Refinance to Consolidate Debt: Weighing Up the Trade-Offs

Refinancing to consolidate debt can lower your monthly repayments, but it often means paying more interest overall. The question to answer before you apply is whether the saving in cashflow is worth the longer time you spend in debt.

If you have a credit card, a car loan or a personal loan on top of your mortgage, it is tempting to roll everything into one. Done carefully, it can tidy up your budget. Done without a plan, it can turn a three-year debt into a 25-year one.

How Does Refinancing to Consolidate Debt Work?

When you refinance to consolidate debt, you take out a new home loan large enough to pay out your current mortgage and your other debts. You are then left with one loan, one repayment and, usually, one interest rate.

The new loan can be with your current lender or a different one. Moneysmart describes staying with your current lender and moving to a new loan as refinancing internally. Either way, your loan amount goes up, and this is where lenders look more closely. The lender needs to check your income, your living costs and your repayment history, and your property is usually valued as part of the process. You can see how much you may be able to borrow with our borrowing capacity tool.

Why Do Repayments Fall When You Consolidate?

Repayments usually fall because the debts are spread over a much longer loan term, and home loan rates are often lower than rates on cards and personal loans. The lower rate helps, but the longer term does most of the work.

ASIC's guidance says that if repayments fall only because the term is longer, the borrower will pay more interest over that term. A lender or broker should explain this effect to you clearly.

Consider a borrower with a $20,000 personal loan, with about three years left, and a mortgage with 25 years left. Rolling the $20,000 into the mortgage at an illustrative rate of 6.75% p.a. adds roughly $138 a month over 25 years. The same $20,000 at that rate over three years would be about $615 a month. Cashflow improves by around $477 a month, but the $20,000 now sits in the loan for 25 years and collects interest for all of that time. Use the mortgage repayment calculator to test your own numbers.

What Are the Costs and Risks of Consolidating Debt Into Your Mortgage?

The main risk is paying far more interest by stretching short-term debts over a long loan term. There are also costs to switch, and those costs can cancel out your saving.

Moneysmart lists the typical costs of switching: a break fee on a fixed rate loan, a discharge fee when closing your old loan, an application fee on the new loan, and possibly lenders mortgage insurance if you have less than 20 per cent equity. Lenders cannot charge an exit fee on most home loans taken out since 1 July 2011, but break fees and discharge fees are treated differently.

There is a second risk. A consolidated loan has your home as security for debts that were once unsecured. If you struggle with repayments later, your home is on the line in a way it was not before.

Can You Refinance to Consolidate Debt If You Are Coming Off a Fixed Rate?

Yes, and a fixed rate expiry is often a sensible time to do it, because a break fee does not apply once the fixed term has ended. A break fee only applies if you end a fixed rate loan early.

If your fixed rate period is ending, you can look at your options without that cost. You might stay with your lender on a variable interest rate, switch to another lender, or lock in a new fixed rate. A loan health check can show where your current loan sits before you decide.

Example: Consolidating Three Debts Without Extending the Term

A borrower can reduce the interest cost of consolidating by paying the extra amount off faster than the loan requires. This keeps the cashflow benefit of a lower required repayment without the long tail of interest.

Consider a borrower with a $12,000 credit card, an $8,000 car loan and a mortgage with 22 years left. They consolidate the $20,000 into the mortgage at an illustrative rate of 6.75% p.a. Their required repayment rises by about $146 a month. They then set up an extra $300 a month toward the loan. At the same illustrative rate, paid on top of the required repayment of about $146, the extra $300 a month would clear the $20,000 portion in about four and a half years, and the interest on that portion would be a fraction of what a 22-year spread would cost. The trade-off is that they keep less spare cash each month than the minimum would leave them.

A redraw facility or offset account may help here, but access to redraw depends on the lender's terms, and offset accounts may carry fees or be limited to certain loan products. The trade-off is that access to your savings can also make it tempting to spend what you have saved.

Does Consolidating Debt Affect Your Chances of Approval?

A higher loan amount means a lender looks harder at your finances, so consolidating does not always get a yes. Lenders must make reasonable inquiries about your needs and finances and check that the loan is not unsuitable for you.

APRA requires banks to test new borrowers against an interest rate at least 3 percentage points above the loan rate. APRA has also said that some borrowers refinancing may not meet standard criteria and can be assessed case by case, taking past repayment behaviour into account. A clean repayment history over the last 12 months or so helps your case. Our Granny Flat Loans team can talk through which lenders may suit your situation.

Are There Tax Implications When You Consolidate Debt?

Consolidating personal debts into your home loan does not make the interest on them tax deductible. The ATO says interest is deductible based on what the borrowed money is used for, not on what property secures the loan.

If your refinance includes money used for an investment property as well as personal debts, the interest may need to be split between the two uses. The split can stay in place for the life of the loan. Speak with your accountant before you refinance, because the right treatment depends on your circumstances.

When Is Consolidating Debt Worth It?

Consolidating is usually worth it when the total cost, including fees and extra interest, is lower than what you pay now, or when you have a clear plan to pay the extra amount off quickly. It is less useful if the main goal is simply to reduce the monthly repayment.

ASIC expects brokers to consider whether the savings outweigh the costs, including any broker fees. If the numbers do not stack up, a good broker will tell you to stay put. If you also have plans to build on your property, our page on refinancing to fund a granny flat explains how a refinance can combine both goals.

Call one of our team or book an appointment at a time that works for you. We will run the numbers on your current debts, show you the real cost of each option and tell you honestly whether consolidating makes sense.

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