When you’re drowning in debt, a consolidation loan might seem like a lifeline. The idea sounds simple: take out one big loan to pay off all your smaller debts. Instead of juggling multiple payments to different creditors, you make one monthly payment. Here’s the thing – while debt consolidation can be a good idea for some people, there are a couple of important things anyone considering it should know before moving forward. We’ll cover what those are here.
What is a consolidation loan?
A consolidation loan is a debt borrowed from a bank, credit union, or other lender to pay off your existing debts. This could include credit card debt, payday loans, personal loans, or other unsecured debt.
Here’s how it works:
Let’s say you have three credit cards with balances of $3,000, $5,000, and $2,000. You also have a personal loan with $4,000 remaining. That’s $14,000 total across four different debt obligations and payments. With a debt consolidation loan, you’d borrow $14,000 to pay off all four debts. Now you only have one payment to worry about, i.e. the loan of $14,000.
Additionally, consolidation loans tend to have a lower rate of interest than many lines of credit. If you qualify for a consolidation loan at 8% interest when your credit cards charge 19%, you could save a lot of money on interest payments.
Ways to consolidate debt
There are a few common ways to consolidate debt.
Loan: An unsecured loan from a bank or credit union. These typically require good credit and steady income. They could come in the form of a personal loan, home equity loan or a debt consolidation loan, a product created specifically for this purpose.
Lines of credit: This is an option that gives you a certain limit up to which you can borrow. Once again, it could be either a personal line of credit that may carry a higher rate of interest or a home equity line of credit with a relatively lower rate of interest. However, be careful not to over-borrow.
Balance transfer credit card: Move all your card balances to one new card with a low promotional rate. However, beware – the rate could jump after the promotional period.
Risks of a consolidation loan
Longer in duration
Consolidation loans tend to be longer in duration. Which means you’ll end up servicing them for longer than the original loans. While it may mean that monthly payouts will reduce, it could be problematic if we’re in an environment of rising interest rates. The Bank of Canada adjusts the rates frequently depending on macroeconomic indicators. Your overall interest payout may actually end up being higher, even though interest rates are lower than what your current creditors charge you. More on this in the next point.
They can be more expensive
Consolidation loans can actually cost you more in the long run. If the term of your new loan is significantly longer, you might end up paying more in interest over the life of the loan, even if the monthly payments and interest rate are lower.
Let’s do the math.
Say you have $20,000 in credit card debt at 19% interest. If you pay $500 per month, you’ll be debt-free in about 5 years and pay about $9,000 in interest.
Now imagine you get a consolidation loan at 12% interest, but the duration of the loan is 10 years. While your monthly payment comes to $300, you’ll end up paying about $16,000 in interest – almost double!
Less flexibility in negotiations
When you have multiple creditors, you actually have more options for debt relief. Individual creditors might be willing to:
- Reduce interest rates
- Accept lower monthly payments
- Offer payment holidays
- Settle for less than the full amount owed
Once you consolidate, you’re dealing with just one creditor who may be less willing to negotiate.
They can tempt you into taking on more debt
This is probably the biggest trap with consolidation loans. When you pay off your credit cards with a consolidation loan, those cards are now empty – and it’s very tempting to start using them again. If you start incurring new charges before you pay off the consolidated debt, you can end up with more debt instead of less.
This is how people end up in worse financial shape than when they started. Now they have the consolidation loan plus new debt on top of it.
No guarantee of lower interest rates
Not everyone will qualify for a better interest rate. Individuals who are exploring debt consolidation loans can face greater hurdles if they have poor credit history. Thus, lenders may impose high interest rates.
If you have bad credit, you might not save any money at all. Some people with poor credit scores get offered consolidation loans with higher interest rates than their existing debt, which can make their situation worse, and they end up replacing good credit with bad credit.
Could end up being a band-aid fix
Before consolidating, ask yourself: what got you into debt in the first place? If you haven’t addressed the root cause, a consolidation loan won’t fix your money problems. You need to fix your cash flow and spending habits, or you’ll likely end up in debt again.
