I’d love a dollar for every time a client asked me about debt consolidation. Let me tell you I’d be thousands richer!
Even though the idea of debt consolidation is quite simple a few people have some trouble getting their head around the concept.
In this article I’ll be explaining what debt consolidation means when you use a home loan; then we’ll look at how to work out whether it’s worthwhile consolidating your debt under the umbrella of your home loan.
Debt Consolidation – What Does it Mean?
Debt consolidation is simply the process of combining all of your non home loan debts into one all encompassing loan. This includes loans like car loans, personal loans, credit cards and store cards.
The idea is twofold.
- Manage your repayments by only having to make one monthly repayment.
- Saving money.
Let’s look at these points one by one.
First, only having to make a single monthly repayment instead of 4 or 5 certainly makes a lot of sense. The more individual debts you have the more likely it is that you might forget to pay one of them on time.
Late repayments usually means that you’ll be hit with a late payment fee or, worse still, receive a reminder call from the lender causing embarrassment. If you make a habit of late payments it could spoil your chances of having a loan approved in the future. So, all in all, managing your repayments makes complete sense.
Second, if you can save money in the process it makes life a lot easier. For instance, say you find a bank offering a credit card at a reduced rate of interest so you can transfer all your credit card debt across. This is a very attractive option and one which many people take up in order to reduce their monthly commitments.
Sometimes, you can combine all your non-home loan debts into one single personal loan which has a lower rate of interest which, once again, helps you reduce your monthly repayments.
Both of these options are a great way to manage your money wisely and save you cash in the process. There is another opportunity here too. If you are able to make the same repayment into your lower interest rate loan, you will pay it off a heck of a lot sooner and save even more money! I’ll show you an example later.
But, by far the most popular way that most people seek to control their personal loans and credit card commitments is to combine them with their home loan. As you probably know, home loans are far cheaper than personal loans or credit cards so you can take advantage of the lower interest rate and a longer term to keep your monthly commitments will in check.
But there is a trap here too!
Okay, let’s look at how a home loan can make debt consolidation easier.
Say you have an existing home loan of $300,000 and you have two credit cards, one personal loan and a car loan with total repayments of $3007 a month, made up as follows.
Home loan: $2085.
Credit Card of $7000: $210.
Credit Card of $3000: $90.
Personal loan of $12,000: $267.
Car loan of $20,000: $355
Total: $3007
Now, if you combine the credit cards and personal loans which total $42,000 and wrap them into a total home loan of $342,000, the required monthly repayment would be $2376.17. This simple debt consolidation process would save you $633.83 a month!
This is an ideal example of how using a home loan to consolidate your personal debts can save you money and certainly make life a lot easier. But we have made a few assumptions here and I need to clarify a few points with you.
In the first place, a bank will only allow you to consolidate your personal debts in this way if you have sufficient equity in your house. A bank will generally not lend any more than 90% of its value. In other words if you own a house worth $400,000 the total maximum loan you will be able to obtain would be $360,000.
In the above scenario if the house was worth $400,000 or more, there would be no problems. But if the house was only worth $350,000 then the debt consolidation would not be able to be completed because the bank would not lend any more than 90% of $350,000. That is $315,000.
This is where many people’s understanding comes unstuck. Remember these rules of thumb.
- A bank will only lend up to 90% of the house’s value.
- You need to satisfy the income requirements before the loan will be approved.
- You need to demonstrate a good repayment history with all the debts you want to refinance. This means that if you have been late on one or two occasions within the last six months it is unlikely the bank will approve a debt consolidation loan like this.
- Some banks have a policy of limiting the number of personal debts you are allowed to consolidate. That’s why it is best to check out your chances with a mortgage broker before you start making an application.
One of the questions most commonly asked is:
Why did the bank declined my application when I showed them that the monthly repayments would be less than I’m currently repaying?
The answer is usually because there have been late repayments in the last six months. It doesn’t matter whether you can show that a debt consolidation package will reduce your commitments and make it easier to you to maintain a repayment schedule. Banks do not like bad credit histories and will not approve a loan where there has been a slow or late repayment history under any circumstances.
Of course, there may be exceptions to this rule but I generally advise everybody not to bother applying for a debt consolidation loan with the current lender if they are in this position.
Debt Consolidation Traps and How you Can Avoid Them and Save Possible Hundreds of Thousands!!
Now let’s look at the traps!
Although the above example demonstrates clearly how consolidating your debts into your home loan can save you a lot of money in terms of monthly repayments, you need to remember that a home loan is taken out over, usually, a long-term like 25 or 30 years.
Personal loans are normally paid off within 5 to 7 years, so consolidating your debts into a home loan, whilst being cheaper in terms of monthly repayments, can take your heck of a long time to pay off.
With this in mind, let’s take another look at the above debt consolidation strategy and work out a way to year two pay even less!
In the example above the total repayments were $3007 a month before the debt consolidation. Imagine if you could continue to pay $3007 a month into the consolidated home loan instead of the required $2376.
If you did this, you would reduce the loan term from 30 years to just over 16 years!
This means you would save nearly 14 years of repayments meaning a total saving of $399,168!!
Absolutely unbelievable but true nevertheless!
This is the real secret behind making your debt consolidation strategy really work for you, all you have to do is talk to your mortgage broker!
