Debt Consolidation from the Expert's Eye View

Tom Elliot originally contributed this article to our Finance FOCUS Newsletter back in 2005. We've re-published it here as Tom provides an interesting insight into the traps and pitfalls of consolidating debt via a home loan.

With interest rates back on the rise, it's tempting for consumers to roll all of their high cost, short-term debts - credit cards, personal loans, car finance, or whatever - into one low rate, long-term loan secured against their home.

On the face of it, this seems a smart idea; after all, home loan rates average only 7%, whereas some credit cards still get away with annual charges of over 20%. In addition, those who feel overwhelmed by the sheer number of different debts they have can consolidate all of these into one monthly payment that undoubtedly facilitates cash budgeting.

Yet this 'rolling' of short-term debt into long-term home loans isn't always as smart as it seems. For a start, short-term debt costs more because it's unsecured. As a result, if you miss too many car payments, your car can get repossessed. Miss too many (now enlarged) home loan repayments, however, and you might no longer have a roof over your head. Secondly, housing finance is usually based on a term of 20 to 25 years. This stretching out of repayments is great for large borrowings (e.g. to buy a house), yet it is not so good for debts that should be shorter-term as it dramatically increases the number of years over which interest will have to be paid.

Consider the example of a $30,000 car loan, taken over three years with an interest rate of 10%. Assuming you pay the principal back in time, the total interest over the term of the loan would be $4,848.56. If, however, you rolled this purchase into a 25 year housing loan at the seemingly cheap rate of 7%, then the total interest over the term of the loan would be a whopping $33,610.13 - that's a difference of $28,761.57! Thirdly, the willingness of banks to lend against the perceived security of the family home means that people who struggle with debt can actually borrow more to finance current consumption than they can genuinely service.

Finally, remember that there's a good reason car finance is usually, for example, 40% residual over four years - few cars are worth more than this proportion of their purchase prices after this length of time. That is, the terms of the loan match the life and valuation expectancy of the asset. Very few things one buys on a credit card will last 20 years or more...