Refinancing your mortgage with a debt consolidation loan can be risky, so here are some traps to avoid to ensure that you remain in control.
Consolidating your personal debt into your mortgage can be an effective way to reduce your repayments if you restructure your debts the right way – but there are some common mistakes that you need to steer clear of to improve your financial well-being. Here's what to watch out for.
1. Debt spiral
Rolling your debts into your home loan can lead to a debt spiral where you get yourself into further debt. For instance, if you transfer your credit card balance onto your home loan, you may end up paying more interest over a longer term which will only increase your debt amount.
2. Borrowing for longer
Many borrowers fall into the trap of ignoring the increased loan term that results when consolidating debt. When you decide to refinance, you should structure the length of the loan to match the life cycle of the product.
For instance, if you buy a car you might want to refinance it over five years – consolidating this personal loan under a 30-year mortgage will see you paying interest on the car for much longer. Ultimately this will increase your debt level and make it more difficult to repay the loan in full.
While this may seem like an effective short-term strategy, the reality is that you are simply prolonging your debt obligation and accumulating additional interest charges.
3. Consolidating the wrong debts
Many financial advisers recommend that you consolidate low-interest and high-interest debt separately. As mentioned above, consolidating personal debt with mortgage debt does not always lead to cost-savings due to the difference in product life cycles and loan terms.
4. Failing to crunch the numbers
Although consolidating debt into your home loan may be attractive particularly if you can secure a lower interest rate for personal debt (e.g. paying 5.5% interest for a credit card if you consolidate with your home loan), many borrowers fail to calculate the cost savings.
The only sustainable way to consolidate debt with your mortgage is to understand how much you can afford to borrow by budgeting carefully.
5. Not researching options
Consolidating debt into your home loan can make sense in some situations, but it's not always the best option. If you are not well versed in financial management, investigate your options by speaking with a financial planner and mortgage broker.
Negotiating a better rate with your current lender, switching to a cheaper mortgage or liquidating your assets (e.g. selling your home) are ways that you can avoid debt consolidation if it is not the right pathway for you.
Don’t underestimate the significance of financial discipline. For instance, if you decide to refinance your home loan for a mortgage that allows you to make additional repayments, the cost savings could be significant. For instance, an additional repayment of $80 into your mortgage may not seem like much but on a $450,000 30 year home loan at 4.5% interest, this could save you a staggering $29,303.47 in interest.
Common debt consolidation solutions
In 2013, ASIC found these to be some of the most common debt consolidation solutions given to borrowers:
- Lengthening the loan term to make repayments cheaper
- Switching to interest only repayments
- Switching to a new loan with a different interest rate
Source: ASIC Report 358, July 2013
6. Asset risk
Be mindful that if you transfer your unsecured debts (e.g. credit card debt) into a secured debt (e.g. using your home as security), if you fail to meet your repayments then you could face losing your home.
Speak to a financial adviser or legal professional about how you can protect your asset to avoid your lender taking possession of your home.
7. Not understanding debt
Although consolidating several debts into your home loan can make sense in some situations, it is important that you identify and understand how you got into debt in the first place – whether it was a poor financial strategy or the failure to speak with the right professionals, you need to work out the root cause of your debt issues so you can move forward.
You should only consolidate your debts into your home loan when you have an effective budget in place.
8. Dishonest lenders and brokers
When refinancing your home loan through debt consolidation, you need to keep your wits about you. There are some lenders and brokers who may charge exorbitant fees – 15% of the equity in your home – or organise refinance agreements where it is highly unlikely that you will be able to afford the new repayments.
You can identify a dishonest broker if they:
- Are not licensed by ASIC
- Fail to discuss your financial situation and needs before organising a loan
- Do not explain fees, charges and repayments before you apply
- Advertise that they can help you no matter how desperate you are
9. Not seeking help
Many debt consolidation mistakes can be avoided by seeking the right professional help. Have a conversation with a mortgage broker, an accountant, financial planner and legal professional to understand your options when consolidating debt into your mortgage.
The Australian Securities and Investments Commission (ASIC) offers free financial and legal counselling services to distressed borrowers. If you’re having trouble paying your debts now, it’s likely that you’ll be unable to pay back a new loan with a higher loan amount or interest rate.
Explore your options before consolidating or refinancing your loans and avoid common pitfalls made by Australian borrowers to free yourself from debt today.