Stay afloat

This edited extract from Paul Clitheroe’s book Free Yourself From Debt explains how you can escape the debt trap

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WATCHING A JUGGLER CAN BE fascinating entertainment – and they make it look easy. Have a go yourself and, if you’re anything like me, you’re bound to find it anything but simple.

Juggling multiple debts can be a similar story. Even if you’re dealing with a comparatively small number of debts, it becomes hard to keep an eye on everything at once and almost inevitably something has to give.

You start missing payments, or lose touch with the rate being charged, so you have no idea if you’re getting a good deal. Or it becomes more difficult to find the cash to spread across all the repayments. An unexpected bill can be the catalyst that sees the whole thing fall apart.

A possible solution is debt consolidation. This is the process of paying out multiple debts by folding all the balances into a single new loan.

With the right approach, debt consolidation can make your debts more manageable. And by folding several balances into one loan charging a lower interest rate, it can also reduce your repayments and generate savings on interest and other fees and charges.

But it is very important to understand that debt consolidation is not the quick fix touted by some unscrupulous lending organisations. Problem debt is a complex financial issue and anything claiming to offer an overnight solution is almost guaranteed to leave borrowers worse off.

Like so many aspects of debt management, debt consolidation is an option that should be approached with care.

Making it work for you

There are essentially three main ways to consolidate debts. The first is to pay out credit card balances using a balance-transfer deal. Alternatively, you can pay out a range of debts using a personal loan. Lastly, if you are a home owner with some equity built up in the property, you can fold several debts into your mortgage. (See “Consolidation Options” at right for the pros and cons of each of these.)

Regardless of which option you choose, there is not much point consolidating debts if it doesn’t save money and that makes it essential to crunch the numbers to see if it will put you in front financially. Start out by gathering all the paperwork for your various debts – the loan statements will show the current rate you are paying, your regular repayments and hopefully any other fees and charges.

It’s easy enough to add up the regular repayments but when it comes to working out the long-term interest cost of each debt, it can be helpful to use the online calculators on the government’s MoneySmart website (moneysmart.gov.au).

Alternatively, if you use a broker (stick with a reputable outfit), they should be able to calculate the possible savings debt consolidation may provide.

Let’s work through an example to see when consolidation can generate worthwhile benefits.

SCENARIO 1

Folding debts into a personal loan

We’ll assume Sue has three credit cards which are all maxed out. One card has a debt of $3000 charging 17% interest, another has a balance of $2500 at 19%, and the third has $3000 owing on it at 16%. So all up she owes $8500.

Sue only makes the minimum card repayments (worth 2% of each balance) and together they total $170 a month. At this rate it will take her over 25 years to clear the debt, by which time she will have paid almost $16,200 in interest – more than double the value of the original debt. Note, too, this figure is based on the very optimistic assumption that Sue makes no additional purchases with the cards.

A simple and straightforward strategy that would let Sue reduce her overall interest bill and clear her debts within a definite time frame is using a personal loan to pay off all three cards.

Let’s assume Sue takes out a loan for $8500 charging 13% to be repaid over five years. In this case, her monthly repayment will be around $194 – not much more than the total of $170 she pays on the cards.

But the interest paid on the loan over the full five years will be about $3100 – a fraction of the money she would otherwise spend clearing the cards by sticking to the card issuer’s minimum repayment.

For anyone beleaguered by a raft of card debt, I reckon this is a very sensible strategy. The set repayments provide the discipline needed to pay the debt off in a given time frame, and that’s something you just don’t get with a credit card balance-transfer offer.

Moreover, there is no opportunity to add to the balance, especially if you cancel the cards that got you in trouble in the first place – which, I believe, is essential to do, lest you start racking up more debt on the plastic.

It is worth pointing out that in this example Sue makes big savings on interest charges, though on the flipside her monthly repayments will increase slightly. This is important because people often refinance their debt in the belief that it will lower their regular repayments.

In many cases it will, but you really need to look at the total interest cost over the life of the debt to see if you are saving money. The best way to save on debt is to pay it off quickly and, if you are switching a long-term debt for a shorter-term option, that can mean facing bigger, not smaller, repayments, even though you will save money overall.

SCENARIO 2

Folding debts into a home loan

One of the most popular approaches is rolling several debts into a home loan. The appeal here is that your mortgage is likely to charge the lowest rate of all personal debts – certainly well below a credit card or unsecured personal loan.

The downside is that home loans typically have a very long term and, as the interest meter is ticking away the whole time, the newly enlarged mortgage could end up generating very costly interest charges over time. This being the case, you need to approach this strategy carefully – yes, your regular payments will be reduced, but your overall loan cost can rise.

