The Ultimate Guide to Debt Consolidation and Refinancing

Debt Consolidation and Refinancing Guide

What is debt consolidation and is it right for you?

Are you juggling multiple debts? Does it feel like your income is being gobbled up by interest charges? Are debt collectors hounding you? It might be time to think about consolidating your debts. On the other hand, debt consolidation is just one of many possible money strategies and selecting the right one will depend on your specific situation.

This information page aims to provide everything you need to know about debt consolidation so you can make an informed decision about whether it suits you, your circumstances and financial goals. Please keep in mind that there are no one-size-fits-all solutions when it comes to money management, which is why this information is provided for general purposes only. If you would like to speak with a debt management specialist about a tailored solution, please contact us to arrange a free, no obligation discussion.

Debt consolidation meaning

Debt consolidation describes a money management strategy where multiple debts (credit cards, personal loans, lines of credit etc.) are combined into a single debt with one, simpler repayment. The aim of debt consolidation is to reduce your costs and make it easier to manage your repayments.

In the financial services marketplace, the term debt consolidation usually refers to debt consolidation loans, but it can sometimes be used to describe debt agreements. This resource will help you understand the difference.

When you finish reading this information, you will understand:

What is a debt consolidation loan?

A debt consolidation loan combines multiple existing debts into a single new loan. The aim is to reduce your repayments by paying out your existing debts and rolling their balances into a single, larger loan with an interest rate and repayment that is lower than the sum of the previous, separate loans. As well as saving money, having one loan with one repayment can also be easier to manage.

You may sometimes hear this process referred to as debt consolidation refinancing. Refinancing describes paying out an existing loan with a new loan that has more favourable terms, such as a lower rate of interest.

What sorts of debts can be consolidated?

Most unsecured debts can be consolidated, as well as some secured debts. Let’s talk about the difference between secured and unsecured debts.

Secured debts are those debts where the lender or creditor has a lien over a specific asset. A lien describes the lender’s right to keep possession of property belonging to another person until a debt owed by that person is paid off. A car loan is a good example of a secured debt. Should the borrower stop paying, the lender will repossess the car to recover their costs.

Unsecured debt describes a debt that is not secured by a specific asset. Examples include credit card debt, student loans, hospital bills, utility bills and other types of debt, including consumer debt, where the creditor has no asset over which to exercise a lien. For this reason, unsecured debt is considered to be more risky for the lender and tends to attract higher interest charges.

Debt consolidation is often used by people who have multiple high-interest unsecured loans, especially credit cards with high balances. The average credit card interest rate in Australia is nearly 17 percent per annum, which can cost the borrower thousands of dollars a year in interest charges.

What debt can be consolidated

Are there different types of debt consolidation loans?

A debt consolidation loan may be either secured or unsecured – and it’s important to understand the difference. In both cases, the aim is to combine multiple debts into a single, easier to manage repayment.

Secured debt consolidation loans

In the case of secured debt consolidation loans, the loan is secured by a specific asset, usually real estate. Having a property to use as security minimises the lender’s risk of losing money should the borrower stop making repayments. The process of taking out a secured debt consolidation loan is often referred to as mortgage refinancing.

Unsecured debt consolidation loans

With an unsecured debt consolidation loan, the lender has no right to repossess a specific asset should the borrower stop making their repayments. For this reason, unsecured debt consolidation loans usually come with a higher rate of interest than secured loans.

Let’s look at how secured and unsecured debt consolidation loans work.

Who qualifies for a secured debt consolidation loan?

Secured debt consolidation loans are intended for people who have a real estate asset that can be used as security for the loan. As we explained above, securing the loan with real estate, which may be a home or investment property, protects the lender from risk. Should the borrower stop making repayments, the lender has the security of being able to repossess the property to cover their costs.

