What is Debt Consolidation?
Debt consolidation is the process of obtaining a new loan to pay out other financial liabilities, such as credit cards or student loans.
Consolidating debt is typically intended to minimize interest costs and streamline multiple credit facility payments into a single payment.
An existing, unused credit facility can also be used.
Do you have a few different higher interest credit cards you want to combine into one payment? Or maybe you took out separate loans to buy a truck and RV five years ago, and are looking for a better interest rate.
There are many options available to consolidate your debt.
How Does Debt Consolidation Work?
Debt consolidation is the process of obtaining a new loan or credit facility with a favourable interest rate, which you use to pay out all of your existing other debts.
Instead of multiple payments and possibly high interest rates, you now only make one payment to your new consolidated loan.
How debt consolidation will work for you will depend on whether you own property, your credit score, and your goals for combining your debt.
If you seek a home equity loan, you’ll likely meet with a bank to discuss your situation and the assets you intend to use as collateral.
These loans can be a more in-depth process than some other financing options.
If you are applying for a personal loan or a credit card, the application process is quite similar.
Finding the right option might include comparing offers from different banks and credit unions to ensure you get the best deal on interest rates, terms and services.
Of course, there are also online financial service brokers and comparison websites.
While the concept of online shopping is hardly new, these firms may offer more variety than a conventional bank.
Some firms partner with lenders like investment trusts, private lending firms, and other diverse businesses.
The result is you might have more options than you thought you once did.
There are some caveats to working with some of these less conventional options, which are covered below.
Considerations before Consolidating Debt
If you’re asking yourself if you should get a debt consolidation loan, much of this depends on personal circumstances.
For instance, what do you hope to accomplish by taking out a loan?
- Do you qualify for a lower interest rate?
- Will it allow you to pay the debt faster?
- Will it streamline your monthly budget?
The other considerations depend on the kind of loan you secure.
For example, applying for a personal line of credit will mean you will need to be diligent about your payback plan.
Having the option to pay only the interest on the principal might be tough to resist for some people.
Common Methods for Consolidating Debt
1. Home Equity Loan
A home equity loan is one form of credit you can obtain for debt consolidation.
You can borrow up to 80 percent of your home’s worth and receive a lump sum amount by doing so.
An important caveat regarding your property’s value is how the financial institution calculates equity; they typically assess the property and then subtract your mortgage balance.
The advantage of choosing a home equity loan is once you’re approved, the credit is accessible, and the interest rates are lower.
These loans can be attractive if you’re in the market for a debt consolidation solution.
However, the application process for this type of credit can be somewhat expensive and time-consuming.
It varies by lender, but it’s typical to pay valuation/assessment fees, legal fees and other costs associated with securing the property.
2. Personal Line of Credit
Another option is a personal line of credit (LOC).
These loans are considered a revolving credit account – you can borrow a little, pay some back and then borrow more, up to the maximum credit limit.
You only pay interest on the amount currently outstanding.
One thing to note is most LOCs comes with a variable interest rate, and a sudden jump in interest rates could create stress if your budget is tight.
According to a 2019 national study, approximately 20 percent of Canadians carry a line of credit.
This kind of loan is a good fit if you’re disciplined about paying down your debt.
The temptation to borrow money and pay only the minimum amount can be tough to resist – especially if you’re working with limited funds.
On the other hand, a LOC can also be a powerful tool for people who need to pay loans over a more extended period of time.
3. Credit Card Balance Transfer
Like any other business, credit card companies are always looking to attract new qualified customers.
Sometimes this involves a credit card promotion advertising a low introductory annual percentage rate (APR), and if done right, a balance transfer could save you quite a bit of money.
For example, a limited-time 0% APR may mean you’re able to pay off debt with no interest.
When looking for the right credit card for a balance transfer, it’s all about the details.
Reading the offer’s fine print will tell you things like how long the introductory APR will last, how much of your balance you can transfer, and any other limitations that apply.
There is usually a fee for transferring your debt to a new card, and depending on your credit limit, you may not be able to move the entire balance.
4. Consumer Proposal/Debt Repayment Program
A consumer proposal is a legally binding agreement between borrowers and their creditors.
Licensed insolvency trustees facilitate these arrangements and can help set terms for discharging the debt.
The trustee negotiates for their client to pay a portion of their debt within a certain time frame.
Consumer proposals can be favourable because they do not require the borrower to surrender their assets.
If you’re in a financial bind and nothing you do seems to help, a consumer proposal might be the best option.
However, not all trustees are created equal, and slick advertising campaigns do not make one firm better than the other.
Make sure to speak to a couple different firms before moving forward – you should feel comfortable with your trustee.
Frequently Asked Questions
- Does consolidation ruin your credit?
No, consolidation by obtaining a new loan shouldn’t ruin your credit score, however new loans will probably require credit checks, so you may see a dip in your score.
If you choose to consolidate your loans through a “consumer proposal”, this will negatively impact your credit score.
- What happens when you consolidate your debts?
It will depend on how you decide to combine your debts. If you are approved for a home equity loan, you will receive a lump sum which you can use to pay off your chosen debts.
If you obtain a line of credit, the money shows up as another account you can draw money from and use to settle your outstanding loan accounts.
A credit card balance transfer is a little different. You must transfer the balance from one card to another. You can initiate the transfer by phone, web, or convenience cheque and the issuer typically pays off the old account directly.
A consumer proposal is not a standard debt consolidation loan. A trustee negotiates directly with your creditors, and once there’s an agreement, you pay the firm. They are responsible for paying your creditors.