Let’s face it, it’s not common to have your finances in order when unforeseen expenses appear on the horizon. Fortunately, it has become easier to utilise credit to deal with these situations. However, credit has a downside too, and if you become overly reliant on loans, you might eventually find it hard to keep track of those you’ve taken on.
If you’re in this situation, consolidating your debt into one loan could be a solution to consider. Typically, people take out a personal loan or home equity loan to consolidate their debt. Explore these options below.
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- Personalised interest rates based on your circumstances
Please consider your financial circumstances, or obtain advice, before you act on the general information contained in this article.
So, what is a home equity loan?
Home equity loans let you capitalise on the capital you have in your existing home. They allow you to utilise the capital gain on your house without the need to sell it. Your home equity is essentially the current value of your property, minus the mortgage you owe.
For example, you own a house with a current market value of $500,000 of which you owe $150,000 on the mortgage. By using the formula given above, you arrive at a figure of $350,000, which is the amount of equity you have in your home.
One thing you need to remember is the fact you can’t use all the available equity in the property. Lenders usually offer 80% of the value of the property minus the amount you owe. In case you require more than this 80%, consider taking out Lender’s Mortgage Insurance (LMI).
What you need to know about personal loans for debt consolidation
Many people take out a personal loan to meet a wide range of needs. When you take out a personal loan for debt consolidation, you need to consider the exit fees and early repayment costs of existing credit. Doing so helps you determine whether the charge for consolidating your loans is more than the money you’ll end up saving.
There are different types of personal loans, such as car loans for purchasing vehicles; unsecured loans for taking a holiday, and so on. Lenders design debt-consolidation loans to help you bring together separate loan and credit accounts. These are the loan types you can use to consolidate debt:
- Personal loans that have a fixed interest rate and repayments.
- Variable rate personal loans that usually offer lower interest rates than their fixed-rate counterparts. Of course, the catch is that these rates could rise in the future.
- Unsecured personal loans that give you access to funds even if you don’t have an asset to guarantee the debt.
- Debt agreements, which are a type of bankruptcy. These are usually taken out by people with more substantial debt or those with bad credit.
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Are home equity loans better than personal loans?
Both home equity and personal loans offer specific benefits. In particular, the former is useful when you have accumulated equity in your house, while the latter is useful especially if you don’t have an asset to guarantee a loan.
A home equity loan may also offer considerably lower interest rates than a personal loan, which means your monthly instalment for any additional amount you withdraw on the home loan is much smaller than a personal loan. However, bear in mind that this interest may be spread over a much longer term, i.e. 25 or 30 years compared to a maximum of seven years for a personal loan. Because of this, it’s likely you’ll pay more for a home equity loan.
For both personal loans and drawing on home equity, you need to pay the associated fees depending on the requirements of the product. If you stay with your current mortgage lender, you may be able to avoid refinancing fees depending on the flexibility of the loan, but again, it depends on the lender and loan in question. Refinancing with a separate lender almost always carries additional charges, so you need to take this into account.
You’re five years into a 25-year home loan and need a loan of $20,000. The interest rate on a secured personal loan is 8.9%, while your home loan offers 6.39%. To accommodate the additional debt, the monthly instalment on your home loan will increase by $148, while you will need to pay $321 each month for seven years if you take out a personal loan. At this stage, the redraw on the home loan seems worthwhile.
However, over the life of your home loan, you pay a total interest amount of $15,477, for the $20,000 you borrow. In comparison, the total interest and fees for the personal loan amount to approximately $7,000-$7,500.
In this scenario, even at a higher interest rate, the personal loan is much cheaper over the maximum term of seven years, as opposed to a home loan that stretches over the next 20 to 30 years at a lower interest rate. To remedy this, you could consider taking advantage of the redraw on your home loan and repay it at a faster rate than your existing monthly mortgage instalments.
When should you opt for home loan redraws and personal loans?
The key to consolidating your loans lies in maintaining the same repayment levels, at a lower interest rate, without extending the life of your credit. So, if you need the funds for a short-term duration, avoid paying the additional fees associated with personal loans.
Instead, you can consider a home loan redraw. However, if you feel that you can only repay the loan over the next five to seven years, consider taking out a personal loan instead. Some personal loans give you the option of early repayment without penalty, so there is this to take into account.
- It is worth noting that the longer you carry a debt, the more you pay in interest. It’s always best to avoid increasing debt to such unmanageable proportions.
- Be mindful that just because you have equity, you shouldn’t keep borrowing against it. Focus instead on living within your means and avoid spending more than you earn. This approach makes your credit report look better and keeps your debt manageable. It also makes your life easier and relatively stress-free.
Updated November 20th, 2019