To see how this can happen, let’s say Steve has a $24,000 car loan (at 9%) and a $20,000 personal loan (at 14%), both with a term of five years. He also has a $200,000 mortgage with a term of 25 years (costing 6.5%). As the arrangement stands, Steve’s total monthly repayments are $2300 and, by the time the last debt is cleared, he will have paid out around $219,000 in interest.

If Steve consolidates both the personal loan and car loan into his mortgage, in the process increasing it to a debt of $244,000, his new monthly repayment will fall to around $1650. That’s a saving of $660 each month. On the face of it, Steve is in front. But instead of paying off the personal loan and car loan over five years, he is now repaying these debts over 25 years, and the lower repayment comes at the cost of a far higher long-term interest bill. In fact, Steve’s overall interest cost under this scenario will be around $250,300, which equates to $31,300 more than when the loans were each held separately.

Happily, there is a way around this issue, and it relies on using the savings on the monthly repayments to make extra payments on the new, expanded home loan.

In the above example, if Steve pays just $80 extra into the loan each month he can bring the total interest charge back to its preconsolidation level of $219,000. If you really want to make debt consolidation work for you, this approach is critical. Aim to pay off any debt used for consolidation as quickly as your budget will allow. If you don’t, chances are you will not be saving money at all.

Added costs and traps to avoid

Whether you choose to consolidate debts by using a balance-transfer deal, a personal loan or rolling the lot into your home loan, it is essential to allow for additional costs.

These can include fees and charges to take out the new loan or discharge the existing debt. Overlooking the impact of fees can cloud the true picture, so it’s really important to ensure that the whole deal leaves you better off.

There are some potentially very serious drawbacks to be aware of – and avoid.

Some of the more significant problems arise when using a home loan to consolidate debt. To begin with, rolling credit card balances and personal loans into a mortgage means transforming unsecured debts into a loan secured by your home. If something goes wrong and you are left struggling to make repayments, you could lose the roof over your head for the sake of what was once an unsecured loan.

Be aware, too, that consolidating debts into a home loan may leave you with fewer avenues for help in the future. Lender’s hardship programs, for instance, entitle borrowers to request a variation in repayments if redundancy, illness or other unforeseen circumstances make it impossible to keep up with loan repayments.

However, these programs are only available if the loan meets certain criteria. Most notably, if the home loan was taken out after July 1, 2010, a hardship variation is only available when the loan is for less than $500,000. If the process of debt consolidation pushes the value of your home loan above this threshold, you have to rely on the goodwill of your lender to suggest an alternative repayment plan.

If goodwill is a bit thin on the ground, the lender has the right to foreclose on the loan and repossess your home.

Underlying issues

A major problem I have with debt consolidation is that it fails to address why borrowers are struggling with debt in the first place. Even with the best plan in place, there is nothing to prevent a fresh build-up of debt on a newly cleared credit card, or further overspending fuelled by lower monthly repayments. This can be the start of a slippery downhill slope to serious financial trouble and the options for getting out of debt become far fewer and much tougher to live with.

When overspending or living beyond your means are the key reasons behind a need to consolidate debts, a sensible first option is to have a go at following a household budget.

This will put limits in place for everyday spending and a chance to regain control of your money. It could be worth a visit to a financial counsellor. For a full list of services near you, visit financialcounsellingaustralia.org.au.

Payday lenders – watch out!

Sadly, some industries prosper from the misery of others. Payday lenders offer short-term loans at ridiculously high interest rates, usually to those who can least afford the crippling terms and conditions. I stress the need to consider other options long before you sign a contract with a payday lender.

For years, fringe lenders in many states were free to charge whatever interest rate they liked. In August 2012, federal legislation was passed capping the total interest payable on small loans of less than $2001 and one year’s duration to a maximum of 68% of the amount borrowed, while on other credit contracts the interest rate is now capped at 48%. It’s amazing to realise this is an improvement on the old system.

The important thing is to consider other options. For example, borrowers who receive Centrelink benefits can request an advance on their payments. No-interest and low-interest loans – often called “microfinance” – are generally available for low-income earners who hold a Centrelink concession card. These loans are usually for small sums of up to around $3000. A starting point is the website of community group Good Shepherd – take a look at goodshepvic.org.au/microfinance.

If you are facing difficulty meeting utility bills for things like the phone, electricity or gas, call the provider and ask to speak to their hardship officers. They should be able to help you work out a plan to pay the bill in instalments.

No matter which course of action you take, make a payday lender your absolute last resort.

Book giveaway

Ten readers can win a copy of Paul Clitheroe’s book Free Yourself From Debt (RRP $19.99) published by Penguin Group Australia. Tell us in 25 words or less the best tip to clear debt. Send your entries to This email address is being protected from spambots. You need JavaScript enabled to view it. or Free Yourself from Debt, Money, GPO Box 3542, Sydney, NSW 2001. Entries close March 5, 2013.

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