Borrowers therefore need sufficient equity accrued in their property to secure the loan amount. Equity describes the difference between the market value of the property and the balance owed on the loan. For example, if Peta’s apartment is valued at $300,000 and her mortgage balance is $200,000, she has $100,000 in equity. Borrowers also need sufficient income to service the loan repayments.

Do you tick the boxes for a secured debt consolidation loan?

  • You have a property with enough equity to use as security
  • You have secure employment
  • You have enough income to service the loan

It also helps if your payments and bills are up to date and there are no defaults on your credit file.

What if you don’t tick the boxes for a secured debt consolidation loan? Can you still consolidate your debts?

If you don’t have a real estate asset to use as security, you may qualify for an unsecured debt consolidation loan. The qualification criteria for unsecured loans will differ from lender to lender. At MyBudget, we help all sorts of people in all sorts of situations.

Do be wary of lenders who promise quick fix solutions for bad credit. Some of them advertise fast or instant loan approvals. Their aim is to attract financially stressed people who feel like they have run out of options. Consequently, these loans represent increased risk to the lender and tend to have higher rates of interest. Depending on the conditions of the loan, it may in fact expose you to greater debt stress. The risk is that you may not be able to afford the repayments and that you are locked in to a contract and lender that is not motivated by your best interests.

If you are unsure whether you qualify for a debt consolidation loan, contact MyBudget for a free, no obligation discussion.

There are no financial problems that can’t be fixed through proper analysis and a realistic, workable budget plan.

Is debt consolidation right for you?

There are many factors that go into assessing the benefits of debt consolidation and it’s important to evaluate each situation on its own merits. Here are some factors that may affect your ability to qualify for a debt consolidation loan:

Does your credit file have black marks on it?

Borrowers who are behind in payments or have defaults on their credit file may find it difficult to get a loan at a competitive interest rate. If the interest rate is too high, there may be no benefit in refinancing.

Do you have enough income to make the repayments?

One of the common reasons people try to consolidate their debt is that their repayments have become unaffordable, often due to a change in their income situation. Being approved for a new loan is unlikely if you do not have sufficient income to service the repayments or your only form of income is a government benefit.

Do you have secure employment?

Some lenders are reluctant to approve applicants whose employment history or current work situation indicates uncertainty. This applies particularly to those who are self-employed, casuals or contractors, as well as people who have recently changed jobs.

Do you have a good history of making your payments on time?

Lenders prefer borrowers who pay their bills on time and save regularly. Good money habits demonstrate that your finances are under control.

If you don’t qualify for a debt consolidation loan now, it doesn’t mean that you won’t qualify for one later. Budgeting is a great way to get your finances back on track while you improve your credit score. Call MyBudget on 08 8215 7684 to find out more.

What are the risks of consolidating your unsecured debts?

When you take out a secured debt consolidation loan, you are converting your unsecured debts into a debt that is securitised by your home or other property. Should you fail to make the loan repayments, it is not just your credit score that is at risk. You could lose your home. For this reason, a debt consolidation loan is not recommended for anyone who has concerns about their income or job security.

Consider reviewing your financial situation with a money management expert. There may be alternatives to debt consolidation, including money management methods that improve cash flow, get creditors off your back and reduce debt stress quickly.

Should you consolidate all of your debts?

With mortgage interest rates at nearly record-low levels, it may be tempting to consolidate all of your debts into your mortgage to get a lower interest rate and smaller monthly installment. But when it comes to loan affordability, the interest rate is only one factor. Another important factor is the loan term. The loan term describes the amount of time over which the loan repayments will eventually pay off the loan principal in full. Mortgage loans usually have terms ranging from 15 to 25 years.

Given that loan interest charges are calculated daily, as the term of the loan increases so does the amount of interest you pay. This is due to the effect of compounding interest where interest charges are calculated on the initial principal plus accumulated interest over the term of the loan.

Bob, Bill and Ben get a car loan

Let’s look at three different scenarios involving a car loan and compare the effects of consolidating that debt it into a mortgage loan.

