If you have a few problem debts, perhaps an outstanding credit card balance, a cell phone bill, or unsecured financing loan, what can you do to pay off that debt faster?
Should you consolidate your debt with a new loan or through a debt management plan with a credit counsellor?
And at what point are your debts too large for either of these consolidation options to be successful? When should you consider a consumer proposal or bankruptcy as a form of debt relief if your financial situation is more severe?
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What is a debt management plan?
A debt management plan, or DMP, is a consolidation program arranged through a non-profit credit counselling agency where you make one manageable monthly payment to pay off certain unsecured debts. Your credit counsellor negotiates an agreement with your creditors to include your debts in the program and may also be able to arrange an interest reduction or interest freeze.
How does a debt management plan differ from a loan?
Credit counselling agencies do not lend money. A debt management plan may consolidate your payments, but it is not a new loan. Unlike with a debt consolidation loan, you are not transferring balances from one creditor to another when working with a credit counsellor to repay debt. You still owe each individual creditor while you are in the program.
There are advantages to consolidating your debt with a debt management plan over a consolidation loan:
- You do not need a good credit score to qualify
- You do not need any security to offer as collateral
- You will not need a cosigner
- A DMP can lower, and perhaps even eliminate, your interest costs, saving you money
- Your credit counsellor will negotiate directly with your creditors, so you don’t have to
- Credit counsellors provide additional advice and support on budgeting
While there is no interest rate with a DMP, an additional fee of approximately 10% of the debts consolidated in the program will be added to your monthly debt payments.
Since you are not paying existing debts off with the proceeds of a new loan, some creditors may decide not to participate in the repayment program, and this can leave you with some debts to pay outside the payment plan.
Debt management programs cannot include all types of debts. A DMP can be good for consolidating small credit card accounts, unsecured loans, and bill payments, however, if you need help repaying student debt, tax debt or secured debts like a car loan you will need to qualify for a large enough debt consolidation loan to deal with these larger debts.
Compare the risks of taking out a debt consolidation loan
A debt consolidation loan requires you to qualify for new credit. You are applying for a new loan to pay off existing debts, leaving you with one monthly payment to your new lender.
A debt consolidation loan will allow you to combine any type of credit if you can borrow enough to cover your current debts. There are, however, reasons why you may not want to consolidate student loans in Canada.
There are risks with unsecured debt consolidation loans compared to working with a credit counsellor to repay debts:
- You may not qualify for a low-interest loan, and bad credit loans can charge as high as 59%
- You risk losing your home or car if you use these assets to secure your consolidation loan
- You could be in debt longer if your monthly payments are too low
- You risk staying in debt if you build up balances on your credit cards again
What is the effect on your credit score?
Your credit score affects your ability to get new credit. If you are already having difficulty paying down debt, the best program for you is the one that improves your creditworthiness the fastest down the road once you get out of debt.
There are several credit score factors to consider with each alternative:
- A debt management plan will be reported on your credit report as a repayment program. This notice will remain as part of your credit history for a maximum of six years and can affect your ability to get new credit during this period.
- In contrast, a debt consolidation loan will appear as a new trade account on your credit report. As long as you don’t drive up your old credit card balances again, a debt consolidation loan can lower your credit utilization rate, which may help improve your credit score.
- Depending on the type of loan you use, a debt consolidation loan can also help improve your credit mix by converting revolving debt, like credit card debt, into an installment loan.
- Both programs can help bring past-due accounts current if you can afford the payment.
Debt consolidation vs debt management vs debt relief
There is a risk with both a debt management plan and a debt consolidation loan that you have too much debt for either approach to work.
With both alternatives, you must be able to afford to repay your debts in full plus any additional fees or interest. If you can’t afford to keep up with the payment terms under either option, then you risk further default, more hits to your credit score, and worst of all, you will be in debt longer.
An alternative may be to consider a consumer proposal. A consumer proposal can consolidate debt and provide debt relief. A consumer proposal is an interest-free debt settlement option that can improve your cash flow sufficiently to allow you to get out of debt sooner.
A consumer proposal has the same benefits of a debt management plan, yet your monthly payment is much lower. A consumer proposal has no worse an impact on your credit score, in fact, I would argue it is better because you pay less, allowing you to save more and rebuild your finances much fast.
A consumer proposal is not for everyone. You may be able to get a consolidation loan with a lower interest rate than your paying on your high-interest credit card debt today and save enough money to pay of your debts. You may benefit from working with a credit counsellor to deal with a few small outstanding accounts if you don’t have a good enough credit score to qualify for a new loan.
However, if you have a lot of debt, and neither option seems affordable, a Licensed Insolvency Trustee is the only debt professional accredited to explain the pros and cons of all debt consolidation options, including a debt management plan, debt consolidation loan and a consumer proposal. Contact a Licensed Insolvency Trustee for a free, no-obligation consultation.