Introduction
In Brandon’s Blog, I will be talking about both the advantages and disadvantages of debt consolidation in Canada. Generally, when we hear the words “debt consolidation”, we recognize that we are talking about a loan. We are taking on a new loan, in order to repay several or many smaller outstanding balances.
What is the smartest way to consolidate debt?
People have several choices when it comes to consolidating debt. It always involves borrowing. The theory is that either:
- your credit score is good enough so that you can get an unsecured loan; or
- you are choosing to offer security for the loan.
The primary objective of settling your debt through this kind of borrowing is to decrease the rate of interest you are currently paying. It is very common for people to have debts spread among various credit cards.
For example, you may have amounts outstanding on 5 credit cards. You are pushing the upper limits of your approved credit. The average annual interest rate you are being charged among those credit cards is 19.9%. If you can get a home equity line of credit at say, an annual interest rate of 5.5%, the benefit is obvious. So it would be a smart choice to offer security to get a consolidation loan.
If you didn’t want to or didn’t have security to offer, you may have a good enough credit score to get an unsecured personal loan. Let’s say you could get this kind of loan at an annual interest rate of 8%. The rate may sound high in today’s interest rate environment, but it is a lot better than 19.9%. So this too would be a smart way to go.
But as I will discuss below, there is a difference between being smart about debt consolidation and settling for what makes sense!
Is it a good idea to get a debt consolidation loan?
If you can get this kind of loan and you are wise about it (more on that in a little bit), I say yes. In the example of the 5 different credit cards I gave, you are juggling multiple debts carrying a high rate of interest and are running out of credit room. The debt consolidation loan will lower the interest you are paying dramatically and will term out your payments.
You will stop being a juggler. That is an advantage.
Should I get a loan to pay off my credit cards?
In a typical debt consolidation funding, you need to get a fixed, not variable, interest rate. You also need to have a fixed repayment schedule which offers you a set time to pay it off. You do not want a variable rate of interest or a revolving line of credit. You want the loan to be automatically reduced with every payment you make, with no chance of increasing the loan for any reason.
That is the kind of loan you need to pay off your credit cards. It is that predictability and certainty that you need to work into your life. If you can get that kind of loan to pay off your credit cards, then that is an advantage and you should.
What happens when you consolidate your debt?
What happens depends on the type of loan you get to consolidate your debt. The various types of loans I have seen people get are:
- an unsecured personal loan from their bank
- a home equity line of credit or second mortgage
- A credit card balance transfer at a promotional interest rate of either a 0% or a special introductory very low rate
- in more recent times, a peer to peer loan
I already spoke about the benefits of either a home equity line of credit or an unsecured personal loan. When it comes to a balance transfer, you can obtain introduction rates that are as low as 0% or 1.99% for a specific period of time, such as 12 or 18 months. You need to have sufficient credit available on such a new balance transfer credit card to assume the total debt spread among the 5 credit cards. With banks competing for your business, it may be possible.
What happens when you are able to consolidate your debts into one loan is that you achieve simplification in your life. You now have just one settlement to make. It’s much less to keep an eye on.
Simply put, simplicity is an advantage. As long as you stay current in your new loan payment, you are working towards paying off your total debt.
How does debt consolidation affect your credit score?
Initially, debt consolidation could improve or at least maintain your credit score. Falling behind on credit card balances hurts your credit score. Paying off those loans and being current on your new debt consolidation loan can improve your credit score. However, there are some traps that you cannot fall into. If you do, then you will not have ended up fixing anything and will end up worse off.
So a debt consolidation loan in itself does not hurt your credit score and could improve it as long as you meet the repayment terms of your new loan. A discussion of the traps leads us into a discussion of the disadvantages of this kind of loan. It is important to recognize that it is not a loan that is the problem, it is the person’s behaviour.
Does a debt consolidation loan look bad?
I would rather have a new loan showing up on my credit report, than have my 5 credit card loans going bad on my credit report. A debt consolidation loan is only a loan. Debt consolidation in itself is not bad, it doesn’t look bad. An experienced financial or credit person looking at your credit report will know what you have done. However, it will also show them that you have been able to get a new loan. So it shows that a lender feels you are a good credit risk. None of that is bad.
What is bad, are the traps that you could fall into. If you fall into one of them, it could be bad for you. This is all about your behaviour, not the consolidation loan.
The disadvantages of debt consolidation in Canada
I will discuss the disadvantages of the type of loan and by behaviour.
Home equity line of credit
If you get a home equity line of credit (HELOC) that is anything other than a fixed interest rate loan that is not a revolving line of credit, you could fall into a trap. You are looking for simplicity and certainty. If your interest rate can rise if the prime rate charged by your bank rises, then you are not getting the full benefits.
Granted a 5.5% loan isn’t going to rise to a 19.9% interest rate, but your room for interest rate increases may be small. If a 1% or 2% increase in the interest rate would make the difference between you being able to afford the repayment and not being able to make them, you will constantly be worried about it in an increasing interest rate environment.
