Do the maths before consolidating your debts

39% of people are in arrears for loans

12 July 2019 - 06:17
By Mxolisi Siwundla
Picture: 123RF
Picture: 123RF

Out of every 100 people in South Africa with some form of formal debt, 39 of them are in arrears on at least one of their debt accounts (National Credit Regulator, 2017). Additionally, millions of people use debt to fund life’s necessities like food, school fees and clothing.

The idea of consolidating multiple debts into one account is becoming an increasingly popular option among those who are struggling to manage their debts. But are all debt consolidation products/plans beneficial to all consumers?

Explained simply, debt consolidation is when an individual combines their debt accounts into a single loan with a single balance and a single interest rate. The debt accounts being consolidated are paid off by the financial institution providing the debt consolidation product, leaving the consumer with one loan account that they have to pay off. 

The reasons why individuals go through the process of consolidating their debts include the following:

  • It reduces the number of debt accounts to one. This means that you will be dealing with one creditor instead of many.
  • Usually, it lowers the total monthly payment due. This is typically the biggest drawcard for why people opt for consolidation loans. For example, instead of paying R2,000 per month across five debt accounts, consolidation can mean paying R1,500 for one account (where the five are combined into one).
  • Since all financial companies charge some form of service fee to maintain your debt account, consolidation means that you only pay one service fee instead of many.

The most fundamental point to remember about debt consolidation plans is that they are loan products offered by financial institutions that are looking to make a profit from such products. As a result, you should assess it in the same way that you would any other debt account. At a high level, you should look out for the following terms:

  • Interest rate charges: How does the interest rate on the consolidation loan compare to those of the debt accounts you are consolidating? Often, consolidation loans are offered at higher interest rates than the average interest rate of your combined debt accounts. This is because the financial company providing the consolidation loan generally regards you as a consumer who has too much debt, and so the risk that you may be unable to repay your debt is high. Higher risk is compensated for through higher interest charges. 
  • Payment term: How long is the consolidation loan for? Debt consolidation loans will typically be over longer periods. However, the longer the term of a loan, the higher the total amount you will pay in interest and principal. If you can, negotiate for a reduction in the payment term (and rather pay a slightly higher amount for a shorter period). 
  • Service and admin fees: The monthly admin fees charged on the loan should generally be lower than the total admin fees of the individual debt accounts. 

And so to answer the question at the beginning: Not all debt consolidation loans are created equal. The responsibility lies with you, the consumer, to understand any loan agreement you sign. 

While debt consolidation loans relieve financial stress by making your debt accounts more manageable, they typically come at the cost of higher total payments at the end of the agreement.

Should you decide to consolidate your debts, keep in mind that the biggest weapon you have to defeat a mountain of debt is not simply bundling them into a single obligation. Your biggest weapon is a change in your financial behaviour. Without this, you run the risk of spiralling into a permanent debt trap. 

* Siwundla holds the financial risk manager qualification and is the investor relations and product analyst at CoreShares.