We are well into the new year, and the bills may be starting to bite. To relieve the pain some institutions are encouraging borrowers to bundle all their loans together into a "consolidation loan", which was once described by a cynic as "putting all your hard-to-pay loans into one impossible-to-pay loan".
A case can be made for this strategy because it enables you to enjoy an overall lower rate of interest but let's remember that lenders rarely come up with a new product just because they think it will be good for YOU. Usually their thinking is dictated by how it will benefit them ... in this case by increasing their market share.
Think about this scenario. The borrowers have a house loan of $350,000 at $1987 a month, a car loan of $25,000 at $635 a month, a personal loan of $20,000 at $425 a month and credit cards debts of $5000 requiring $200 a month. Total debt is $400,000 and overall payments are $3248 a month. If they borrowed $400,000 to consolidate all these debts into the housing loan the repayments should drop to $2270 a month, saving $978 a month - that's a whopping $225 a week.
While consolidation may be a useful strategy in some situations, you need to understand the principles involved in any borrowing. First, it is the height of financial irresponsibility to take out a loan with a term that exceeds the life of the asset purchased with the loan. This is why nobody in their right mind takes out a 30-year loan to buy a car.
If financial troubles are caused by bad money management, consolidation will often lure you into deeper trouble. The example assumes that our borrowers are foolish enough to consolidate all those loans into one 30-year loan at the current rate of 5.5 per cent. Sure, this frees up $225 a week - but where will that money go? In almost every case it will be spent, and the credit card debt will start creeping up again.
In a year or so the couple will probably be having trouble meeting their repayments again, but now their position is worse, as their home loan balance has gone from $350,000 to $400,000, leaving them even more vulnerable to future interest rate rises.
Instead of consolidating, a much better solution would be to call a family meeting, explain how bad the situation is, and figure out ways the family could cut expenses or increase income to produce $100 a week. If that extra $100 was applied to speeding up payments on the credit card, and no further expenses were paid on the card, it would be paid out in under a year. That's a big if, but once you learn this habit it is surprising how easy it becomes.
Once the credit cards were paid off, the $300 ($200+$100) no longer being used to pay the credit card could be added to the $425 being used to repay the personal loan. At a repayment rate of $725 a month it would be paid off in a further 18 months.
Finally, once the personal loan is paid off, the $725 a month longer needed for those repayments could be used to speed up the payments on the car loan.
In less than four years the only debt remaining would be $310,000 on the house. Not only that, but over those four years our couple would almost certainly gradually become good money managers, and they would be able to use the $725 a month no longer needed for servicing other debts to increase their home loan repayments. Total payments would increase to $2712 a month, which would reduce the time needed to pay off the home loan to less than 15 years. The combination of strategies I've outlined has moved the family from a parlous financial situation into a healthy one, with this couple totally in control of their finances and well ahead with their mortgage payments.
Most financial problems are caused by ignorance or poor money management. The above example shows two strategies: one leading to wealth, the other to disaster. The one that leads to disaster looks attractive at the start, but breaks a fundamental principle of borrowing. Now you know why so many spend their lives in debt.
Noel Whittaker is the author of Making Money Made Simple and numerous other books on personal finance. His advice is general in nature and readers should seek their own professional advice before making any financial decisions. Email: firstname.lastname@example.org