How to make a debt consolidation work for you

Ben’s costly situation proves that debt consolidation can be a good way to free up cash flow in the short-term, but it may also expose you to greater interest costs in the long-run. That’s why it’s important to pay off your debt consolidation loan as quickly as possible.

Budgeting is an important factor in saving money on interest charges by reducing debt more quickly. By analysing your finances and developing a detailed money map, you can identify areas to free up cash for debt reduction, which can significantly reduce your exposure to interest costs over time.

Budgeting is the only way to properly:

In the process of budgeting, you may also discover that a debt consolidation loan is not necessary or that the risks are not worth it. Budgeting allows you to look at your money problems from different angles and explore alternatives.

What are the alternatives to a debt consolidation loan?

People usually become interested in debt consolidation because their existing debt repayments are messy, unmanageable or too expensive. Perhaps your credit card balance has snowballed or you’ve fallen behind in bills or your income situation has changed. The fact is that nobody gets into financial problems on purpose. In most cases, money troubles are caused by life changes — divorce, illness, job loss, a business failure. Even positive events, such as having a baby, can result in money worries.

That’s why it pays to take the time to understand your financial situation fully before jumping into a new loan. There are no one-size-fits-all solutions when it comes to money issues and a good debt management strategy will take into account your specific situation, goals and priorities.

The first step is to create a long-range budget that takes into account all of your expenses, debts and income over a 12-month period. This is a great way to get to the bottom of your finances and explore all of your options. If a debt consolidation loan is right for you, your budget will reveal how much you can afford to pay off and how quickly. If not, your budget can be used to test alternative strategies.

Alternatives to debt consolidation

Talk to your creditors

Most creditors are willing to help with alternative payment arrangements. Possible options include an instalment plan, a break from payments or lower payments for a period of time. Having a budget in place shows creditors that you’ve “done the numbers” and are serious about fulfilling your commitments.

Pay your way out of debt

Once they start budgeting, many people discover that they can meet their existing obligations and pay down their debts using their current income without needing to take out a new loan.

Zero-interest balance transfer

If credit card debt is contributing to your debt stress, a zero or low-interest balance transfer to a new credit card may help to free up cash flow. It works by transferring the balance from one or more credit cards to a new card that has a zero or low-interest “honeymoon” period. Budgeting is extremely important to guarantee that you pay off the balance within the interest-free period and quit your credit card habits once and for all.

Borrow money from family or friends

Borrowing money from people you know is never easy, but it helps when you can show them that you have a workable plan in place and that your repayments to them are budgeted and affordable.

Formal debt agreement

A formal debt agreement is a legal contract between you and your creditors in which they accept an amount of money you can afford to pay over a set period of time. The consequences, however, are not dissimilar to bankruptcy and budgeting is extremely important to ensure that you fulfil your obligations. To read more about debt agreements, refer to the ‘What is a debt agreement?’ section below.

Sell your home

A good money management strategy will aim to protect your real estate assets, especially your family home. But there are times when selling makes more sense than refinancing, especially if your home is already under threat from being repossessed. Budgeting can help you make this difficult decision.

What is a debt agreement?

A debt agreement, also known as a Part IX Debt Agreement, is a legal contract between you and your creditors (the companies you owe money). It allows you to offer your creditors a reduced settlement figure based on a repayment amount you can afford.

Should your creditors accept your proposal, your debts will no longer attract interest and your payments will be consolidated into a single repayment for a fixed period of time, usually up to five years. Part IX Debt Agreements are administered by the Australian Financial Security Authority, a government agency.

It is important to recognise that entering into a debt agreement is considered an act of insolvency and that the consequences are not dissimilar to bankruptcy. Applicants also face the possibility of being forced into bankruptcy by their creditors.

If you do enter into a debt agreement, it is important that you have a budget in place to ensure that you have enough money to live, pay your bills and meet your debt agreement obligations.

