Debt consolidation: What you need to know - MoneySense

Debt consolidation: What you need to know

By consolidating your loans, you can transfer higher-interest debts that you struggle to keep track of into a single lower-interest obligation. Read on to learn the different options, and whether consolidation is the right choice for you.

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Historically low interest rates have motivated Canadian consumers to take on additional debt in recent years. Bloomberg Businessweek reported in March 2019 that Canadians are “Feeling the Debt Burn,” as the ratio of household debt to gross domestic product was at a staggering 100.2%, well above nations with similar economies in the study. Excess debt is creating tremendous stress in households across the country—but there are solutions available to address overwhelming debt.

Healthy borrowing

First, let’s distinguish between the different types of debt we carry, and the reasons we may borrow money. 

Good debt, or “healthy borrowing,” is any debt that increases your net worth or has future value. Healthy borrowing is the sign of a modern economy, and it’s an integral part of our everyday lives. Examples of healthy borrowing include taking out a mortgage, opening a line of credit to finance a home renovation and borrowing money to fund your higher education.

Bad debt, on the other hand, is debt that does not have future value or increase your net worth, and which you do not have the cash to pay down. Anything that deteriorates in value the moment you walk out of the store, and have purchased on credit, is bad debt. This includes many of our optional “wants,” such as a vacation, a brand new flat-screen TV and cable. Unfortunately, it can also include many things we find necessary for living in a modern society, such as clothing and automobiles—even food. 

What is debt consolidation?

In light of recent economic trends, more Canadians are searching for ways to better manage their debt. Debt consolidation is one important tool that’s helping many Canadians overcome their financial hurdles. We’ll talk about what debt consolidation is, and offer some guidance for deciding whether it’s right for you.

Debt consolidation is a type of refinancing where you, the borrower, take out one loan to pay off your unsecured debts. Though it may seem counterproductive to take out yet another loan to pay off multiple loans, doing so can save you considerable money and hassle. By consolidating your loans, you can transfer higher-interest debts that you struggle to keep track of into a single lower-interest obligation. Because you make a single payment each month instead of several, you can more easily manage payments and reduce your risk of falling behind.

Unsecured debts include credit card debt, medical bills and any other personal loans you were granted without a collateral requirement. Collateral refers to the asset you pledge as security for repayment of a loan, which the lender may use to recover the debt in event of default. Common types of collateral include real estate, cash or a payment reserve.

There are three ways borrowers can consolidate their unsecured debts:

Debt consolidation loan

This loan is usually offered through a bank or another lending institution and can either be secured or unsecured. Borrowers use the loan to pay off all their outstanding obligations and then just have one loan to repay instead.

Balance transfer credit card

This type of borrowing is used to consolidate existing credit card debt to a more favourable interest rate. This option is limited to credit card debts and allows the borrower to transfer the balance from high-interest rate cards to a more appealing interest rate with another credit card provider. A minimum balance transfer fee—usually 1% to 3% of the total amount you are transferring onto the new card—may be charged to you.

Home equity lines of credit (HELOC)

With a HELOC, you use your home as collateral, and receive the ability to borrow money, up so a specified maximum amount; you pay interest only on the the money you’re currently using, as you don’t receive the maximum in a lump sum. In general, borrowers can use up to 65% of the value of their home. (This Financial Consumer Agency of Canada web page has more details.)

What does consolidation look like?

As an example, imagine you have $15,000 in debt from these four sources. (APR stands for “annual percentage rate,” which most lenders use in order to convey to you the real cost of borrowing, on a yearly basis.)

Source #1: Credit card – $3,000 at 20% APR

Source #2: Credit card – $4,000 at 12% APR

Source #3: Bank loan to pay off medical debt – $3,000 at 18% APR, with a one-year term

Source #4: Bank loan to finance a home remodel – $5,000 at 16% APR, with a three-year term

A balance transfer credit card can consolidate the two credit cards into one, totalling $7,000. If you have good credit, you can get a 0% APR introductory rate for six to 12 months. This means you can apply more money to the principal, which will help you pay off the debt quicker.

However, this option does come with the risk that you will fall behind again once the low introductory rate has ended. Combine high-interest rates with monthly fees, annual fees and late fees, and you risk undoing all the hard work you put forth to whittle down your debt. To avoid falling further behind, shop around for a balance transfer card that boasts a low regular APR, has no monthly or annual fees, and charges a reasonable late fee.

A typical debt consolidation loan would allow you to consolidate all four debts into one. The interest rate you have to pay will depend on your credit score. This option allows you to simplify your debts into one monthly payment over a fixed timeframe of three to five years. A lender providing this service will usually require you to have a good credit score.

Both options have their merits and drawbacks, so how do you decide which is right for you? Ultimately, the decision should come down to fees, interest rates, your total balance and your credit score.

Your credit score (which is free for you to access) determines which types of consolidation solutions you qualify for. Once you’ve narrowed down your options, compare interest rates (both introductory and regular), fees (one-time, monthly, annual, and balance transfer), late payment repercussions and the impact on your future credit rating. For many borrowers, balance transfer credit cards are an appealing option but don’t allow them to cover the entirety of their debts. You may discover that by splitting your debt between a personal loan and balance transfer credit card, you can eliminate your debt before the regular interest rates and fees kick in.

If this all sounds more than a little daunting, there is help. For example, LoanConnect* a Canadian online platform, lets you explore options to consolidate all your debts, even if you have a bad credit score.

In situations where a person’s debts outstanding are no longer manageable, they can work with a leading not-for-profit debt management program (DMP) through Loan Connect. A DMP works directly with your lenders to help you consolidate your debts and lower your overall monthly payment. As opposed to a traditional debt consolidation loan, this is a service that distributes your monthly payments to your lenders to help you become debt-free.

A debt management program can help to:

  • Simplify your budgeting
  • Reduce monthly payments
  • Obtain a lower interest rate
  • Reduce pressure from creditors
  • Make only one monthly payment 

There is no magic bullet to paying off your loans. However, debt consolidation can potentially help you manage your debt situation.

Consolidating may be good for you if:

  • You have multiple debts
  • You struggle to make monthly payments on time
  • You make only the minimum payment each month and struggle to reduce your principal
  • Collection agencies are calling or sending letters frequently
  • You are unable to negotiate lower interest rates with your lenders
  • You need to reduce monthly payments and can afford to pay over a longer term 
  • You want to do away with the hassle of paying multiple lenders each month and, instead, want to make one easy monthly payment

Consolidating may not be good for you if:

  • You have a limited amount of debt
  • Consolidation will enable you to rack up more debt
  • You can’t afford to make payments over a longer term

If your life and the decisions you make are dictated by the presence of enormous debt, you can regain control by enrolling in a debt management program or consolidating your loans.

Launched in 2016, Asset Direct of Canada (doing business as LoanConnect) is a financing solutions provider based in London, Ont. The company is dedicated to making people’s lives better by providing access to financing alternatives which give them more control over their financial well-being.