DEBT consolidation — using a big loan with a longer repayment plan to settle smaller loans — might sound like a great idea when you are finding it difficult to keep up with all your loan payments at once. But if not done carefully, this big loan can become a big roadblock on your path to financial freedom. Sagicor financial advisor Granville Knight says he does not recommend using debt to clear debt, unless your new loan has low or no interest.
“So, for example, if you owe two million dollars in student loans and your employer says they'll clear it, and bind you in a contract for you to stay with them while you repay the loan interest-free, then that's a good deal,” he explained to All Woman. He cautioned, however, that you should be wary of institutions that offer debt consolidation with the main selling point being 'more time to repay' as this can quickly become a slippery slope that keeps you in debt for longer.
“That would be erroneous and it can keep you in debt forever,” he argued. “While it may appear to reduce your monthly payment amount, it will keep sending you further into the future with more debt, which will have you owing for longer.”
“The best solution is to take baby steps to debt elimination,” he suggested. “Start with the smallest loan first, try as best as possible to pick that one off, then move onto the next one, and then the next.”
Let's say you have three loans — the first is one million, another is two million, and the third is 10 million dollars. Knight advises that at first you maintain minimum payments on the 10 million and the two million, while you aggressively try to pay off the one-million-dollar loan.
“This means you will rearrange your finances entirely and make sacrifices to get rid of the first loan as quickly as you can, but you must ensure that you keep your other payments up to date to avoid those hefty late penalties.”
When you're done with this loan, Knight warns that it is not the time to celebrate or return to your usual spending habits. Instead, you should now channel the same amount of funds you were paying on that loan into your second loan.
“So if you sacrificed $50,000 per month to get rid of that first loan, while paying $25,000 on each of your other loans, then you should now start paying $75,000 to your two-million-dollar loan, and still pay $25,000 to your 10 million loan,” he explained. “When this is cleared, then you channel the full $100,000 into the $10 million loan. Pretty soon you will realise that you are eliminating your debt in a shorter time frame, and with a smaller sum of money, than if you had taken out another loan.”
Knight pointed out that the challenge many of us will have in sticking to these baby steps is the same challenge that we had before we got into the debt bed — not living within our means.
“Most of us believe that we can always borrow more money, and money is so easy to borrow, so we don't assess the real deficit in our finances and figure out how we can live within our means, or expand those means,” he pointed out. “So when we find ourselves in debt traps, we ultimately have to make sacrifices to free ourselves from them.”