By Troy Tisserand
Debt consolidation is one of those terms that Canadians have a lot of confusion about. Is it a good idea? Does it wreck your credit? Is it a scam?
I’ve worked in the financial services industry for 20+ years and so I thought that I’d explain in plain English what debt consolidation is, the pros and cons, and how it works in Canada.
By the end of this short guide, you’ll be a debt consolidation pro! You’ll learn everything including the answers to common questions like:
- What is debt consolidation and how does it work in Canada?
- What are the advantages and disadvantages of debt consolidation?
- What is the difference between debt consolidation versus debt settlement?
- Should I use debt consolidation or file a consumer proposal?
- Is debt consolidation a good option for paying down credit card debt?
So what is debt consolidation?
In simple English, debt consolidation involves taking out one big loan to pay off many small loans.
Why would you want to do this?
Small loans typically have high interest. For example, if you buy a $3,000 TV from a major retailer on credit, they will charge you a very high interest rate. But if you take out a $25,000 student loan, you will get a better interest rate.
So debt consolidation is really about increasing your leverage with the primary goal of lowering your interest rate.
The key benefits of debt consolidation are:
- Lower interest rate means you get out of debt faster.
- It’s easier to plan for one payment each month.
- You can use your assets (such as a home) to secure a lower interest rate.
- You protect your credit rating
How debt consolidation works in Canada
The basic way debt consolidation works is to combine your smaller loans into a larger loan with the goal of getting a lower interest rate.
However, you can also use your existing assets (such as your home) to have even more leverage with creditors. So debt consolidation can also involve a secured loan against an asset that serves as collateral, most commonly a house.
Benefits of using your house as collateral in debt consolidation:
- You will get an even lower interest rate.
- Banks will see you as a less risky investment.
- You increase your bargaining power with lenders.
The reason that an asset helps with debt consolidation is that without an asset you can be a risky investment for banks and lending institutions.
For example, the worst-case scenario is the creditors can force the sale (foreclosure) of the asset to pay back the loan if payments aren’t met. This makes the banks feel more comfortable about lending more money to you and earns you an even lower interest rate.
When should you apply for debt consolidation?
The big point to realize is that debt consolidation is about lowering your interest rate. If you lower your interest rate, a larger percent of your monthly payments will go to paying down your principle, helping you get out of debt faster.
You should use debt consolidation for the following situations:
- You are trying to pay down credit card debt.
- You have consumer debt (such as a small collection of debts from retail stores, a high interest car loan, and other high interest loans).
- You aren’t paying down your principle for small loans and are paying high interest.
- You have lots of equity in your home.
Credit card debt is one of the most common reasons why people use debt consolidation. Credit cards can carry a much larger interest rate than even an unsecured loan from a bank.
And debtors with property such as a home or car may get a lower rate through a secured loan using their asset as collateral. Then the total interest and the total cash flow paid towards the debt is lower allowing the debt to be paid off sooner, incurring less interest.
I have bad credit. Can I still qualify for debt consolidation?
Unfortunately, it’s much harder to get a consolidation loan if you have bad credit. Creditors use your credit scores and payment history to determine risk. If you have not always been able to pay your existing debts most lenders will see this as a red flag.
But if you can offer security or a strong co-signer the lender will be more willing to work with you. Make sure you fully understand the interest rates and fees before agreeing to a consolidation loan as with bad credit these can be substantially higher.
I’m sorry about all the warnings, as I know you’d prefer to hear clear answers. But when it comes to paying down debt, it can get complex and I want you to be aware of the different options.
The pros and cons of debt consolidation
Like all financial decisions, the path you should take to paying down your debt varies on your situation.
But here are a few advantages and disadvantages to debt consolidation.
The pros of debt consolidation
The interest rate charged by a financial institution for a personal loan is usually lower than the rate charged for a credit card. As a result, you will save money on interest payments.
This has many benefits:
- Your creditors will be promptly paid in full by the bank.
- You can maintain a good credit rating if you act quickly.
- You will only have to make one monthly payment
to your financial institution, instead of a bunch of different payments to different lenders.
- You will pay less of your money to interest, getting you out of debt faster.
As long as you follow the terms of your consolidation loan and make your payments on time, your credit rating should not be negatively affected.
The biggest benefit to you is paying less interest though. You work hard for your money and it really is a shame for you to pay high interest rates if it can be avoided. Paying high interest rates can turn small loans into massive sums over time.
The cons of debt consolidation
Debt consolidation does have a few disadvantages.
You may save on interest charges, but will still have your debt. So, you will still have to work hard to repay the money you borrowed.
A few other things to be careful about:
- You may still have access to your credit cards — don’t be tempted to use them and go further in debt.
- Financial institutions will expect prompt payments and if you found the debt hard to pay before it may still be a challenge to repay the new consolidation loan.
- If you used a co-signer, you may leave your co-signer struggling to pay your debts if you cannot pay them.
- If you have used your house as collateral you can risk losing your home if you are unable to make the loan payments.
Over the past five years, there are fewer and fewer unsecured consolidation loans given. This is because the bank that gives you the loan takes on all the risk of losing it if you cannot pay it.
What are the requirements to qualify for a debt consolidation loan?
To qualify for a debt consolidation loan, creditors are looking for a few things.
- Acceptable credit rating (but your credit rating does not always need to be perfect).
- Regular income so they know you will be able to manage the monthly payment.
- A reasonable level of monthly expenses (might be time to cancel the lease on the Lamborghini).
In short, financial institutions want you to demonstrate that you can make the monthly consolidation payment, in addition to paying for your regular monthly bills and expenses.
A blemished credit rating will likely diminish your ability to secure a consolidation loan, therefore it is best to review all your options to deal with your debt and act as soon as possible.
As mentioned, a debt consolidation loan is only one option available to you.
Debt consolidation vs. debt settlement. What’s the difference?
To answer this question, it’s going to get a bit technical. So, the most important point I want you to understand is this: be careful about the option you choose.
Remember, most of the debt repayment options that people know about are designed to benefit the company lending you money. Creditors do not always care about you or your struggle to climb out of debt. They only want their investment to pay off.
Lending money is about returning a profit. Be careful about the advice you receive—and who is giving it. For example, a credit counsellor might offer a program to settle with your creditors by paying 100% of the debt.
This is wonderful for the creditors. They get their money back in full. But for you, the consumer, it will negatively impact your credit rating, as you did not pay back the debt based on the original terms and conditions
Here are some more details about the different options open to you.
The benefits and danger of debt settlement
With the option to settle, you may be able to actually reduce the amount of money that is owed, but the effect on a credit rating is often negative since you are not paying the debt back in full or on the original terms and conditions agreed when the credit was advanced.
This negotiation process requires the creditors to agree to the new payment amount and the new payment terms.
So debt settlement can reduce the amount of money you owe, but can harm your credit rating.
Without a good credit rating, it becomes very hard to rebuild your finances. Debt settlement can be a good short-term solution for you, but can also have negative consequences on your future finances and you could end up right back where you started.
The benefits of debt consolidation
Debt consolidation is a good path for individuals who need a lower payment.
For one, the convenience of paying only one amount is much less stressful to manage than staying on top of numerous obligations. Also, the interest savings even on a lower interest loan can be substantial.
Finally, consolidation can be less harmful to a consumer’s credit score since the sum of the loan is used to pay off creditors and there are no delinquent payments being reported to credit bureaus as can be the case with debt settlement.
I know that probably was a little confusing as it is hard to choose between the different options.
But it’s important not to sugarcoat debt options as the decision you make now can have a long-term impact on your finances.
Related resources on debt consolidation
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