How Does Debt Consolidation Work?
By Debra Pangestu
Keeping up with different debt obligations is a common struggle for many Canadians, and if you’re trying to get your head above water, sometimes understanding how debt consolidation works could be the first step towards rebuilding your finances.
Although debt consolidation can certainly help improve your finances, it isn’t a blanket solution for all financial challenges. If you’re thinking about consolidating your debts, we’ve outlined some things you should know about debt consolidation in Canada, as well as some debt consolidation pros and cons.
What is Debt Consolidation?
If high interest rates, high monthly payments and juggling multiple bills are putting unnecessary stress on your finances, it may help to do a debt consolidation. But what is debt consolidation, exactly? In a nutshell, this involves taking out one big loan, which you use to pay off your current debts. Once your outstanding debts have been paid off, you’ll just have one payment to make each month towards your consolidation loan.
A debt consolidation is helpful in that it accomplishes three things. First, it lowers your interest rate. Many credit cards have high interest rates – some as high as 36% – and if you haven’t been making more than your monthly payments, chances are your balance isn’t going down very quickly because of the interest charges. A good debt consolidation loan has a lower interest rate than the credit cards you are consolidating, which saves you money in the long run because more of your payment will go towards paying down your debt.
With the lower interest rate you’d get on a consolidation loan, your monthly minimum payment may be lower as well, making it easier to get your finances back on track. On a high interest credit card, your monthly minimum payments could reach a point where they’re difficult to keep up with. Missing a payment leads to a domino effect, where your payments increase month after month. Here’s a handy loan repayment calculator to give you an idea of how easy it is for your high-interest payments to spiral out of control if you miss a payment.
Lastly, debt consolidation also has the benefit of keeping your bill payments a bit easier to manage. If you’ve got a handful of credit cards, it can be difficult to juggle multiple payments and keep track of different payment dates. Consolidating your debts eliminates the juggling, because you reduce the number of you bills you have to just one. With only one bill payment to make each month – towards your consolidation loan – it’ll be easier to focus your time and energy on getting out of debt.
How to Get a Debt Consolidation Loan: What’s Involved and What to Expect
Although getting a consolidation loan is a fairly straightforward process, not everyone facing financial challenges qualifies for it. To qualify for consolidation loans, you need to have an acceptable credit rating because lending institutions will use your credit score and payment history to determine risk. It also helps to have a regular source of income, so your lender knows you’ll be able to manage your monthly payments. If you have security for the loan – such as property or a vehicle that’s not too old – it could also work in your favour. However, it’s important to keep in mind that prime lenders who offer reasonable interest rates aren’t interested in taking household possessions as collateral for a loan. Only subprime lenders who charge really high interest rates will take this kind of security.
If your credit rating isn’t in the best shape, there are other ways to consolidate your debts. For starters, if you have a low interest credit card, you can request a credit card balance transfer and consolidate all your debts onto that one credit card. For example, if you have credit cards with interest rates of 25%, 20% and 13%, you could transfer the credit card balances on to the card with the 13% interest rate. It would improve your situation in the long run because more of your payment would go towards paying down the principle.
Another way to secure a consolidation loan is to ask a family member or trusted friend to co-sign on the loan. If your co-signer has a strong credit history, the lender or financial institution you’re working with may be more willing to sign off on the loan. However, if you do ask someone to co-sign for you, it’s important to ensure they are aware of their responsibilities. In the event that you can’t make payments on the loan, your co-signer will be saddled with the responsibility of making the payments.
If you’re a homeowner and you have enough equity in your home, another option is take out a second mortgage from your mortgage lender. Since the lender is using your home as collateral, they will likely offer a lower interest rate because they won’t be too concerned about you defaulting on the loan. In the event that you can’t pay back the loan, your lender can take your house and sell it to get their money back.
Some Debt Consolidation Drawbacks
Debt consolidation can be the right course of action if you’re juggling different consumer debts – like credit card debt – and haven’t been able to make much progress in paying down your balance because of high interest charges. But if you’re not careful, you could end up with more debt on your hands than you started out with.