Choosing a debt consolidation loan

There are literally thousands of credit providers offering debt consolidation loan products, from retail banks to niche lenders. It is important that you choose a competitive, suitable loan product as well as a trustworthy service provider motivated by your best interest rather than commissions.

When shopping for a debt consolidation loan, ask lots of questions!

The pros and cons of debt refinancing

Case study 1 – A clear case for debt consolidation

Like many couples, Sam and Leanne are juggling multiple debts and feeling the pinch. In addition to regular bills, living expenses and their home loan, they have a credit card and personal line of credit that they used to buy materials and equipment for their home hobby business, which they run in addition to their full-time jobs. Sam and Leanne’s multiple loans come to $2,520 per month, which includes $320 towards their credit card and personal loan. The couple are frustrated that this $320 is only just enough to keep up with interest charges, let alone make a dent on the balances. At this rate, they feel like they’ll never get ahead.

Sam and Leanne put a budget together, which they take to their bank to talk about consolidating their debts through refinancing. They are up to date in all of their payments, have a clean credit record, sufficient equity in their home and enough income to qualify for a debt consolidation loan. Their loan application is approved by the bank at the same rate as their original home loan (4.5% p.a.) with no application fee or establishment charges.

Their new loan balance is $420,000 and their new monthly repayment figure is $2,345. Their personal line of credit and credit card have been paid off in full, which has saved potentially thousands in interest charges, plus they have an extra $175 in their monthly budget.

Is debt consolidation always as easy as Sam and Leanne’s case?

Debt consolidation is rarely straightforward. There are many of possible factors that contribute to debt stress and it’s important that these are taken into consideration. After all, your goal should be to choose a debt solution that resolves the underlying cause of your problem, as opposed to briefly relieving the symptoms. You want to avoid the not uncommon situation where someone consolidates their debt only to end up in deeper debt and financially stressed yet again.

In the case below, you will see that Amy’s debt stress was caused by overspending and that taking out a new loan did not address the underlying cause of her money problems. Only through budgeting, did Amy learn to take control of her spending and live within her means.

Similarly, where a person is having trouble paying their debts, a debt consolidation loan may relieve the symptoms, but it may do little to solve the cause of their cash flow crisis. What is more, it may put their home at risk by securitising their previously unsecuritised debts. Unscrupulous lenders have also been known to offer loans to debt-stressed mortgage holders where huge penalties, hidden in the terms and conditions, are levied against borrowers for late or missed payments. The aim of these dodgy lenders is to force borrowers into foreclosure so they can repossess the property and gouge profits from the equity.

Case study 2 – Sometimes debt consolidation isn’t the solution

Based on a true story… When Amy got a bank loan to buy her townhouse, it came with a new credit card with an $18,000 credit limit. It was a pleasant surprise. Amy immediately started using the card for moving expenses, paint and renovations and new furniture and, before long, had maxed out the card. Feeling worried about how she would pay it off, Amy applied for a zero balance transfer to a new credit card. But instead of paying down the balance within the interest-free period, she went on a holiday with friends and racked up charges to the new and old cards, leaving her with total credit card debt of $25,000.

Feeling embarrassed, and after trying for months to get on top of the payments, she eventually approached her bank to ask about rolling her credit card balances into her home loan. Amy was disappointed to discover that the refinancing costs would come to thousands of dollars, plus the new loan would have a higher rate of interest and higher repayments because it no longer conformed with the bank’s standard lending criteria.

Amy confided in a friend who encouraged her to take control of her spending habits properly. With the help of MyBudget, Amy put together a budget, tightened her belt, took in a roommate for extra income and took out another zero-interest balance transfer. But this time, she cut up all her credit cards, including the new one. With a workable budget in place, Amy felt confident that she had the support and discipline she needed to live comfortably while she paid her bills on time and set aside savings that would break her reliance on credit cards once and for all. She paid off her credit cards in two years.

Further information

To find out more about tailored debt solutions, call 08 8214 4263 to make a free, no-obligation appointment with a debt management specialist.