More and more South Africans are considering consolidating their debts into one affordable debt with an easier repayment plan. The credit market has taken notice of this and subsequently started marketing consolidation loans to South African consumers, where one essentially borrows from a certain creditor to pay off other creditors.
Even though consolidation loans are allowed by the National Credit Act, there are several misconceptions regarding these agreements which often blind us.
The first misconception is that a consolidation loan is a debt management technique. This could not be further from the truth. A consolidation loan is not a debt management technique. It is a separate credit agreement, with its own qualifying requirements and costs, though it is intended to settle some of your debts. You may think of a consolidation loan is “borrowing from Peter to pay Paul”. What is effectively happening is that you are simply moving your debt around, but that does not mean that you have managed your debt in any manner nor does it necessarily mean that your debt will become cheaper.
Furthermore, some credit providers will pay out a consolidation loan directly to you, as opposed to paying off your debts directly. This means then that as a consumer, you know that the money that has just been deposited to your bank account is meant to settle some of your debts, however as human behaviour would dictate, settling your debt becomes a second priority once the money is in your bank account. We start off by taking out our family to a nice restaurant, filling up the petrol tank of our cars, getting that one little electronic gadget we have always wanted and very soon the funds are spent on other things other than paying off your debts.
One needs to be prepared to pay off the consolidation loan for longer than it would have taken them to settle their debts individually as well. If, for instance, one had a credit agreement that would be paid up in 6 months, another in 12 months and the last in 18 months, consolidating these agreements may mean that one may have to pay the consolidation loan itself over a period of 24 months or longer. This is because consolidation loans are normally stretched out over a longer period of time to enable the consumer to effectively pay less than the sum of the total monthly debt repayments.
Furthermore, consolidation loans tend to be more expensive than paying off your debt individually. Yes, you may get a lower interest rate than the average of your current credit agreements, however since you will be paying the consolidation loan over a longer period of time, the lower interest rate will compound over a longer period of time thus ultimately leading to you paying more than what you would have on your original credit agreements.
The other unexpected disadvantage of consolidation loans is to give the impression that your debt is actually reducing. When we see that some of our credit agreements have been settled, we automatically think that we don’t have as much debt as we used to have. We then start taking more debt under the illusion that we don’t have as much debt as we used to have. This is obviously not the case because we just took all smaller amounts and consolidated them into one bigger amount. One could therefore unintentionally fall into this trap and invite heaps of debt into their lives.
It is would be wise not to take out a consolidation loan with the idea that we are managing our debt. Other than just making your debt a bit easier to pay through one instalment, there isn’t much benefit to taking out a consolidation loan.