HOW TO BORROW
Lenders are now encouraging borrowers to bundle all their loans together into a "consolidation loan", which was once described by a cynic as "putting all your hard to pay loans into one impossible to pay loan". A case can be made for this strategy because it enables you to enjoy an overall lower rate of interest but let's remember that lenders rarely come up with a new product just because they think it will be good for YOU. Usually their thinking is dictated by how it will benefit them… in this case by increasing their market share.
A recent advertisement outlines a typical scenario. The borrowers have a house loan of $150,000 at $1307 a month, a car loan of $20,000 at $425 a month, a personal loan of $18,000 at $420 a month and credit cards debts of $5,000 requiring $250 a month. The total debt is $193,000 and overall payments are $2402 a month. Borrow $193000 to pay these all out, states the advertisement, and your repayments drop to $1220 a month saving $1182 a month - that's a whopping $272 a week.
While consolidation may be a useful strategy in some situations you should understand the principles involved in any borrowing exercise. First it is the height of financial irresponsibility to borrow for such a length of time that the term of the loan exceeds the life of the asset purchased with the loan - nobody in their right mind would take out a 30 year loan to buy a motor car.
If financial troubles are caused by bad money management consolidation will often lure you into deeper trouble. The example assumes that the mythical borrower is foolish enough to put all those loans into one 30 year loan at the current rate of 6.5%. Sure there is $272 a week freed up but in almost every case that will be used up and the credit cards debt will start creeping up again.
The price would be huge. At their present rate of repayments the borrowers have around $99,000 of interest still to pay - at $1220 a month over a 30 year term this would leap to $246 000.
There is a much better way out. If the family situation was tight the best strategy would be to talk to the bank about converting the housing loan to interest only for two years. Payments would reduce to $812 a month freeing up $495 a month. If the credit cards were destroyed this $395 would be used to speed repayments on the credit card debt. This would leave $100 a month extra cash available to help the family cope and the credit card debt would be paid off in only six months.
Once that was paid off the $645 ($250+$395) not now required could be added to the $425 being used to repay the car loan. It would be paid off in a further 18 months.
After just 24 months from now the only debts remaining would be $150,000 on the house and $10,000 on the personal loan. If these were bundled together and refinanced at 6.5% over an eight year term the monthly repayments would be $2142 a month. This is $260 a month less than what they are paying today.
Total interest still to go now drops to $45,000 saving the family almost $200,000 which they would have incurred if they had fallen into the 30 year trap. When you consider that interest on the above items is not tax deductible it is obvious that the family would have to earn nearly $400,000 in pre tax dollars to pay that extra $200,000 in interest.
Most financial problems are caused by ignorance or through poor money management. The above example shows two strategies - one leading to wealth, the other to disaster. Now you know why so many spend their lives in debt.
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