Debt consolidation loans explained

A debt consolidation loan is an ordinary personal loan used for a specific purpose: you borrow enough to pay out several existing debts, then repay the single new loan instead. There is no special product category and usually no special rate. What makes it a consolidation loan is what you do with the money.

The debts people combine are typically credit cards, buy now pay later balances, store cards and other personal loans. What these have in common is high rates and, in the case of cards and buy now pay later, no fixed end date. Those two properties are what make them expensive over time, and consolidation addresses both.

Two things change when you consolidate, and they are worth separating because only one of them is about money. The first is the interest rate: a personal loan at, say, 9% replacing card debt at 21% obviously costs less to carry. The second is the structure: a personal loan has a fixed term, fixed repayments and a date on which it ends, whereas a credit card limit sits there indefinitely and can be redrawn the moment it is paid down. For many people the structural change matters more than the rate.

The calculation is straightforward, and it is what separates a consolidation that saves money from one that does not. It takes three figures for the current position and three for the proposed loan.

For the existing debts:

1. The total balance across every debt being consolidated.
2. The current monthly repayment in total, across all of them.
3. How long that would take to clear at the current repayment level, and the total interest over that period. Close to the minimum on a card, the realistic answer may be decades.

Then add the fees, which matter more on a personal loan than most people expect. An establishment fee of $150 to $600 plus a monthly service fee spread across a short loan can move the effective cost noticeably. This is exactly what the comparison rate is designed to capture, which is why the comparison rate on a personal loan often sits well above the advertised rate, and why it is the figure that puts loans on the same footing.

One more adjustment matters. Personal loan rates are set by risk-based pricing, meaning the advertised rate goes to the strongest applicants and the actual offer depends on credit history and income. For someone consolidating because they are struggling, the rate offered may be materially higher than the advertised one, which changes the calculation. Some lenders give a quote without a full application.

Consolidation is one option among several. How they compare depends on the size of the debt and how quickly it can realistically be cleared.

Rolling debt into a mortgage is the option that looks cheapest and carries the most risk. The rate is by far the lowest available, which is the attraction, but a 25-year term means a $20,000 debt at a low rate can still cost more in total interest than a three-year personal loan at a much higher one. More seriously, you have converted unsecured debt into debt secured against your home. If circumstances change, the consequences of falling behind are no longer a default on a card, they are a risk to where you live.

Consolidating into a mortgage only keeps the cost down when the consolidated portion is repaid at the old rate rather than the new minimum, so the term does not stretch. Few people do this, which is why the option so often disappoints.

1. Every debt listed with its balance, rate and minimum repayment. Lenders ask for this as part of the application.
2. The credit file. It is free from each credit reporting body once every three months, and errors on it can cost a better rate.
3. The comparison rate, and a quote for the applicant’s actual circumstances, which can differ from the advertised rate.
4. The term. Shorter terms cost less in total, and loans that allow extra repayments without penalty can be cleared faster.
5. Applications. Multiple applications in a short period are recorded on the credit file and work against the applicant.
6. Payment of the old debts. Many lenders pay them directly, so the money never passes through the borrower’s account.
7. The paid-out accounts. A cleared credit card with the limit still open is the single most common way consolidated debt comes back.
8. Repayments. Automatic repayments timed for the day after payday reduce the chance of a missed one.

That seventh step is the one that determines whether consolidation works over the long run, and it is the one most often missed. The mechanism is easy to see: consolidating clears your cards, the limits remain available, and within a year or two there is a new balance on them alongside the consolidation loan. The person now has more debt than before, at a higher total cost. Lenders frequently require the accounts to be closed as a condition.

A final point, and an important one. Debt consolidation is a tool for a manageable debt at a bad rate. It is not a solution for a debt you cannot service. Where the repayments on a consolidated loan would not be affordable, a new loan is likely to make things worse rather than better. Free, independent and confidential financial counselling is available in Australia through the National Debt Helpline on 1800 007 007. Counsellors can negotiate with creditors, arrange hardship variations and explain options that no lender will mention, and the service costs nothing.