Tidying up your debts with a loan
Interesting fact: the three BIGGEST reasons for taking out a personal loan are
- To buy a car
- For home improvements
- To pay off existing debts – such as loans.
The third is called debt consolidation and it can be a very bad or a very good idea.
Many people decide to consolidate because their finances are not just in a mess, but are scattered all over the place.
They’ve a credit card debt, overdraft, a car loan, and maybe another personal loan.
They’re probably paying too much interest on some of these, and the plethora of payments makes it hard to keep on top of things.
It also increases the risk of missing payments, so incurring penalties.
What better than to take out a new loan and pay all the old ones off?
WELL IT DOES have the virtue of forcing the badly organised to start adding up all their outgoings.
But there are some important things to understand here. Obviously you want to ensure that your new loan is at a lower rate of interest than your old.
Understand the difference between secured and unsecured loans.
A secured loan will almost certainly have lower interest, can be over a longer period and you can borrow much more (up to £100,000 or so).
But it’s likely to be secured against your house. The phrase ‘Your home is at risk if you fail to keep up with repayments’ can start to sound very scary.
If you MUST borrow against your house, consider extending your mortgage instead.
You’re dealing with your existing lender, you’re not giving another party a claim on your property and you may even get a lower rate of interest.
Unsecured loans are far safer, though you WILL pay more. Read the small print.
Are there penalties if you want to pay the loan off early?
Do you know the difference between the interest rate and the APR? The latter is the actual cost of the loan and is invariably higher than the simple headline rate of interest.
A word of warning. Go online and you will find hundreds of websites offering to ‘consolidate your credit’ into one tidy bundle.
They’ll typically compare your current repayments with your repayments should you refinance with them.
But the monthly repayment figure is MEANINGLESS Unless they mention the interest rate, the term of the loan and how much of the capital you’re paying off each month – it’s no good slicing your repayments in half if your debt keeps on growing.
Look at all the figures. Grasp the difference between capital (or principal as it’s called in the US) and interest.
Let’s take an extreme example – though it’s no worse than some of the loans people take out.
I have a parcel of debts, totalling £1000 and my repayments come to £75 a month.
So I borrow £1000 at 20% per annum, and I have to repay £1200 at the end of the year. Each month I have to pay £15 to the loan company.
At the end of the year I’ve paid £180 … and my debt stands at £1020, because I’m never eating into the capital.
You CAN cut your repayments to make monthly budgeting more manageable but it ALWAYS means you pay more in the long run – and at some point you HAVE to repay your debts.
Which brings us to the BIG one.
You cleared all your debts with your new loan and now you have a clean slate. But have you changed your spending habits?
After all, the reason you GOT in debt is because you weren’t too clever at managing your money.
Change the way you see money, or you’re just going to start running up debt again … and you’ll end up deeper than before.
Debt consolidation is a good idea if it’s twinned with some financial discipline.
