You have a car loan, two personal loans, and two credit cards. You have been struggling to meet your monthly loan/card payments. Unable to pay card bills in full. Every month is a juggling act and there is hardly any money left at the end of month.
Then a colleague mentions about a “debt consolidation loan” and suddenly it sounds like the answer to everything. In this post, let us find out about debt consolidation and see when it can work for you and when it won’t.
What is Debt Consolidation?
The concept is simple. You have multiple loans and credit loans. Cash is tight and you are struggling to meet your monthly commitments. You take one big loan, ideally at a lower rate. Use the loan proceeds to pay off all the other loans and settle outstanding credit card bills.
This helps in three ways.
- Lower interest rate: Credit card outstanding carries cost of 36-42% p.a. A personal loan is cheaper at about 10-18% p.a. A top-up home loan or a loan against property may cost much less.
- Easier tracking: You must track and pay only one EMI instead of five.
- Flexibility with tenure: Your existing loans may have different tenures. Everything else being the same, a shorter tenure means a higher EMI. When the cash is tight, a bigger EMI is a problem. When you are applying for “debt consolidation loan”, you can pick a loan tenure and EMI that is a better fit with your cashflows.
Consider a simple example. You have Rs 5 lacs outstanding on credit cards. Your bank charges 36% p.a. on credit card interest. And charges 12% on a personal loan. You save 24% p.a. by taking a personal loan to pay off the outstanding credit card debt.
Credit is power. It gives you the power to spend money that you have not earned yet. However, if you are irresponsible with this power, you will soon find yourself in trouble again. A debt consolidation loan is no different.
When Debt Consolidation helps?
#1 Your credit card interest is crushing you. Almost any personal loan rate beats this. If the bulk of your debt is on credit cards, debt consolidation almost always makes mathematical sense.
#2 You own an asset to borrow against. Say gold, property, stocks, mutual funds etc. These secured loans will be even cheaper than unsecured personal loans and thus reduce the cost further. However, taking secured loans may be a longer process compared to almost instant personal loans.
#3 You have a decent CIBIL score. A good credit score will fetch you a better offer from the banks.
When Debt Consolidation may not work for you?
Strategies can look great on paper but can still fail with poor execution.
A debt consolidation ticks all the check boxes of a good strategy. You pay a lower rate and get more breathing space. However, you can still mess this up.
It is massive relief when you pay off all your existing cards and loans with a single debt consolidation loan. However, if this relief results in irresponsible spending on cards, then you will soon be back to square one. Hence, you must maintain credit discipline.
The banks will take their pound of flesh from your savings. This will apply to such loans from NBFCs and fintech as well. A high processing fee and ancillary charges will reduce the benefit of debt consolidation. The payment structure may be such that you cannot easily calculate the loan’s annual percentage rate (APR). All lenders must now provide you with the APR in the information sheet before the loan is processed. Pay attention to such details before signing up.
What should you do?
If you are struggling with debt, especially credit card debt, a debt consolidation approach will almost always make sense. If you can’t make it work for you, the problem lies with you, not with the strategy.
Learn from mistakes. You got into debt troubles for a reason. If you got there because of indiscriminate spending, then you must fix the underlying habit.
Additionally, any loan must be repaid. Hence, a debt consolidation loan is not the end of your troubles. Ensure that this loan is repaid. Don’t bank on hope. Be proactive. If you can see that even debt consolidation will not help, do explore other options. For instance, selling an asset rather than taking a loan against it. Try to increase income and cut down on discretionary expenses. Or taking a hand loan from a friend/family.
Always ask, “Am I solving my debt problem or just moving it?”
If it is the latter, the real work starts not with a loan application but with your monthly budget.