When to opt for a consolidation loan
The 60% rule
Here’s a simple test financial advisors use to assess whether a consolidation loan may be a good option. Add up all your monthly debt payments. If this amount is more than 60% of your monthly income, a consolidation loan probably won’t help. You need more comprehensive debt relief. For example, if you earn $4,000 per month and your debt payments total $2,500, that’s 62.5% of your income. A consolidation loan might lower your payment slightly, but you’ll still be struggling.
Compare the length and cost of the loan
Calculate the total cost of the consolidation loan over its entire term. Compare this to what you’d pay if you kept your current debts but focused on paying them off faster. Sometimes, keeping your existing debts and using a debt management strategy might work better. Also, the cost of the loan will depend on your credit score. Typically, a score above 650 could signal that you may qualify for a low interest rate.
Can you qualify
It’s close to impossible to get a debt consolidation loan with bad credit. Banks and credit unions want to see:
- Stable income
- Good credit score
- Low debt-to-income ratio
- Sometimes collateral (like your home)
If you don’t meet these requirements, a consolidation loan isn’t an option anyway.
How to make a consolidation loan work
If you opt for a consolidation loan is right for you, follow these rules:
- Close the paid-off accounts: As soon as you pay off credit cards with the consolidation loan, close those accounts. This removes the temptation to use them again. Though doing this may bring up issues with your credit score. Do some research beforehand to understand what closing the accounts would mean for you.
- Create a strict budget: You need a detailed plan for your money. Track every dollar coming in and going out.
- Build an emergency fund: Start saving at least $1,000 for emergencies. This prevents you from using credit when unexpected expenses come up.
- Focus on the root cause: Address why you got into debt in the first place. This might mean increasing your income, cutting expenses, or changing your spending habits.
- Make extra payments: If possible, pay more than the minimum on your consolidation loan. This saves money on interest and gets you debt-free faster.
How to get a consolidation loan
If you’ve decided a consolidation loan is right for you, here’s how to get one:
- Check your credit score first: Know where you stand before applying. You can get a free credit report from Equifax or TransUnion.
- Shop around: Compare offers from banks, credit unions, and online lenders. Credit unions often offer better rates than big banks.
- Consider a co-signer: If your credit isn’t great, a co-signer with good credit might help you qualify for better terms.
- Get pre-approved: This gives you a better idea of what rate and terms you’ll qualify for.
- Read the fine print: Watch out for origination fees, prepayment penalties, and variable rates that could increase.
Other debt management alternatives
If a consolidation loan isn’t right for you, consider these alternatives:
Consumer Proposal
A consumer proposal is a good option if you are dealing with more than $10,000 in debts, can’t qualify for a debt consolidation loan, and are struggling to keep up with your monthly payments.
With a consumer proposal, a Licensed Insolvency Trustee negotiates with your creditors to reduce the amount you owe. You might pay only 30-50% of your total debt.
Debt Management Program
A Debt Management Program is an arrangement made between your creditors and a credit counselling agency to simplify your debt payments and reduce the total interest owed. They can help you create a budget and negotiate with creditors.
Focus on high-interest debt first
Sometimes the best strategy is to keep your existing debts but attack them strategically. Pay minimum payments on everything, then put all extra money toward the highest-interest debt first. This saves money on interest without taking on a new loan.
Wrap up
Consolidation loans can be helpful for the right person in the right situation. However, they’re not a magic solution for debt problems. You may save on interest charges, but your debt obligations still remain.
Before considering any debt relief option, take a hard look at your finances. Can you realistically afford the payments? Have you addressed what caused your debt problems? Do you have good enough credit to qualify for beneficial terms?
Consult with a financial advisor or a credit counsellor. They can help you understand all your options and choose the best path forward. With discipline and the right strategy, you can get back on track and build a stronger financial future.
