But before you decide to consolidate, it’s worth researching whether it’s right for you. Let’s take a closer look at what debt consolidation involves.
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How To Consolidate Your Debts
You consolidate your debts by applying for and taking out a new personal loan. You use the proceeds of that loan to pay off your various existing loans—be it credit card debt or other personal loans. That leaves you with the one loan to pay off—ideally at a competitive rate.
So, for example, if you have a debt of $2,500 on one credit card, $2000 on another credit card plus a $7,000 car loan and $500 remaining Buy Now Pay Later debt, you could take out a new personal loan for $10,000, pay off all of those debts and have just one repayment a month.
Some companies may offer to pay back your existing debt for you but you may find it easier and cheaper to pay back the old debts from the new loan yourself.
Pros and Cons of Debt Consolidation
There are pros and cons to any financial product or strategy, including debt consolidation.
Pros
Convenience: There is something to be said for having one monthly repayment instead of three, four or five. It means you are probably less likely to miss a repayment and it can help with budgeting.
Lower interest rate: Given the interest rates on personal loans are often lower than most credit cards (assuming a good credit rating), you could end up with a much lower interest rate on your new personal loan.
Lower monthly repayments: You may also end up with lower monthly repayments as repayments are spread out over a new, and possibly longer, term.
Credit score improvement: A credit score or rating is a funny thing. While your credit score will be impacted by the application for the new loan, if you can show good debt hygiene by regularly meeting your loan repayments, this will eventually have a positive impact.
Cons
Could cost you more in interest over time: While the monthly repayments may be reduced you need to calculate whether or not you will be paying more over the term of the loan as the interest accrues over a longer period.
Higher interest rate: A lower interest rate than your existing loans isn’t guaranteed, especially if you don’t have an excellent credit rating. Don’t take out a new loan just for the convenience if the terms are not better than what you currently have.
More fees: New personal loans come with new fees which are in addition to the fees you are already paying on your existing debt. Depending on the type of personal loan you take out there could be loan application fees, late payment fees, monthly account fees and even early repayment fees.
May entrench debt habits: If you continue to use credit cards recklessly, and you don’t pay off your credit card balances in their entirety every month, you will still end up with more than one debt to pay off. My debt consolidation loan in my twenties only worked because I also canceled my extra credit cards and didn’t rack up additional debt on my remaining card.
The regulator ASIC’s Moneysmart website cautions against turning a number of unsecured debits into a single secured debt for which you put up an asset such as your home or car as security (via a secured loan).
“This means that if you can’t pay off the new loan, the home or car that you put up as security may be at risk. The lender can sell it to get back the money you borrowed. Consider all your other options before using your home or other assets as security,” Moneysmart says.
Does Debt Consolidation Hurt Your Credit Score?
Applying for a new loan will have a negative impact on your credit rating. But if having one loan repayment a month makes it easier for you to meet your regular debt repayments, that will eventually have a positive impact on your credit.
The National Debt Hotline says that it’s important to watch out for debt consolidation scams where you pay set-up fees but never receive the loan.
It says to never respond to advertisements for debt consolidation on social media or via unsolicited emails. To avoid companies that are not licensed in Australia search ASIC Connect’s Professional Registers to check your credit provider has been licensed, or phone ASIC’s Infoline on 1300 300 630.
Additional editing: Kevin Pratt
Frequently Asked Questions (FAQs)
Can I still use my credit card after debt consolidation?
Yes, you can use it, but if you continue to rack up debt that you can’t repay on time, you will still have more than one loan repayment each month—essentially defeating the purpose of your debt consolidation loan.
What are the disadvantages of consolidation?
You could end up paying more over the lifetime of the new loan, especially if you take it out for a longer term than your existing debt.
Is debt consolidation a good way to get out of debt?
It can help you get out of debt by reducing the number of monthly payments, and it may reduce your debt if the new debt consolidation loan is at a lower interest rate, but it won’t make your debt disappear. The success of debt consolidation is predicated on not accruing more debt, but switching to paying off just the one loan.
