"Debt consolidation" is often a phrase that people associate and confuse with "debt relief". The belief is that if you consolidate your debt, you’ll be better off.
But is that true?
There are pros and cons to the different forms of debt consolidation. Whether or not it's right for you depends on your situation.
Consolidating your debt means that you’re taking separate smaller debts and turning them into one large new one. The hope is that when you consolidate your debt, you'll get a lower lumped interest rate instead of paying a higher rate on the individual debts added up.
Traditionally, the three most popular ways to consolidate debts are:
- apply for a loan or line of credit from the bank
- refinance your home equity (if available) or
- file a consumer proposal
Fundamentally, debt consolidation will only work if you successfully repay the consolidation loan without accumulating new debt. If you get a consolidated loan and keep putting new debt on the old credit cards, you’ve essentially just doubled your debt, which will undoubtedly lead to problems.
Debt Consolidation: Helpful, or harmful?
All of your loans will be on one monthly payment. The interest rate charged by financial institutions for one personal loan will be lower than the interest rate on three or four credit cards or lines of credit. You're repaying the full amount of your debt, which will keep your creditors happy.
Depending on the bank, they will usually only consolidate debt that you have with their bank. This means your remaining debt outside of their institution remains as a separate payment. Half a consolidation is not nearly as effective as a full consolidation.
By asking the bank to consolidate, you’re indirectly telling them that you’re having trouble keeping up with payments, which could make the bank nervous. If you don’t have a good, steady income, it’s unlikely you’ll be approved. Even if you have a good credit rating, banks primarily only consider an approval if you have a co-signer. This means someone else will guarantee the bank that the consolidation will be paid if you run into problems repaying.
So take these factors into account and make sure, if you’re approved, that you stick to the plan and don’t accumulate new debt. Use tools like our debt repayment calculator to make sure you’re able to make your payments.
Refinancing a Mortgage
With house prices appreciating, many home owners are opting to remortgage their home to consolidate their consumer debt. There are typically two ways to refinance a mortgage if you own a home. You either apply for a brand new first mortgage, or apply for a second mortgage.
Typically when you refinance your mortgage, you're freeing up cash flow. The payment on a consolidated debt will be much lower than the payments on high interest consumer debt. This increased cash flow means that you can start putting some money aside to save for those unexpected expenses.
Recent rule changes have made it a little more difficult to qualify for refinancing. Banks are now limited to lending up to 80% of the home’s value. If your balance on your current mortgage is already more than 80% of the home’s value, chances are you won’t qualify.
Although your interest rates are lower, you're paying more long-term. You're now paying 3%-4% over the course of 15-20 years. This adds up in the grand scheme of personal finances. If you’re thinking of using a second mortgage to clean up your debt, read our post here.
A consumer proposal consolidates your debts with no interest. It does not require a co-signer, a good credit rating, and it can include all your consumer debts.
You will effectively consolidate all of your debts into one monthly payment with a consumer proposal. The application process doesn't require a co-signer, so you aren't making someone else liable for your debts. Your credit score doesn't affect your ability to be approved.
There's no interest on consumer proposal payments and you're only repaying a portion of your debt. Once a proposal is filed, calls from creditors will stop as it is a legally binding document. They cannot come after you for more money than what's negotiated and approved in your proposal.
Consumer proposals impact your credit score because they remain on file for three years after you're finished your payments. While this seems like a deterrent, your existing debt load and late payments also negatively affect your credit score. So the best solution for you long-term is to tackle your debt problem and eliminate debt.
Because it's a legally binding document, you cannot alter the payment schedule or amount without refiling. You also cannot take more than five years to complete your proposal. There's no early repayment penalty, however you cannot exceed the five year mark.
If you’d like a professional to look at your current situation and help you determine which method of debt consolidation is most helpful for you, contact us today.