We have touched on this quite a lot of times, we have mentioned it, adviced it but never have we written an article about the actual finance reasons of why using credit to pay credit is a bad idea. Here is our run through:
-
It isn’t supposed to work:
The whole idea of credit is to commit smaller amounts of cash flow on a recurring basis against a larger sum of cash flow given to you today (you get 50,000 AUD and commit to paying 800 AUD a month for 6 years). The problem with using one credit against other credit is that you are going to be using other people’s money to pay your loans even though you cannot afford to pay them both. Consequently, you head into a downward spiral of economic issues. From our point of view, if you cannot afford to pay one loan then chances are you are not going to be able to pay two. Sure it sounds fancy to do balance transfers and other financial products that help you transferring credit from one line to another, but they all have one simple aim, get you on larger debt commitments. Never forget that.
-
You go from one loan to two loans (Partial payments):
Most clients we speak to use one credit to partially pay another (because they think they will be able to repay the original within a few months), but they don’t free themselves from the original debt. That leads them to have two debt commitments on a monthly basis instead of only one. Let’s give you an example: “Say you have a 10k debt with CBA and decide you want to reduce it and use a 7K loan with NAB to partially pay the original one. You will now owe two banks, two different amounts but your repayment to CBA hasn’t changed and you increased your monthly outflows by taking another loan”
-
Compounded interest to its best:
This is the most important part and also where a lot of our customers and normal day to day people get confused, the purpose of every loan is to give the borrower money in exchange of a principal + interest repayment (basically for the finance company to charge interest to you). When you use one credit line to pay another the issue is that you are effectively opening you up to the risk of paying interest to two parties and on two loans. And then they will charge interest on the interest the next month, and so on. Which is no good for your cash flow. If you want to understand compound interest on more detail click here!
How to use it effectively:
There might be situations when you can actually save money and time from transferring credit lines and using one bank to pay out the other one but normally our advise is to only use this when you are fully closing one of the loans and reducing both cashflow repayment and interest on the new one. I.E you are closing your initial loan and from there you are reducing your interest from 15% to 10% .