the biggest risks when consolidating debts into a mortgage

The 5 biggest risks when rolling debts into your home loan (and how to avoid them)

Rates and Fees verified correct on April 28th, 2017

While refinancing your home loan to a debt consolidation loan can be a good strategy for some borrowers, make sure you’re well-versed in the associated costs and risks.

Combining your personal debts into a new mortgage can be a good way to roll multiple payments into one manageable repayment which can save you money in the long run if you are strict with your repayments and make a conscious effort to repay the debt as soon as possible.

However, there are some risks and drawbacks involved when refinancing to a debt consolidation home loan. Before you decide to go down this path, talk to professionals and do some research to make sure it’s the right solution for you.

1. Refinancing can be expensive

Many borrowers overlook the cost of refinancing. Just because you’ve found a lower rate does not automatically mean you’ll save money. Although consolidating your debt into your home loan can seem like an effective strategy, especially if you’ve sourced a lower interest rate for which you can allocate to personal debt, many people don’t take the time to crunch the numbers.

You can use our switching cost calculator to estimate your refinancing cost.

Remember that you face the risk of paying lender’s mortgage insurance (LMI) twice if you borrow more than 80% of the property purchase price so try to keep your loan-to-value ratio (LVR) below 80%.

If it makes financial sense to refinance and consolidate your debts into a mortgage, it’s vital that you understand how much you can afford to borrow by budgeting carefully and visiting an accountant.

2. A longer loan term can mean you actually pay more on your debts

When you refinance to consolidate debt, you often ignore the lifespan of the loans you are consolidating.  As a result, this can mean that you end up paying more in interest and fees.

For example, if you took out a $10,000 personal loan at 14.5% interest over 5 years, you would have monthly repayments of $235 and total interest payable of $4,117. However, if you decided to consolidate this debt into your refinanced mortgage over 30 years (even at an average interest rate of 4.5%), the total interest payable on this portion of the loan would be $8,241 as repayments are stretched out over a longer term.

This would boost your debt level and make it more difficult to repay the loan in full.

One way to avoid this is to make additional repayments on your mortgage so you can gradually pay off your additional debts off and take advantage of a lower interest rate.

The difference loan length makes to your debt

Up arrow 2$8,241

Paying the debt off over 30 years @ 4.5%

Down arrow 2$4,117

Paying the debt off over 5 years @ 14.5%

3. Your other debts could make you lose your home

Be careful if you transfer your unsecured debts (e.g. credit card debt) into a secured debt (e.g. using your home as security) because if you’re unable to meet your mortgage repayments, 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.

4. It could lead to a bad debt cycle

You should be cautious if you decide to refinance with a debt consolidation home loan as you don’t want to get into a bad debt cycle. Debt consolidation can get you into deeper debt so once you’ve consolidated and transferred the balances into your mortgage, consider cancelling all of your credit card and personal loan accounts so you’re not tempted to increase your borrowings.

It’s important that you only borrow within your means and budget carefully to avoid experiencing mortgage stress or financial hardship.

You’ll need to allocate a large portion of your income towards your debt consolidation loan for in order to manage it effectively.

5. It can harm your credit score

When you shop around for a new lender, submitting too many applications with different lenders can negatively affect your credit file. Generally speaking, if you make more than 5 enquiries in a 12 month period, this can restrict the number of lenders that you're eligible to refinance with, so try to be selective about the lenders you approach to consolidate.

This is because when you close your smaller accounts and credit cards to refinance with a debt consolidation loan, your credit history is shortened which can reduce your credit score.

Images: Shutterstock

Belinda Punshon

Belinda is a journalist here at Specialising in the home loans and property sections, she is passionate about helping Australians improve their financial wellbeing.

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