Building on booms & surviving slumps – does debt consolidation make sense today?
01/09/2008
When house prices soar, then slump, does it make sense to use your equity to sort out your finances, consolidating your debts with a secured loan? The answer may depend on where we stand today, but first we need to take a look at how we got there…
Back in September 2006...
Back in September 2006, the average house price had reached an unprecedented £169,413*. With house prices booming and confidence soaring, many homeowners saw a secured debt consolidation loan as a great way to make their debt more manageable.
After all, house prices had gone up around £13,000 in the space of a year, and debt consolidation let them put that ‘new’ money to work, reducing their monthly payments, simplifying their finances and turning their high-interest debt into low-interest debt. (For more on the benefits and drawbacks of secured debt consolidation loans, see ‘Debt consolidation – the pros, the cons & the alternatives’ below.)
But now (bad news)
Fast forward to July 2008 and it’s a very different picture. House prices are falling and lenders are much more careful about giving out credit, secured or unsecured. They’re not likely to grant a secured loan that’ll leave the borrower with too little equity – if the house’s value drops any further, at least part of that secured loan won’t actually be secured against anything until the value rises again.
House prices from Sep 06 – Jul 08*
However (good news)
A quick look at the above chart, however, shows that the average house was still worth £169,316 in July 2008 – pretty much what it was worth in September 2006, back when homeowners were so optimistic about prices. What’s more:
It was worth… |
…more than it was at the start of… |
£10,838 |
2006 |
£34,510 |
2004 |
£76,085 |
2002 |
£94,256 |
2000 |
£107,496 |
1998 |
Plus, that ‘natural’ house price growth is unlikely to tell the full story. Every month, anyone on a repayment mortgage is slowly paying off more and more of the money they still owe on that mortgage. Each monthly payment might not account for much (especially at the start of the mortgage**), but they do add up – someone who took out a mortgage back in the 90s could easily have paid off more than half of it by now.
Then there are home improvements: someone might improve their home so they have somewhere nicer to live, but those improvements could easily add to its value. Many improvements actually increase a property’s value by a lot more than they cost (an interesting concept: for more on this, click here).
So property prices would have to fall a long way before a secured debt consolidation loan was no longer an option for most people who bought their home some time ago. And the longer they’d owned their home, the more ‘leeway’ they’d have – the less reason they’d have to worry about ending up with negative equity.
Even so (bad news)
House prices are going down now and no-one’s expecting them to start climbing again in the next month or so. Some expect them to drop by 30%, which would certainly make secured debt consolidation loans a lot less appealing. Whenever house prices come down, there’s always the threat of negative equity (owing more on the house than it’s worth).
Equity & negative equity – in a nutshell:
1) The less someone owes on their house, the bigger the ‘buffer’ they have against negative equity.
2) Secured loans and remortgages are probably not a good idea for anyone who owes more on their house than the house might be worth in the foreseeable future.
3) Negative equity is a scary thought, but it needn’t be a real problem if the homeowner doesn’t have to sell. The housing market is cyclical, so house prices will go up again – it’s just that no-one knows how long that’ll take.
Negative equity – an example:
Last summer, Mr. Jones took out a £200,000 mortgage to buy a house – which he now needs to sell.
The bank will expect to be repaid (almost) £200,000, but no-one will offer Mr. Jones more than £180,000. So the house’s value has dropped, but the mortgage hasn’t. It isn’t the bank’s fault the value has decreased – it’s simply one of the risks of being a homeowner.
He can’t sell for £180,000, as he’d have to find another £20,000 to clear the mortgage debt before anyone will give him a mortgage for a new house. One option (depending on Mr. Jones’ credit history) would be to ask the bank for a £20,000 personal loan to cover the shortfall. If the bank won’t, and if he can’t find the money elsewhere, he’ll have no choice but to wait for house prices to go up again.
But then again (good news)
Some people think this slump will be short lived, and lead to more dramatic house price increases before too long. After all, they point out, since many builders have stopped building now, there won’t be enough houses to keep up with the demand that appears as soon as the mortgage market recovers.
Debt consolidation – the pros, the cons & the alternatives
Finally, anyone who’s considering a secured debt consolidation loan is probably doing it for a good reason – i.e. to help them cope with their debt repayments. What they’ll want to know is this:
- What are the benefits?
- What are the drawbacks?
- What other choices do I have?
Secured debt consolidation – the pros
- Can lower monthly repayments
- Can reduce interest rate paid
- Simplifies finances
- Helps borrowers avoid late / non-payment charges, saving money and protecting their credit rating
- Helps them keep their debt repayments in line with their disposable income (if their income drops / cost of living rises)
Secured debt consolidation – the cons
- Can cost more in the long run (if the borrower arranges to pay it back slowly, they’ll be paying interest for longer)
- Puts their property at risk – as with any secured loan, if the borrower doesn’t keep up with repayments, the lender may force them to sell their property (although this should be the last resort)
- The psychological risk: it can be tempting to use credit cards and overdrafts again once they’re paid off, which can lead the borrower deeper into debt.
Secured debt consolidation – the alternatives
Secured debt consolidation loans aren’t the only way of tackling debt. Depending on the individual’s circumstances, another approach may be more suitable. To find out more about the alternatives, click on a link:
Debt management plans
Remortgages
Individual Voluntary Arrangements (IVAs)
Debt advice
* all house prices in this article taken from the Nationwide House Price Index (HPI).
** mortgage payments tend to be ‘slanted’ so the bulk of each repayment goes towards the interest, rather than paying off the capital; towards the end of the mortgage, it’s the other way around.
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