What is a debt consolidation loan and how do they work?

Juggling repayments for multiple debts can be stressful and expensive, but you may have options to help get your debt under control.

Depending on your circumstances, a debt consolidation loan could be one solution. Consider these pros and cons, and what options are available to you, before you sign on the dotted line.

A debt consolidation loan – sometimes referred to as refinancing – could help manage debts with a single new debt. A consolidation loan pays off your current debts and could offer you more flexibility and certainty about your financial situation.

Depending on your situation, it could help you manage existing debts on the following things:

• Home
• Car
• Credit cards
• Personal loan, etc.

The eligibility criteria for debt consolidation loans can vary depending on the lender and your personal circumstances. If your total borrowed amount is quite high, you may find it more challenging to find a lender to consolidate all of your loans.

Lenders will offer different loan terms, but typically they range from one to seven years when arranged as a personal loan.

When you take out a consolidation loan, you pay off your other nominated debts using the funds from the new loan. You must then pay your lender off as agreed with interest – weekly, fortnightly or monthly.

You will usually need to nominate an account for your lender to debit your repayments from. That can be handy for you, too, because it helps ensure your repayments on the loan are not missed – just make sure you choose an account with available funds.

If you are approved for an unsecured loan, your lender won’t ask you for security, such as your home or other assets, before lending you the money. If you opt for a secured loan, this means you risk losing a nominated asset if you can’t meet the obligations of your loan contract.

Some people prefer a single regular payment and the probably lower overall interest than paying off each debt separately, however consolidating your debt can cost more if your interest rate or fees are higher. Consolidating your debt means you’re not trying to prioritise one debt over another. You can chip away at all debts at once and don’t have to manage multiple debts simultaneously.

Another bonus is that you’ll have a visible endpoint as to when you could become debt free. That’s a strong motivator to live within your means.

Some lenders may approve loans within a few hours depending on the circumstances. There are some fees to be aware of, which some lenders may or may not charge, including:

• A loan set-up fee
• Ongoing account administration fee
• Establishment fee
• Late payment fees
• Fees for using BPAY or non-preferred payment methods
• Early payment penalty fee
• For secured loans, a security registration fee.

You can use the comparison rate, which will factor in some of these fees and their impact on the overall cost of the loan, to help compare lenders.

Debt consolidation helps you to restructure your finances, but you’ll still need to control your spending to ensure you can pay it back.

Check the repayment schedule – how affordable and reasonable will it be for you to manage? If it’s not, consider discussing with the lender a loan contract and debt that is more aligned to your ability to meet the repayments. On the flip side, if you can make extra repayments on the consolidation loan, check if you’ll be penalised with an early repayment fee.

Your credit score may also take a hit when you use a debt consolidation loan. The tell-tale sign is the word ‘settled’ showing on your accounts. However, if you meet your repayments on the debt consolidation loan, that could boost your credit history. So, it’s a fine balance, but ultimately reducing your debt will usually help.

Some lenders may not allow you to consolidate your payday debts, defaults or credit arrears. Moneysmart cautions against signing with lenders that make unrealistic promises, are unlicensed, rush you or demand you sign blank documents yet won’t discuss repayments, for example.

If you default on your debt consolidation loan, or any other loan for that matter, your lender could pass you onto third party enforcement to help recover their costs.

Depending on your circumstances, you may opt to consolidate your debts, have a debt management plan or use balance transfer cards. It’s important to do your research to ensure debt consolidation is suitable for you and your circumstances.

Balance transfer cards could enable you to transfer a credit card balance to a card with a temporary low rate. This could provide you with time to power up your repayments to get ahead. However, it’s important to review the details of ongoing interest rates to ensure you do not end up in a worse financial position after the balance transfer rate ends.

Interest rates on consolidation loans can vary depending on your financial situation and the terms of the loan you’re approved for.

There will usually be a choice of variable or fixed interest rates. A variable rate means your repayment amount may increase and decrease over the loan term, whereas it won’t change with a fixed rate.

The term ‘personalised interest rates’ means they cater to your circumstances and credit history rather than offering you a standard rate.

As part of your due diligence, find out if the consolidation lender offers a lower interest rate overall than what you were paying with an average rate of your previous debts. Make sure you include the costs of all fees and you consider all other loan information to ensure you don’t end up in a worse position.

If you haven’t checked this, you could be paying extra for the convenience of a singular regular payment. For example, if you’re bundling your home loan into the debt consolidation loan, use Moneysmart’s mortgage switching calendar to check if it might be better to move to a different lender.

To be approved for a consolidation loan, some lenders will require you to be:

• Aged 18 or over
• A permanent Australian resident
• Earning at least $25,000 before tax per year
• Able to show a good credit history for the past five years
• Free from bankruptcy for the past seven years.

However, if you do not meet this criteria, there may be other options available. Often, these factors can help the lender determine the interest rate and terms of the loan they provide.

For an insight into your possible repayment plan, use an online consolidation calculator. If that looks manageable compared to your usual budget, apply directly to a lender online or by phone to start the application process. You’ll need documentation to verify your identity and income.

If you’re struggling with any of your debts, there may be hardship options available with your existing lender, so speak with them to see what might be available to you. In addition, you may be able to access financial counselling services who may be able to help you negotiate with your lender or credit provider. Moneysmart provides more information about financial counselling services and how they can be accessed.