Debt consolidation loans combine a number of smaller debts into one loan. This has the benefit of reducing the number of payments to only one (if all debts combined) and reducing the minimum monthly payment (if consolidated into a loan with a lower interest rate. However, while these loans might seem easy to use, there are multiple benefits as well as disadvantages in consolidating your debts into one loan. In this article we look at the pros and cons of these loans in the Australian environment.
What is A Debt Consolidation Loan?
The debt consolidation loan works basically on an organizing principle. What this means is that if, for instance, on has payments due to various creditors, the debt consolidation process entails that the person can take out one loan of a larger amount in order to pay off the smaller creditors. In that case, the only payment remaining will be that of the single large creditor. This makes it easy for the user to organise his/her finances and provides an enormous psychological as well as financial boost.
The aim in opting for a single debt consolidation loan is to lower the interest rates. So for instance instead of having an $8000 total debt divided into multiple smaller fragments each with a separate interest rate, one can now avail of a single lower interest rate on the entire amount. When short of cash, many Australians turn to their credit card to meet the deficit. However, with an interest rate that can be as high as 20% this is not a cheap option. By consolidating your debt, the interest rate should be reduced and therefore the overall minimum monthly payment should be more manageable. An increase in administration efficiency as well as ease of monthly payment is the key reason for the popularity of debt consolidation loans.
The one big advantage of debt consolidation is that it is not a settlement option. Rather it is a consolidation scheme. What this implies is that there is no direct negative reflection on your credit score. This in turn reduces the chances of one facing financial hassles later on when the time comes for subsequent loans.
Pros of Debt Consolidation
The key benefits of the debt consolidation model are as follows:
A Single Payment: As opposed to the multiple payment model (with many debts and separate minimum payments), the first and primary benefit of debt consolidation loans is that there is a reduction in the number of creditors. This makes it easier to manage as the transactions are now between two parties instead of multiple parties. For many this is one of the biggest steps towards reducing financial stress. Since there is just one transaction that needs to be tracked, the debt consolidation model offers the dual benefits of relieving financial stress and organising your monthly transactions.
- Lower Interest Rates: The first advantage of this particular type of loan is a lowered interest rate. This is the case, however, mainly of secured loans rather than unsecured ones. Secured loans are those that are levied against property or cars or any such title deeds. With these types of loans,
there is a certain security that the creditor experiences. Hence, not only is it easier to secure the loan but the interest rate itself is substantially lowered. In the process of repaying the loan, this amounts to a lesser monthly financial burden. Secured loans, however, carry their own psychological burden since the pledge is of something worthwhile such as a car or real estate.
- Lower Monthly Payments: Instead of paying multiple debts every month with individual high interest rates, the single payment model makes sure that the monthly payment is lowered significantly.
- Possible Credit Rating Improvement: Since the debt consolidation model replaces multiple loans with one single loan, there are chances that the reduction in interest payments actually reflects well on your credit rating. This is invaluable for future financial transactions.
Disadvantages of Debt Consolidation Loans
While there are many benefits of the debt consolidation model, there are also a number of disadvantages that are associated with this arrangement. These are:
- Losing Assets: One of the primary and major disadvantages of the debt consolidation process is the possibility of loss of assets. In most cases in Australia, the bank or other approved agencies lend out money against the pledge of property or assets. These are called secured loans and while they are the easiest to get, they also carry with the possibility of lose of assets in the event that you default on your loan.
- Risk of Greater Debt: The other disadvantage of debt consolidating in Australia is the risk of falling into even greater debt. For instance, let us take a situation where the interest rates are 9% on an $8000 loan. If one is unable to pay the required amount by the end of the month, the interest rates compounds at the end of two months and so on and so forth till the debt becomes insurmountable. This is a potential hazard for everyone who opts for loans
For those who are consolidating debts due to the inability to manage their money in the past, reducing future temptation is a must to ensure the effectiveness of the debt consolidation strategy. For example, if the source of your debt was multiple credit cards, it may be time to cut them up. This will avoid you falling into deeper debt in the future. The best and most effective way to get out of debt and stay out of debt is by changing your habits. Living on less than you earn, working an extra job or cutting out unnecessary expenditure for additional funds to pay down loans.
The way you get out of debt is by changing your habits. You need to commit to getting on a written game plan and sticking to it. Get an extra job and start paying off the debt. Live on less than you make.
3. Longer Time for Payoffs: While many might see this as good news since it initially lightens the financial burden, the fact that the larger loan taken to consolidate debts stays around for longer is a stress in itself. Also, there is the potential that you will pay more interest over the long term as you may have converted a short term loan to a long term loan. The key to address this issue is to pay off as much as you can every month and not just the minimum payment amount. This ensures that the debt gets paid off as quickly as possible with the minimum amount of hassle. Also by paying your debt off in a prompt manner, your credit rating will improve and this will potentially improve your options should you require a loan in the future.
While debt consolidation is a well organised plan for those who have multiple debts to settle, it is accompanied by a fine balance of pros and cons. Even though the Australian census has found that those who avail of consolidation practices pay off their loans fairly quickly it is not without making some adjustments in the daily life patterns. Moreover, it is worthwhile to remember that not everyone is eligible for a loan. Hence, possibly the most prudent situation in cases of financial transactions would be to avoid falling into debt in the first place. While debt consolidation loans are always an option, the scenario for their need is possibly not optimal in the first place.
Please note the above is provided for information purposes only and is not intended as advice. It has not taken into account your personal circumstances and objectives. You should seek the advice of your financial planner, accountant or other professional before implementing any of the ideas or concepts outlined in this article.