Debt consolidation is where many loans are combined into one.
The most common circumstance is where multiple unsecured debts (such as personal loans & credit cards) are combined into a single loan to reduce outgoing payments. The single loan is generally secured by residential property. For smaller loan amounts they could also be combined into a single personal loan.
As a general rule when combining debts secured by your home you’ll want to ensure that the total debt is less than 80% of the value of your home to make it worthwhile.
There are a number of reasons to look at consolidating multiple debts into one loan.
If the debts are secured by residential property the interest rate will be significantly lower than for unsecured loans (especially credit cards). This can result in significant savings in terms of interest paid.
This is partially due to having a lower interest rate, as well as being able to pay the debt off over a longer term.
It can be more convenient for some borrowers to just have one regular repayment to worry about rather than juggling multiple debts.
In order to consolidate debts into one loan there’s a few general requirements. Notably these requirements vary from lender to lender which is a key advantage of using a mortgage broker.
Debt consolidation is not always worthwhile.
If the value of the debts exceed 80% of the property’s value it is less likely to be worthwhile consolidating. This is due to the additional charge of mortgage insurance that will likely be incurred. There may be additional charges involved if you need to consolidate with a different bank.
It’s also important to realise that you’ll often be extending the time to pay off the debts. Most home loans are paid off over 30 years, whereas car loan and personal loans generally have a 5 year term. If you’re looking at debt consolidation for this purpose be aware that the main reason why payments are significantly lower is due to paying them off over a longer time frame. The interest rate has a lower impact in these circumstances than many people think.
Finally, be careful when combining debt that is tax deductible (often the case when looking to consolidate business debt). It’s generally advisable to have the deductible debt as a separate loan split to make it easy for your accountant at tax time. We always recommend our clients seek advice from their tax professional before consolidating debt in these instances.