You also want to make sure that the HELOC is not a revolving line of credit. Once you make a payment, you want the principal portion of a paydown by each payment to be permanent. You cannot be enticed about the ability to borrow more on the line. Remember, you took on this loan to pay off debt, not to either remain at the same debt level or to increase it.
So having to pay more interest or being able to go deeper into debt are two traps to avoid with this kind of loan.
A credit card balance transfer at a promotional interest rate
As I mentioned earlier, normally these zero or very low-interest promotional rate is for a fixed period of time. So if you can repay the whole amount, in the monthly payments required, within the time period given, it is a great thing. However, if you can’t, then your promotional interest rate goes up to probably at least the average 19.9% rate in our example. Now you are back to where you started.
Maybe you missed a payment; either because something got in your way or inadvertently. Normally when this happens, you immediately lose your promotional interest rate and a fee is charged. That is a disadvantage.
You may have used this method because you were being chased by a bank for your business, but could have used one of the other methods at the time. If that is the case, and you plan for replacing the promotional interest rate loan balance before it reprices, with one of the other methods, then great. However, if you don’t, then you are back to where you started. Maybe not worse off (see more below), but certainly no better, other than for the principal you were able to pay down.
An unsecured loan
Just like a HELOC, if the unsecured loan cannot revolve and has a fixed rate of interest, that is a good thing. If it does revolve and you have not paid down any principal, and/or your interest rate rose, that is a trap. That is a disadvantage.
Do consolidation loans work?
This is where we talk about the biggest trap or the greatest benefit. It all comes down to answering this one question. Has your behaviour changed?
Debt consolidation in Canada is a terrific device when your behaviour changes. The first step to changing your spending behaviour is to budget. I have written several of Brandon’s Blogs on the topic of the need to have a proper household budget and stick to it.
But what if your behaviour doesn’t change? Did you close out the 5 other credit card accounts when you did the debt consolidation loan? Or, did you keep them open and keep running up the balances for spending greater than your income, while paying down your debt consolidation loan?
They were paid down to zero when you consolidated them. Now you have run them back up and have only made the minimal necessary payments. So, once more, you have overspent and are now back to the same stress-filled life as before. There is only one thing different now – you owe even more money, so your life has worsened. Your credit score is probably worse now too.
So if you change your financial behaviour, debt consolidation works well. If you don’t, then it doesn’t either.
What can you do now that a debt consolidation is no longer an option?
There are various options available. Most will negatively impact your credit score and provide a worse credit report. However, when you have run out of options, perhaps a lower credit score stopping you from taking on more debt might be a good thing. Maybe the fact that no one will loan you more money is what you needed as a wake-up call to once and for all get back on track.
The options include:
Credit counselling and budgeting
Many people require aid with things such as:
- budgeting
- accomplishing certain financial objectives
- a spending plan
- learning how to use credit wisely
Often times as soon as this assistance is received, people can continue by themselves with no more troubles.
A consumer proposal or Division I Proposal
A consumer proposal and also a Division 1 proposal are alternatives to bankruptcy. Although equivalent in numerous facets, there are some substantial differences. Consumer proposals are used by people whose debts aren’t greater than $250,000, not consisting of any kind of financial debts registered against your home. Division 1 proposals are for both companies, and for people debts exceed $250,000 (again leaving out home mortgages).
A consumer proposal is a procedure under the Bankruptcy and Insolvency Act (R.S.C., 1985, c. B-3) (BIA). With the licensed insolvency trustee (Trustee) you make a proposal to:
- pay your creditors a portion of what you owe them over a certain period of time not greater than 5 years.
- prolong the time you have to pay what you promise to pay in your accepted proposal.
- a mix of both
Payments are made to the Trustee. That cash pays the administration fees of your proposal and distributes money to your creditors. When you have made all the required payments, the balance of your debt that you did not pay is written off and discharged forever (with certain exceptions outlined in the BIA).
These are your realistic options, once a debt consolidation in Canada option is no longer viable.
Summary
I hope this Brandon’s Blog has provided you with some insight into when debt consolidation is a useful tool and its advantages. I also hope you can see where it could also be a trap for some people. If debt consolidation relieves the pressure on you because of the state of your finances AND motivates you to budget and bring your spending in line, then it is a good thing.
If it does not change the necessary behaviour pattern that got you into financial trouble in the first place, then things will only get worse. Is it now time for you to take a positive step in the right direction to free yourself from your debts?
Are you in financial distress? Do you not have enough money to pay your creditors as your bills come due?
If so, call the Ira Smith Team today. We have decades and generations of experience assisting people looking for financial restructuring, a debt settlement plan and to AVOID bankruptcy.
A restructuring proposal is a government-approved debt settlement plan to do that. We will help you decide on what is best for you between a restructuring proposal vs bankruptcy.
Call the Ira Smith Team today so you can eliminate the stress, anxiety, and pain from your life that your financial problems have caused. With the one-of-a-kind roadmap, we develop just for you, we will immediately return you right into a healthy and balanced problem-free life.
You can have a no-cost analysis so we can help you fix your troubles. Call the Ira Smith Team today. This will allow you to go back to a new healthy and balanced life, Starting Over Starting Now.
