Debt is unfortunately a reality of life. At some point or the other, we will likely end up juggling several debts at once, be it credit cards, personal loans, mortgages, etc, keeping track of payments and balances on outstanding debts can be a hassle. Debt consolidation is one method people can use to simplify things and maybe even get lower monthly payments in the process.
However, is it really a good idea?
The answer is maybe. Like all things, consolidating your debt into a single loan has its pros and cons, and depending on your financial situation can either help or hinder you. To help you decide if it is the right path for you, let’s walk through the advantages and disadvantages of this financial strategy.
What is debt consolidation?
For those who are unfamiliar with the term, debt consolidation works by merging all your debts into a single loan, generally at a lower interest rate compared to paying off each debt individually.
The process of consolidating debt with a personal loan involves using the proceeds to pay off each individual loan. Many lenders do offer certain specialised debt consolidation loans, however, a standard personal loan can work as well. Certain lenders pay off debt on behalf of the borrower, while others may disburse the proceeds so the borrower can make the payments themselves.
For example, let us assume that you have RM30,000 of credit card debt, split among three different credit cards, with each card having an interest rate of 20% p.a., and a monthly repayment of RM500. You will likely end up paying around RM6,798 worth of interest, as seen in the table below.
| Credit Card/Loan | Credit Balance | Interest Rate | Monthly Payment | Total Interest Paid |
|---|---|---|---|---|
| Credit Card 1 | RM10,000 | 20% | RM500/month | RM2,266 |
| Credit Card 2 | RM10,000 | 20% | RM500/month | RM2,266 |
| Credit Card 3 | RM10,000 | 20% | RM500/month | RM2,266 |
| Total | RM30,000 | RM1,500/month | RM6,798 |
Should you choose to consolidate your debt, you could get a RM30,000 loan at 10% interest rate p.a., and RM1,000 in monthly payments. This would mean that you will only have to pay around RM4,666 in interest over a slightly longer period of time.
If you choose to continue paying your consolidation loan at RM1,500, you will notice that your interest payment and term will be significantly lower.
However, if you choose to only pay RM500 a month, you can see that your interest will rack up by a huge amount over time. This is why you need to carefully work out the right amount to pay back your consolidated debt each month to ensure that you are actually saving on interest.
| Credit Card/Loan | Credit Balance | Interest Rate | Monthly Payment | Total Interest Paid |
|---|---|---|---|---|
| Consolidation Loan at RM1,000 | RM30,000 | 10% | RM1000/month | RM4,666 |
| Consolidation Loan at RM1,500 | RM30,000 | 10% | RM1500/month | RM2,954 |
| Consolidation Loan at RM500 | RM30,000 | 10% | RM500/month | RM11,762 |
Is debt consolidation a good idea?
Overall, debt consolidation is a good method for borrowers who have several high-interest loans running at once. However, it might only be viable if your credit score is high enough to prove that you are trustworthy enough to pay back this consolidated debt, which is a possibility if you are a student. If your credit score isn’t high enough to qualify for a lower interest rate, it may not make sense to consolidate your debts. In this case, having a student bank account and a credit card for credit-building purposes can help you build a credit record.
Finding a loan with the right terms may also be challenging. It’s easy to make a mistake and end up paying more after consolidating your loans.
It also may not be a good idea to consolidate your debt if you have yet to fix the underlying problems that have led to your debt in the first place. For example, if you have a tendency to overspend, a habit of going over your monthly budget, or a gambling issue, debt consolidation might be more trouble than it is worth.
Paying off multiple credit cards with a debt consolidation loan is not an excuse to run up the balances again, and can lead to even greater problems if not handled properly.
Advantages of debt consolidation
In summary, here are a few advantages that debt consolidation offers to borrowers:
Financial streamlining
Combining multiple outstanding loans into a single one will reduce the number of repayments and interest rates that you have to keep track of. This can help ensure that you do not get overwhelmed by the sheer volume of financial information you have to go over each month. This also means you will have a reduced chance of missing payments, thus leading to an improvement in credit score.
Reduce monthly interest rates
If your credit score is in good enough standing, you will likely be able to obtain a consolidated debt at lower interest rates, even if you already have multiple low-interest loans. Doing so can save you money over the length of your repayment term, especially if you do not consolidate with a long loan term. Remember that some debts come with higher interest rates than others. When consolidating debt, be sure to focus on what you are saving as a whole, and not merge every debt you have without reason.
Expedite payments
Considering the fact that consolidated debt will likely leave you with a lower interest rate on payments, consider putting the extra you save each month back into repaying your new loan. This can help to repay your debts even faster, thereby saving even more on interest in the long run. However, debt consolidation typically leads to more extended loan terms, so you will have to make a point of paying your debt off early to take advantage of this benefit.
Read More: Here’s How Debt Consolidation Can Help You Reduce Your Interest Payments
Disadvantages of debt consolidation
Debt consolidation is a great way to streamline your debts, but it does not come without its risks. Here are a few disadvantages that may apply to you:
May have some added costs
Taking out a debt consolidation loan may involve additional fees like origination fees, balance transfer fees, closing costs and annual fees. When looking for a lender to help consolidate your debt, make sure that you research and understand the true cost of each debt consolidation loan before locking yourself in.
Can raise interest rates if you are not careful
As mentioned previously, debt consolidation works by merging your loans and allowing you to pay them off at a lower interest rate. However, you could still pay more in interest over the life of the new loan. Your overall monthly payment may end up being lower, but interest will accrue for a longer period of time since such loans will often have very long repayment terms. To avoid this problem, budget for monthly payments that exceed the minimum loan payment, preferably with some of the money saved from your lower interest rate.
Additionally, if your credit score isn’t sufficient enough, you may not qualify for the more competitive rates. This means that you may be stuck with a rate that is higher than your current debts.
Doesn’t solve underlying financial issues
As mentioned previously, debt consolidation can help streamline debts, but it does not solve the issues that led you to debt in the first place. There is a very good chance that you may end up in deeper debt even after consolidating if you have not worked towards fixing these underlying financial issues. You need to develop good financial and spending habits in order to take full advantage of debt consolidation.
