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 various debt consolidation loan options that you can explore.
How Does Debt Consolidation Work?
Debt consolidation involves getting a new loan or credit facility with a favourable interest rate, which is then used to pay off all existing debts.
This simplifies the repayment process by reducing multiple payments and possibly high interest rates to a single payment towards the consolidated loan.
The effectiveness of debt consolidation for an individual depends on factors such as property ownership, credit score, and debt consolidation goals.
For those seeking a home equity loan, a meeting with a bank to discuss their financial situation and the assets they intend to use as collateral is likely required.
he process of obtaining such loans can be more complex than other financing options.
The application process for a personal loan or credit card is quite similar, however, can generally be completed quickly online.
It may involve comparing offers from various banks and credit unions to ensure favorable interest rates, terms, and services.
Furthermore, apart from banks and credit unions, there are many other financial service brokers that offer debt consolidation loans.
These firms partner with a variety of lenders, including investment trusts, private lending firms, and other diverse businesses, to provide more choices for borrowers.
However, there may be some caveats to working with these unconventional options, which are discussed further 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
Start by understanding the differences between a loan vs line of credit as each has its pros and cons when it comes to debt consolidation.
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.
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 lines of credit 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 line of credit can also be a powerful tool for people who need to pay loans over a more extended period of time.
A car loan can be paid out using a line of credit for example if you have a better interest rate on the line of credit.
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 with a debt consolidation loan – 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.