The expression “robbing Peter to pay Paul” is often applied to the debt consolidation process, in that you’ve merely shifted your debt rather than taking concrete steps to address the behaviors that got you into debt in the first place. Whether the reason for your debts is a spending problem, not following a budget, an unrealistic budget, a job or income issue, or an unexpected emergency, it’s important to change your behaviour otherwise you’ll find yourself in a similar predicament a few years later.
If you take out a consolidation loan and use that amount to pay off your credit cards, you’ll be freeing up spending money on those cards and the temptation is there to spend, unless you take the initiative to close your cards. If the cards remain open, you run the risk of charging up more debts on your cards on top of your consolidation loan debt, and in the end, you could end up in a far worse position with more debt and higher payments than you started out with.
If you are consolidating using the equity in your home as security, the risks of course include the possibility that your home could decrease in value leaving you with loans that are worth more than the home, and if you fall behind on your payments, you could lose your home.
Tackling Your Debt with Other Options
If you’re struggling to keep up with your debt payments and you’re not in the position to take out a consolidation loan – or ask someone to co-sign for you — there are other options available to you.
Learn How to Budget and Avoid Racking up More Debt
Not knowing how to budget and how to plan your spending are some of the common reasons people often find themselves in debt. If you tend to spend freely without taking into account how much you’re spending each month in relation to how much you’re earning, you’ll spend yourself into debt without even realizing it.
To avoid this, it’s essential to learn how to live on a budget and how to plan your spending. Not only will this prevent you from getting into the debt spiral, but it will also help you dig yourself out from under a mountain of debt. You’ll have better control over your money, and you’ll know exactly where your money goes – and which areas you can cut back on – so you can start making more payments towards your debt. To learn more about how to budget, click here.
Reduce and Avoid Further Debt by Understanding Your Issues
Most consumers are under the impression that if they get a consolidation loan, the loan will solve their financial problems and reduce their debt. However, getting a consolidation loan doesn’t solve the issues that created their financial problems in the first place. Oftentimes, money problems stem from using credit irresponsibly, impulse spending, a business deal gone bad, a lack of income, and in some cases, an addiction.
If the reason for your debt and financial strain is due to a behavioural or psychological issue, it’s best to address that issue before implementing a financial solution. You can try to remedy your finances all you want, but if the issues underlying your debt still persist, your finances will start to deteriorate.
Talk to an Accredited Credit Counsellor
If you’ve been turned down for a debt consolidation loan and other options aren’t working for you, it would help to speak with one of our accredited Credit Counsellors. In a credit counselling session our counsellors can help you go through your finances, put together a workable budget, and show you all your available options. One of the options a Credit Counsellor can help you look into is a Debt Management Program (DMP).
A DMP is similar to debt consolidation in that all your unsecured debts are consolidated, and you only have to make one payment a month. No loans are involved. Instead, your Credit Counsellor will negotiate lower interest rates and fees on your outstanding debts and once an agreement is reached, you’ll make a monthly payment to the credit counselling organization, and they in turn will disburse those payments to your creditors.
When you’re on a DMP you’ll pay either a lower interest rate or no interest, so more of your payment goes towards servicing your debts. The accounts and credit cards involved in the DMP will also be closed, so you won’t face the temptation of future spending and racking up more debt. And, when you’re on a DMP you’ll also receive continual financial coaching and support to help you improve your budgeting and money management skills. By working with a Credit Counsellor, not only will you work your way towards getting out of debt, but you’ll also have the tools you need to make smart financial decisions in the future so you’ll never find yourself buried in debt again.
Some Final Thoughts on Debt Consolidation
Getting a debt consolidation loan can be the right course of action for you if your goal is to reduce your overall debt payments and to organize your monthly payment obligations. But it’s also important to keep in mind that with a consolidation loan, you’re merely shuffling your debt and that you will still be responsible for repaying the money you borrowed. The danger with getting a consolidation loan is that once you use the loan to pay off your creditors, more credit becomes available to you, unless you take the initiative to close your credit cards and accounts. If you don’t, you could find yourself racking up more charges and getting deeper into debt.
If you’re thinking about taking out a consolidation loan as a means to get out of debt, consider making a free appointment to speak with one of our accredited Credit Counsellors. They’ll walk you through your finances, help you create a realistic budget, present all your available options, and further explain how debt consolidation works.
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