Debt consolidation has been touted as an attractive solution to highly indebted consumers but David Scholtz, chief financial officer at Eduloan, warns that it can actually facilitate a slip into financial ruin.
Scholtz comments comes amid rising concerns that many South Africans are getting deeper into debt in what can cause a serious crisis for the whole economy. These concerns come at the back of rocketing unsecured debt lending suggesting that many consumers are taking on debt to finance lifestyles. It was this sort of thing which pushed the American dream into a crisis in 2007 which eventually became a global economic crisis.
“The main appeal of debt consolidation is convenience,” says Scholtz. “Instead of a consumer paying off a number of different loans every month, which might have different interest rates, the consumer can just apply for one big loan, pay off all the other debt they have, and then be left with making a single payment towards that loan every month. The repayments are usually lower instalments, giving them more disposal income, which sounds very attractive.”
However, debt consolidation is not always a good idea, says. “What most people are not aware of is that debt consolidation locks you in and you still end up owing the same amount of money. You pay your debts off over a longer period and not always at the lowest available interest rates, ending up paying more. All that is happening is delaying the repayment of the debt from the immediate to long-term”
Some financial institutions can charge up to the ceiling interest rate as prescribed by the National Credit Act (NCA) (currently 31% for unsecured lending). This means a person ends up paying more interest to service their loans and often over a longer period.
“Therefore what we are telling our clients is that because we offer lower interest rate repayments, it is better to not consolidate their Eduloan loan with their other debts because they will not get a more competitive rate and will end up paying more to service the loan.”
Another major pitfall of debt consolidation, says Scholtz, is that it does not automatically convert to savings. “Debt consolidation means you still owe that debt. It will not go away.”
He says what often happens is that a consumer would need a loan of a certain amount to settle their debt. However, the financial institution would end up offering them more than what they require to settle their debt which is not helping a consumer becoming financial independent.
“And as human nature would have it, instead of saving the excess, they often spend it. This is because people tend not to budget or be disciplined in their spending. This perpetuates the cycle of indebtedness and poverty.”
Scholtz also warns against consolidating using any secured loan for example a home loan. “This is because while your other debt such as your credit card is considered unsecured debt, your home loan is secured. By bundling it up with your other debts you are in fact offering your home as collateral. This means you are in danger of losing your home should you be unable to make the loan repayments anymore.”
Scholtz suggests doing a simple exercise to see if debt consolidation is worth the person’s while. “If a person is considering debt consolidation, I would suggest that they sit down and calculate the interest and fees on all their existing loans to compare whether the costs of the new, bundled loan will really be a saving at the end of the month. If it is not, then debt consolidation does not make sense for that person.”