Managing your debt position is one of the most important personal finance responsibilities you need to face. Debt consolidation is a common debt management strategy used to alleviate debt-related burdens, let’s explore the pros and cons of such a strategy.
What is debt consolidation
In essence, debt consolidation is the practice of taking multiple debts and consolidating them into a single debt. This will alleviate the burden of managing multiple repayments and their varying interests.
How to do it
It is common for people who have credit card debts, car loans or personal loans to refinance their home mortgage with additional funds cash-out to repay these loans. If you have already repaid down some of your mortgage debt, you can refinance for a new loan at maximum Loan-to-value ratio such that funds can be drawn as cash additional to those used to repay your last loan.
Advantages:
1. Lower interest rates
Mortgage home loans with fixed rate repayments generally have lower interest rates than personal loan, car loans and credit card debts, where you can save on interest in the short-term if you consolidate these debts into your mortgage loan. So if you are feeling some temporary financial pressure in the short-term, it might be wise to consolidate your debt.
2. Cash back offers
Banks and lenders often give promotions to people who refinance to them, which include cash back offers where cash incentives of up to $4000 (depending on the lender) will be rewarded to their new customers. This is an additional source of funds that you can use if you wish to quickly repay your loans.
3. Keep track of your debt
By consolidating your debt, you won’t be juggling multiple loans with their individual payments and interest rates. Instead, your one mortgage loan will be easier to manage and keep track of, with a singular monthly payment and interest rate applied.
Disadvantages:
1. Long-term costs
Mortgage loans have very long loan terms (often 30 years), meaning that despite lower interest rates applied, you could potentially pay more interest in the long-term, as personal loans, credit card debts and car loans have shorter life spans than mortgage loans, so:
If you are not feeling short-term financial pressure, it is not recommended for you to consolidate these short term loans into your mortgage loan as the trade-off of easing financial pressure now vs increased payment in the future is not worth it.
You can potentially reduce your long-term interest payments by using mortgage loan product features such as 100% offset accounts, extra contributions or redraws, consult your mortgage broker to see if that’s a viable strategy
2. Borrowing capacity
Refinancing your mortgage means your borrowing capacity needs to be re-examined. If your income level has reduced since the last time you applied for your mortgage loan, you might not be able to borrow as much as you need, therefore there are risks of not being able to fully consolidate your debts.
3. Your property value
Since banks and lenders evaluate how much they can lend you using loan-to-value ratio, which uses market value of your property, so if your property value has decreased since you bought your property, you may not be able to borrow as much as you need, again resulting in the risk of not being able to fully consolidate your debts.
Debt consolidation is a viable strategy to manage your debt obligations, but you must understand the costs and benefits associated with the strategy and tailor a debt management strategy specifically to your personal financial situation. Talk to your financial manager or mortgage brokers if you are unsure, always seek professional financial advice when necessary.
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