Managing Your Debts with Debt Consolidation
How did you get there?
Much like an unsightly car crash on a highway, too much borrowing can cause you to be the unfortunate victim of an inadvertent debt pile-up. Debt piling occurs when one avails too much credit either by taking out loans for various purposes or through excessive usage of credit cards.
In many cases, debt piling can start early in one’s life with education loans. As life progresses, this graduates to heavier financial obligations such as car loans, home loans and personal loans. Add to this the lure of easy spending through multiple credit cards and before you know it you’ve lost track of what you owe whom. Delays and defaults becomes the order of the day and poor credit scores threaten to haunt you for the rest of your financial life.
However, there is a way out of this unholy mess and it presents itself in the form of debt consolidation.
What is debt consolidation?
Debt consolidation is the clubbing of all forms of outstanding debt to form one total outstanding amount. This can then be paid off through one mode of finance, usually a loan. Many people find it hard to manage debt; either tracking or making payments. Some take on debt at a time when they are financially sound or assume a rise in income will help pay-off dues over time. However, unfortunate adverse financial conditions can affect credit servicing abilities. Still others may simply have availed credit at a time when credit was generally expensive and with more economical offerings available over time look to refinance loans.
Debt consolidation loans are a form of refinance whereby borrowers can source funds to pay off outstanding debt at a more affordable interest rate and save money.
Let’s consider this with an example.
Suppose you have outstanding debt attributed to an education loan of Rs.5 lakhs @ 10% p.a. payable over the next 5 years and a car loan of Rs.7 lakhs @ 11% p.a. also payable over the next 5 years.
The EMI on your education loan = Rs.10,624; EMI on your car loan = Rs.15,220
Total EMI = Rs.10,624 + Rs.15,220 = Rs.25,844
Total amount due over the next year = Rs.10,624 * 12 + Rs.15,220 * 12
= Rs.1,27,488 + Rs.1,82,640
Suppose you decide to go for a personal loan (i.e. a debt consolidation loan) of Rs.3 lakhs @ 15% p.a. for 5 years to pay off both these loans. This will translate into an EMI amount of Rs. 7137 per month and Rs. 85,644 for one entire year.
Thus, your savings over the next year by refinancing your existing loans with a debt consolidation loan = Rs.3,10,128 - Rs.85,644 = Rs.2,24,484
The same principle can be applied to outstanding dues on multiple credit cards. If you max out your cards or can’t pay dues in time, you will be charged interest on balances outstanding. By paying off these dues with another credit card or a loan at a lower interest rate, you save money.
What makes debt consolidation preferable and when?
Debt consolidation is a helpful instrument to free you from various forms of debt and their corresponding high interest dues. Credit taken for consolidating and paying off debt is generally on better terms and rates.
There are three major points that make debt consolidation positive for customers under multiple forms of debt.
- High interest rates can be done away with.
Debt consolidation is a positive move if existing rates of different debts owned by an individual are higher than the loan that he/she can to avail on a debt consolidation loan. This is subject to favorable terms and only when savings are substantial.
- High monthly payments can be avoided
Since high rates of interest can result in high EMIs, large monthly repayments can be avoided by consolidating and paying off debt via credit availed at a lower rate.
- Confusion caused by managing too many bills can be minimized
Having too many EMIs and/or bills to be tracked can result in missing payments or can even lead to non-payment. Consolidation of debt can eliminate this risk.
However, debt consolidation is not a magic wand that can eliminate all debt-related troubles with one touch. As with most financial instruments, debt consolidation, too, has its pros and cons. While it might work like a charm for few people, others might do better without it.
When should debt consolidation be avoided?
Although debt consolidation might sound like saving grace when faced with all kinds of debt trouble, it might not always be a good idea.
Here are a few situations wherein consolidation of debt might not be a favorable move.
- If you’re concerned about your credit score then debt consolidation might not be a good idea. Almost all debt consolidation instruments can impact your credit score negatively. However, if this hit on your score isn’t as bad as the hit it might have taken from non-payment on existing debts, it might be worth it. No pain, no gain!
- If you’re borrowing money against your house then debt consolidation might not be a preferred move since, although the rates might be much less, the loan would be secured against a very valuable asset - your house. Any failure to clear your debt consolidation loan would land you in bigger trouble.
- If you don’t alter your spending and repayment habits, debt consolidation might not work out very well for you. Debt consolidation may get you out of a pickle but poor financial management will always leave you in a jam. An unsavory one at that. Once you’ve paid off your dues, ensure you don’t let debt pile up again.
- If you have not done thorough research regarding debt consolidation, it might not yield the best results. Knowing all the pros and cons of trying to consolidate your debt is necessary to make it work for you. Understand all terms and conditions attached with the new as well as existing loans, especially interest rates and repayment schedules and pre-payment penalties. Do your math!
Decide better: Know the ups and downs
High interest rates can be done away with
Affects credit score
Poor financial management. Not your cup of tea!
High monthly payments can be avoided
If borrowing against house.
Too many bills can be minimized
If you still can’t decide if it’s the right option for you, seek help. Many financial counselors provide services with regards to consolidation and elimination of debt. Debt consolidation may sound like a charm, but to get it to work like one, you should know how to use it wisely. Research is the first step towards deciding to opt for it but proper application is the only way it can help you out of the vicious circle of debt.