Money

Debt consolidation

Updated: 05 Aug 2008
Debt-consolidation-hero

Introduction

Rolling all your debts into one easy low-interest payment sounds great. But there are some risks.

Be careful when restructuring your debt - some deals are much better than others, and there are alternatives.

We look at some of the options for getting spiralling debt under control.

Controlling your debt

Every Kiwi man woman and child owes on average $41,000 in mortgages and consumer loans such as credit cards and hire purchase. Some have no debt of course, but others are finding their debt overwhelming and are barely able to make the minimum monthly payments on their loans.

Bills.

Budget advisers and lenders are seeing clients who owe tens of thousands of dollars to multiple lenders, on top of what they owe on mortgages.

Margot King, marketing and products manager at financial services co-operative the PSIS told us: "It's not just a low-income issue, we are seeing people from all sorts of backgrounds and income levels coming to us."

So what can people do to get on top of their debts? One answer is debt consolidation, where you pool all your debts with one lender and only have one regular payment to make. But there are some pros and cons with it and it won't suit every borrower.

Debt consolidation

Debt consolidation will only improve your financial position if you cut the total cost of your borrowing. Debt consolidation shouldn't become a habit; the aim should be to pay off the debt and not take on new loans in the meantime. The best way to use this method of debt management is to cut the cost of borrowing while paying off your debt as quickly as possible.

You need to look at the causes of your debt and your ability to pay it off. Do you just need some breathing space or do you need budgeting advice to help you get your expenditure and borrowing under control? If you are struggling with debt and are already late with payments, replacing several lenders with one may buy time but won't necessarily solve your problem.

A number of lenders mentioned the need for the loan to be structured to improve the borrower's position. Non-bank lender General Finance said it was cautious about debt-consolidation lending unless it was confident that the applicant's debt resulted from unusual one-off circumstances. Otherwise it feared they would continue to build up debt after consolidating.

Several said that they would be aiming to help customers pay off their debts by offering various levels of counselling, discussion and ongoing monitoring. If you're having trouble paying your bills and keeping up with loan payments, it may be worth seeking advice from a budget adviser before diving into a consolidation loan. Many debt-consolidation lenders are cautious about lending to people who don't have steady incomes or who have had repayment problems in the past.

Where to go

Debt consolidation is offered by banks, credit unions, financial services co-operative PSIS, building societies, non-bank lenders such as Liberty Finance and GE Money, finance companies, and credit brokers such as Credit Express and Active Finance. (Credit brokers select loans for customers from a range of lenders including finance companies.)

  • Credit unions: A not-for-profit attitude and often lower rates and fees make credit unions and other financial co-operatives worth a visit. Credit unions are subject to a regulatory regime.

  • Banks: Banks are reputation lenders - they work under the Code of Banking Practice. Your bank has several consolidation options - personal loans, mortgage top-ups or low-rate credit cards. Make sure your bank works out all the options so you can compare them to get the best deal.

  • Finance companies: Best treated as a last resort. Interest rates and fees can be very high. Get advice before committing yourself from your local CAB, budget advisory service or local community law centre (see "More information" for details).

  • Credit brokers: Make sure you read and understand all forms you're asked to complete. Don't focus solely on the credit contract - you may be committing yourself to a formal relationship with the broker as well.


Case study

Struggling with debt

Stephen and Janine owed more than $40,000 and were struggling in a cycle of debt with bills, credit cards, default and disconnection notices. It got to the stage where they had no money for food. They were so desperate that in 2006 they turned to Credit Union South for help.

Its lending officer explained the credit union's debt-consolidation options. Stephen and Janine's interest rate would be a lot lower than their existing loans and they would only have one loan payment to make. A tight budget helped them cover food, petrol and other day-to-day costs. A savings plan was also set up for long-term goals.

Types of loans

The main types of debt-consolidation loans are:

Credit cards

Banks from time to time offer special low rates of interest on debt transfers to their credit card. This is mainly suitable for smaller debts from other credit cards or store cards totalling less than $10,000. It works best if you can repay as much as possible during the special-rate period.

Recently Kiwibank and BNZ were both charging 5.99 percent for six months on credit-card balance transfers to their cards. After six months the standard rate on the Kiwibank Lowrate Mastercard is 13.3 percent and BNZ Lite Visa's is 13.75 percent.

Make sure you check the standard rate on the card. You may not gain much by transferring debt if you end up paying 20 percent or more after the special-rate ends. You should also check the annual fees on cards and close your former credit card so that you're not paying fees on more than one card.

See our Credit cards report for more information about credit card rates.

Unsecured loans

These can be standard personal loans or specifically designed for debt consolidation. They usually have set repayment periods and set monthly payments. There are also setting-up fees, which can be $150 or more. There may be charges for repaying early.

Interest rates vary widely. Banks, credit unions and building societies usually have a set interest rate for this type of lending, although it varies from institution to institution. Kiwibank, for instance, charges a lower rate on consolidation loans than standard personal loans, even though consolidation lending is riskier. The bank said it aimed to work with "consolidation" borrowers to help them improve their financial position and to become profitable customers

Some lenders, such as finance companies, charge according to how risky they think the customer is. Rates start in the low teens but can be much higher; GE Money's customer enquiry line quoted rates ranging from 14 percent to 32.25 percent depending on the borrower's "profile".

