Refinancing and debt consolidation
Information about refinancing and debt consolidation
What is refinancing?
Refinancing is simply a strategy for replacing or restructuring an existing loan or loans with a new loan. There are a range of reasons why you may wish to refinance, including:
- seeking a lower interest rate or additional features;
- switching from one loan type to another;
- converting equity in your home (the portion you own) to raise cash for other purposes including renovations, buying a car or a holiday;
- increasing your loan amount by replacing your existing mortgage with a new one;
- removing a co-borrower from the mortgage (often to assist in a separation or divorce); or
- consolidating all your debts including personal loans and credit card debts into one loan (debt consolidation).
While refinancing may save you money, there can also be many pitfalls. It is important to take into account all the costs and the impact refinancing will have, including it’s effect on your overall financial commitments in both the short and the long term.
Factors to consider before refinancing
Examine your current financial situation closely and consider your future needs. Over the life of your loan, your needs and personal circumstances may change (e.g. starting a family, getting a new job or moving out of the property) and new finance products may be introduced. Before you consider refinancing, ask yourself:
- Will my loan repayments decrease?
- Will there be exit fees or charges for exiting my current loan?
- Will there be establishment fees for the new loan?
- Will I be charged stamp duty and mortgage insurance?
- How much equity do I currently have and what is my loan balance?
- What will happen if the value of my house drops?
If you calculate that refinancing is too expensive, your lender may agree to a variation of your loan rather than total refinancing. Variations can include ‘up stamping’ the mortgage (where a new property valuation shows there is additional equity in the home which may be accessed) and redraw or offset facilities.
If you decide refinancing is an option for you, ensure you have considered both the costs and the long term implications. Refinancing for the short term can come at a very high cost as it takes a number of years to recoup the costs and should be viewed as a long term commitment.
Choosing to refinance: research your options
In order to retain your business, your existing lender may be willing to offer you incentives such as lower mortgage interest rates, discounted home insurance or waived fees and charges.
Even if you are choosing to refinance with your current lender it may be worthwhile investigating what is offered by other banks and non-bank lenders. Information from the following agencies can assist your research:
- Canstar Cannex is an independent consumer finance research firm and provides product information from a variety of financial institutions;
- Choice is an independent consumer organisation which researches issues of concern to consumers and publishes articles and tips;
- FIDO (Federal Interagency Databases Online) the consumer website of the Australian Securities and Investments Commission, has a multi-loan calculator in it’s publications and resources section;
- InfoChoice provides an independent financial comparison with a range of calculators, guides and articles.
Finance brokers have knowledge of a range of lending products and can research and arrange loans on your behalf. It is important to clearly outline your borrowing needs and current financial situation for the best advice. Using the services of a finance broker is usually free as brokers are paid commission from the lender which they are required to disclose in writing. Make sure your lender or broker is a member of an Australian Securities Investment Commission (ASIC) approved external dispute resolution scheme. This will enable you to seek compensation through an independent body, should things go wrong.
Financial costs to consider
Refinancing costs can range from hundreds to thousands of dollars depending on the circumstances surrounding your refinance. Refinancing incurs most of the same fees and charges as a first mortgage such as settlement costs, application fees, registration fees and account fees.
- Costs that are exclusive to refinancing include exit fees for withdrawing from your old loan early. Consider asking your lender for a statement of exit fees prior to refinancing as these can be high and require careful examination.
- If you are borrowing more than 80% of the value of the property (or lower in the case of low-doc loans) your lender will generally also require you to pay mortgage insurance, to protect their interest in the property.
- A loan with more features may cost more by way of interest rates and fees.
- Additional costs added to the loan balance will incur significant interest which you will be paying over the term of the loan (for instance, if you have paid for advice or mortgage insurance).
Don't be fooled into paying someone thousands of dollars for advice as part of a loan / mortgage minimisation or debt reduction programme. Most of these programmes rely on tight domestic budget planning so simply drawing up a budget may be the best place to start – a financial counsellor can help with this or refer to FIDO for a budget planner calculator. If you were to allocate these funds to your loan instead you could wipe years off it. Your existing lender and most mortgage brokers will provide this advice free of charge.
Debt consolidation
Debt consolidation is combining a number of different loans into one loan which usually has a lower interest rate. This leaves you with just one loan to worry about. It involves reducing the number of outstanding debts you have owing by integrating them all into the one loan. This can be done in a number of ways:
- A common practice is to take high-interest debts (e.g. personal loan, credit card debt) and incorporate them into a low-interest loan (e.g. your mortgage). In this way, you may have an opportunity to reduce your immediate repayments. However paying these loans off over the length of a 25-30 year mortgage can increase the total cost of the loan;
- One or more high interest debts (such as credit cards or store cards) can be consolidated into a personal loan which has a fixed repayment schedule over a reasonably short period of time (e.g. 5 years) and does not allow for further borrowings. This way the loan will be paid out in a set period of time with a set amount of interest. If payments are made on time it will not escalate into a larger debt with no fixed date of finalisation (as many credit cards do);
- Another option could be to transfer to a loan provider offering the same type of product but which better suits your spending and repayment patterns. For instance, if you pay your credit card balance off in full every month, a card with low fees and an extended interest free period may suit you. However, if you rarely pay off your balance in full you may be better off looking for a card with a low annual interest rate. A card with an interest free period may not benefit you if you are never able to take advantage of it.
Remember though, interest is also based on time - so consolidating a $10,000 car loan with your home loan and paying it off at 7% over 20 years might end up being more expensive than paying the original $10,000 loan back at 15% over 3 years. It can be a way to increase your cash flow in the short term and give you time to investigate other solutions to financial problems which may be long term. However, consider the risk if you are rolling all of your unsecured smaller debts into a secured debt over the family home. If you default on your payments you could lose your home.
Before consolidating your debts, prioritise them, ranking them in order of the highest interest rate debts first. If you have any savings you could use a portion to pay off high interest debts: savings earning 7% may be better allocated to clearing a personal loan which is costing you 19%. High interest debt reduces your cash flow and your potential to accumulate future savings. Once you combine the remaining debts consider continuing to make repayments at the original level to get the most benefit.
Shop around if you are transferring any of your loan products to a new lender but be aware that lenders do examine your credit history. Credit suitability is assessed partly on the number of credit applications you make. Habitually moving from one credit provider to another may be seen as risky and may mean you are not approved for credit when applying in future. To obtain a copy of your credit history, visit www.vedaadvantage.com or www.dunandbradstreet.com.
Financial hardship
If financial hardship is the reason for refinancing or debt consolidation you may wish to seek professional advice. For a FREE and CONFIDENTIAL financial counselling service, contact either the Financial Counsellors’ Resource Project or Financial Counsellors’ Association to find a financial counselling service near you.
If you are experiencing severe financial hardship, you may also wish to consider a hardship variation (or financial variation). If your financial distress is caused by sickness, loss of work or some other good reason (you do not have to be behind in your repayments) you may be able to change your loan contract. Under the Consumer Credit Code you are entitled to ask for a hardship variation. This may involve a reduction in your repayments or for the payments to be put on hold for a set period of time or a combination of both.
If your financial difficulties are extreme you may be advised to enter into a debt agreement. This is a legally binding agreement, negotiated with one or more of your lenders, and may allow you to pay back your debts over an extended period of time. There are restrictions and far reaching consequences. Debt agreements are only to be used where you are insolvent (i.e. unable to pay debts as and when they fall due) and should be considered a last option as entering into one is committing to an act of bankruptcy through Part 9 of the Bankruptcy Act.