Consolidated credit is a financial product that can be very advantageous if you have several loans. In addition to consolidating credit to reduce your expenses in times of financial hardship, it is also a solution if your finances are in good health. In the latter case, as a rule, those who resort to this type of credit want to free up their family budget to achieve a goal.
However, if you are considering using credit consolidation to reduce your expenses, you should first be aware of how this credit works. This means knowing why you can save a significant amount through credit.
What is credit consolidation?
Consolidated credit is a personal loan that combines all your loans into a single loan, which usually has better terms. In other words, on average, you benefit from a single installment that is lower than the total amount of your loan installments. In fact, through credit consolidation, you can reduce your monthly installments by up to 60%.
As the name implies, credit consolidation requires you to have several loans. This means that in addition to your mortgage, you need to have at least two other loans. These two loans are usually associated with credit cards, but they can also include other types of personal loans without a specific purpose or car loans.
In practical terms, consolidating your loans makes managing your payments easier, as you only have one installment to pay. This reduces the possibility of forgetting or falling behind on your obligations.
However, you need to be aware that in order to get the green light for your consolidated loan, you need to meet certain criteria. For example, if you are in default with any financial institution or your name is already on the Bank of Portugal's blacklist, your application will most likely be rejected.
In other words, if you are currently in default, you first need to settle your debts. Then, try to renegotiate your contractual terms with the financial institutions. This solution can reduce the risk that an institution sees in approving your consolidated loan.
If you currently have a very high debt-to-income ratio, the bank may even accept the consolidation of loans. But be prepared to provide additional guarantees, such as a guarantor, or even opt for a consolidated loan with a mortgage.
What is the difference between a consolidated loan and a consolidated loan with a mortgage?
The main difference between a “normal” consolidated loan and a mortgage-backed consolidated loan is that the latter uses real estate as collateral. The property used for the mortgage can be your own home, a second home, or even a family member's property.
And what is the purpose of providing real estate as collateral? As a rule, because it increases the likelihood of your credit consolidation being approved. In addition, consolidated credit with a mortgage gives you the opportunity to save even more on your total payments, as the interest rate applied is usually lower or you can extend the term of the contract. For example, in this case, the reduction can be up to 70%.
However, keep in mind that if you default, the bank will take possession of the property. It is also important to remember that although there is a significant reduction in monthly payments with any type of consolidated credit, you should create a strategy for these savings.
After all, in some cases, you are increasing the maturity of some loans, which in the long run generates a higher amount of interest.
4 Ways Credit Consolidation Can Reduce Costs
1. Reduce your monthly credit payments
When you are approved for a consolidated loan, all your payments are reduced to a single payment. And a single interest rate is applied to this payment. For those who have several loans, especially credit cards, the interest rate applicable to the consolidation is much lower.
According to the latest data released by the Bank of Portugal, the maximum APR that can be applied to a consolidated loan in the fourth quarter of 2022 is 13.3%. However, many entities charge rates well below the maximum limit, depending on the guarantees, the amount and purpose of the loans, and the outstanding capital. In the case of credit cards, in the fourth quarter of 2022, the APR may reach 16%.
To get an idea of what you can achieve by consolidating your loans, let's use the maximum example of a 60% reduction in installments. If, before approval, you paid $1,000 for all your loans, with consolidated credit you could have a single installment of $400.
qwIn other words, you could save €600 per month. Even if you don't achieve a 60% reduction, a 30% reduction will still save you €300 per month.
This reduction in costs is extremely useful for those at risk of defaulting or who want to combat their over-indebtedness. In most consolidated loans, you can extend the maximum term to 7 years.
2. With credit consolidation, you gain financial stability
When you achieve significant savings on your loan payments, you automatically gain some breathing room in your family budget. However, this breathing room should be used wisely to get your finances in order, which will allow you to achieve long-term financial peace of mind.
Therefore, one goal you should set is to use part of your savings to build an emergency fund. An emergency fund should cover at least six months of your essential expenses. This is a way to ensure stability in the event of a loss of income or unemployment. However, if something unexpected comes up, this fund can also cover those types of expenses, such as car repairs or even unexpected health expenses.
If you have recently cut back on essential or important monthly expenses, the savings you have achieved by consolidating your loans can help you regain your quality of life.
For example, if you have canceled your health insurance or not renewed contracts that are essential to you, these savings can help you re-contract these services/products. However, carefully analyze your priorities and what is really essential for you. Otherwise, you may fall into the same spiral and lose control of your finances.
3. Prevents the need for new credit
With new leeway in your budget, you may be tempted to pursue some goals that were on hold due to your financial situation. For example, you may want to do home improvements, renovate your furniture, invest in professional training, buy a new car, among other goals.
Although any of these examples are valid and even essential to improving your quality of life, they require a relatively high investment. Therefore, you will most likely want to take out a new loan to achieve this goal. The problem in these cases is that you have just consolidated your loans to reduce the risk of indebtedness. Therefore, this should not be an option to consider.
Instead of taking out a new loan, use the savings you have obtained through the consolidated loan for this purpose. It is normal that it will take longer to achieve this goal, since you have to save monthly for several months or even a few years (in investments of thousands of euros).
The best way to reach the amount you need is to know how much you have to set aside each month. Then create a bank account for this purpose and automatically transfer that amount each month (at the beginning of the month).
Of course, this is not the fastest way to achieve your goals. But it is a strategy that allows you to save hundreds or even thousands of euros in interest and never puts your personal finances at risk. In addition, if you create thishabit, you can even start setting other financial goals that can change your future, such as savings for investments.
4. You can pay off debts or repay your loan
Finally, by consolidating your loans, you can significantly reduce your debts. In other words, in most cases, consolidated loans allow you to save hundreds of dollars each month. If you add up these monthly savings over several months, you can repay your loan or even pay it off early. This is a way to pay off part of your debts in the shortest possible time.
However, if you decide to go ahead with this option, you should carefully check the contractual terms of your loans. This is because there may be costs associated with repayment, such as an early repayment fee.
Nevertheless, if your financial situation allows you to repay your loan or settle your debts, this is one of the best options you can take. Even if you can only repay or settle one loan, you are reducing the amount of capital owed and the interest you pay.
Let's do the math: real cases of debt reduction
Dr. Finances receives many requests for help in reducing credit costs. When customers have several loans, one of the viable solutions, or not, is debt consolidation. So, when this is not the ideal solution, it is important to know why it will not be possible to proceed with this solution.
João (fictitious name) was paying €1,700 for various credit installments. After an analysis process, it was possible to consolidate the loans and he ended up paying €577 in a single monthly installment. In other words, he achieved a monthly saving of €1,223 with the consolidated loan.
Another example. Joana and Paulo (fictitious names) wanted to reduce their monthly credit payments, as they were already struggling to pay all their installments, which totaled €2,153. After analyzing the case, the debt-to-income ratio was already well above the desired level, at 67%.
After consolidating their various loans (credit cards, personal loans, and car loan), this couple was left with a single installment of €1,084, payable over 84 months. In other words, they achieved monthly savings of €1,069. This represents annual savings of €12,828.
Although it is not always possible to reduce your expenses so significantly, this is a solution you should consider if your budget is at risk or if you want to gain some financial breathing room.
Source: Doutor Finanças