Mortgages

These offer some of the lowest interest rates for debt consolidation. In July the cost of floating-rate mortgages from most lenders was less than 11 percent, while two-year fixed rates started at around 9.2 percent from the major banks.

Lenders may allow borrowers to increase their mortgages to consolidate other debts. Or you could switch your mortgage to a lender charging a lower rate of interest than you're paying now and increase the mortgage at the same time to pay off credit cards and other loans.

Even though rates of interest on mortgages are low compared with most other types of borrowing, the total cost can still be high if you spread the payments over 20 or 30 years. In the long term, this can be the most expensive way to consolidate debt and as the debt is secured on your property, you run the risk of losing your home if you can't keep up payments.

You may be able to put your consolidated debt on to a shorter term than your main mortgage. You'll want to pay it off as quickly as possible. If you put this sort of debt on to a fixed-rate loan there are likely to be repayment charges for repaying within the fixed term.

See our Mortgages report for more information about mortgage lending.

Secured personal loans

These are a half-way house between a mortgage and an unsecured personal loan. The interest rates are generally lower than on an unsecured loan as you will be asked to put up an asset, such as a boat or a car, as security for the loan if you default. The repayment periods are similar to those for unsecured loans.

Debt consolidation costs

The lower the interest rate and the lower the fees, the cheaper the loan will be. Don't just focus on the monthly payments - always look at the repayment period and total amount you will repay as well.

The total cost of a Westpac $10,000 consolidation loan repaid over five years at an interest rate of 17.35 percent would be $15,360. This included a $250 upfront "establishment fee". The monthly payments were $256. Repaid over three years, at $367 a month, the total cost would be a much lower $13,212.

You should go to several lenders for quotes - including your bank or mortgage lender.

Use our checklist to assess what's being offered:

The lower the interest rate and the lower the fees, the cheaper the loan will be.
  • rate of interest
  • fees and charges to set up the loan (including administration fees to document any asset you're putting up as security)
  • early repayment charges on loans you want to get rid of (it's usually better to leave finance with interest-free periods in place and refinance at the end of the interest-free period)
  • repayment insurance (if required)
  • whether there are broker fees or commissions of any kind
  • whether fees and insurance are added to the loan and charged interest
  • the length of the loan
  • monthly amount you'll pay
  • total cost of interest over the term of the loan
  • total amount repaid compared with the amount borrowed
  • whether there are repayment penalties on the new loan.

Alternative options

Gavin Earle of Credit Union Baywide suggested that for customers already in difficulty with their commitments it may be better to set up a formally structured debt-repayment programme through a special purpose account. "This way the individual has a certain amount credited to this account from their income with repayments then split off to the various creditors."

Bills.

Credit Union South's Andrew Leys said that while it offered debt-consolidation loans this was not always the best way to help.

"Often a straight out debt consolidation, whoever does the loan, will simply give the individual a temporary reprieve to go out and incur more debts. By working closely with individuals and their families we can, over an extended period, achieve a much better outcome - whether or not that included a debt-consolidation loan."

Margot King from PSIS said it worked out a repayment plan with customers: "Where we're unable to fully refinance all a customer's debt we will try to refinance some, particularly high-interest debt, so they can get a tailored repayment plan in place and often save on interest costs with a lower rate."

Legal options

Maureen Pitman President of the New Zealand Federation of Family Budgeting Services said its advisers often organise repayment plans known as Summary Instalment Orders (SIOs), set up through the government's Insolvency and Trustee Services.

SIOs allow you to repay up to $40,000 of unsecured debt in agreed amounts to creditors in instalments. This is usually over three years but in some cases can be up to five years.

An SIO also stops lenders from adding penalty payments to outstanding debts.

Alternatively, an informal instalment plan might be agreed with creditors. A borrower would set aside a certain amount to distribute among a pool of creditors.

Individuals can apply directly to the Insolvency and Trustee Service for an SIO order. The advantage of seeking help from the Family Budgeting Service is that advisers have experience in dealing with creditors and the service is known to lenders. This might make it easier for someone in difficulty to negotiate a repayment plan rather than going it alone.

Our advice

  • Take a hard look at your finances. Ask yourself why you have too much debt and whether you can change your habits and expenditure so that you don't get further into debt.

  • Do you need help sorting out a budget and managing your finances rather than just another loan?

  • If you think consolidation can work, get quotes from several lenders. Shop around for the best interest rate and lowest fees you can get. The reason for getting a consolidation loan in the first place is to get out of debt, not sign up to a larger one. Talk first to the banks, credit unions or PSIS.

  • Use our checklist to work out your total borrowing costs.

  • A lender that asks detailed questions about your finances and suggests monitoring of your repayment programme might be doing you a favour.

  • Don't include interest-free debts when you're consolidating interest-bearing debts.

More information


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Report by Maria Scott