A Guide to Debt Consolidation

 Debt consolidation has become an increasingly popular financial strategy in Kenya for individuals looking to manage multiple debts effectively. Consolidation combines several debts into a single loan, helping you simplify your financial obligations, potentially reduce interest rates, and improve your financial health. This article explores how debt consolidation works in Kenya, its impact on loan costs and creditworthiness, and when it might be a good or bad idea.

How Debt Consolidation Works

Debt consolidation involves taking out a new loan to pay off multiple debts. This new loan comes with a single monthly instalment, which makes managing finances straightforward.

Step-by-Step Debt Consolidation Process

1. Assessment of Debts: You must evaluate all existing debts, including mobile, digital, bank, and SACCO loans, as well as any other outstanding financial obligations.
2. Loan Application: You approach your bank's loan officer, Microfinance or SACCO, or a specialized debt consolidation service armed with all your debts. You should know the monthly installment you can afford to pay without straining when applying.
3. Approval and Disbursement: Upon approval, the lender disburses the loan amount, which, after deducting all other loans, you may owe them. Your obligations outside the institution can be settled upon your instructions, or the money can remain in your account for you to pay on your own time.
4. Repayment: Lastly, you begin repaying the monthly installment amounts of the consolidation loan agreed upon for the agreed period. The ideal situation should see you pay at a lower interest rate and maybe a lower installment.

Does Debt Consolidation Affect the Cost of the Loan?

Debt consolidation can affect the overall cost of the loan in several ways, depending on the terms of the new loan compared to the original debts.

Interest Rates

• Lower Interest Rates: One of the main benefits of debt consolidation is the potential to secure a lower interest rate than what was being paid on the original debts. This is particularly beneficial for those with high-interest loans. Lower interest rates would result in lower monthly payments, providing immediate financial relief and improving cash flow.

Suppose you have three loans with interest rates of 18%, 20%, and 19.5%. Consolidating these into a single loan with a 17% interest rate can lead to significant savings over time.

• Longer Repayment Terms: Extending the repayment period will lower monthly payments, making managing your finances easier and avoiding missed payments. However, a longer repayment means that interest accrues over an extended period. As a result, the total amount of interest paid over the life of the loan will be higher, even if the monthly payments are lower.

If you extend a 5-year loan to 10 years, the monthly payments might decrease, but the total interest paid over those 10 years will certainly be higher than if the loan were repaid in 5 years.

Fees and Charges

• Origination Fees: Lenders' origination fees are upfront charges for processing a new loan. The fees are a percentage of the loan amount and add to the cost of consolidating your debt.

If the origination fee is high, it might offset some of the savings gained from a lower interest rate. You need to calculate whether the potential savings from a lower interest rate outweigh the cost of the origination fee.

For a loan of Ksh 500,000 with a 3% origination fee, you would pay Ksh 15,000 upfront, which needs to be considered when calculating the total consolidation cost.

• Early Repayment Penalties: Some original loans come with penalties for early repayment. If the existing loans have early repayment penalties, these costs must be included in the overall cost of debt consolidation. These penalties can reduce or negate the financial benefits of consolidating.

You should, therefore, review the terms of your existing loans to identify any potential early repayment penalties and calculate their impact on the total cost of debt consolidation.

If you have a loan with an early repayment penalty of Ksh 5,500, this cost must be factored into the overall savings calculation when considering a consolidation loan.

Debt Consolidation Impact on Creditworthiness and CRB Status

Debt consolidation can positively and negatively impact your creditworthiness and Credit Reference Bureau (CRB) reports.

Positive Impacts

• Improved Credit Score: Consolidating debt and making consistent, on-time payments on the new loan can improve your credit score. This is because payment history is a significant factor in credit scoring.
• Simplified Payments: With only one loan to manage, you are less likely to miss payments if your earnings haven’t changed, positively affecting your credit score.

Negative Impacts

• Credit Inquiry: Applying for a new loan involves a hard inquiry on your credit report, which can temporarily lower your credit score.
• New Credit Account: Opening a new credit account can also impact the average age of your credit accounts, which can affect your credit score significantly.

When is Debt Consolidation a Good Idea?

Debt consolidation can be a beneficial strategy in some scenarios:

v  High-Interest Debts: If you have multiple high-interest debts, consolidating them into a loan with a lower interest rate can save money on interest payments.

v  Simplifying Finances: For those struggling to keep track of multiple payments, consolidating into a single monthly payment can make financial management easier.

v  Improving Credit Score: If you aim to improve your credit score by reducing your overall credit utilization and making timely payments, debt consolidation can help.

When is Debt Consolidation Not a Good Idea?

However, debt consolidation may not always be the best option when:

v  Low-Interest Debts: If your existing debts already have low interest rates, consolidating them might not save you money and could even cost more if the new loan has higher fees.

v  Discipline Issues: If you have difficulty managing credit and tend to accumulate new debt, consolidation could lead to a cycle of debt if not handled responsibly.

v  Short-Term Costs: If the origination fees and other costs associated with the consolidation loan outweigh the benefits of lower interest rates, it might not be worth it.

Debt consolidation in Kenya offers a viable option for managing multiple debts, potentially lowering interest rates, and simplifying financial obligations. However, it’s crucial to carefully evaluate the terms and costs of the new loan, understand its impact on your creditworthiness, and assess whether it aligns with your financial goals. This will help you decide whether debt consolidation is right for you and your CRB status.