If your current debt carries a high-interest rate, one way to reduce your borrowing costs is to consider a debt consolidation loan. Every day I talk with someone about whether or not a debt consolidation loan will work to help them deal with large debts.
Before you jump in and start talking with a lender, it’s a good idea to understand how debt consolidation loans work, so you know how to structure your consolidation loan to make sure you benefit financially. The problem is there’s just too much noise out there around this subject to be sure. So we thought we’d cut through some of the chatter for you and unpack it all for reference.
What you need to know about debt consolidation loans
In this guide to debt consolidation loans, we answer these common questions:
- What can I consolidate with a consolidation loan?
- What are the advantages of consolidating with a new loan?
- How are debt consolidation loan interest rates determined?
- What are the eligibility requirements of most loans?
- What are the steps to apply for a debt consolidation loan?
- What kinds of debt consolidation loans are best?
- Are consolidation loans good or bad for my credit score?
- What are my other debt consolidation options?
What is a debt consolidation loan & what can I consolidate?
A debt consolidation loan is a new loan that you use to pay off and refinance existing debts. You get money from a new lender to pay off old accounts and then make a single monthly payment to pay off that new debt.
Almost any kind of unsecured credit can be rolled into a consolidation loan including:
- Credit card debt
- Unsecured lines of credit
- High-cost finance company loans
- Outstanding bills
- Payday loans
- Income tax debts
If your accounts have been referred to a collection agency, you may have more difficulty getting approved for new credit. Be prepared to pay a much higher interest rate if you do qualify.
Secured loans and term loans, like a car loan, cannot be consolidated into a new loan unless the original lender agrees. The reason being is that you signed a loan agreement with the original lender for a specified term and interest rate, and they have registered security on the asset you financed. They may agree to let you out if you pay a penalty.
Student debt consolidation is rare in Canada. It is possible to consolidate private student loans like a student line of credit or credit card; however the costs of consolidating government-guaranteed student loans generally outweigh the benefits.
Why get a consolidation loan? And what to watch out for.
There are advantages to taking out a consolidation loan:
- You can reduce your monthly loan payment which can help balance your budget
- You convert multiple loan payments into one, simple monthly payment
- You can pay off debts sooner.
But these benefits are not guaranteed. Two common mistakes people make with debt consolidation loans are getting an expensive high-cost loan and lowering their payment by extending the term too far.
Beware high-cost financing loans
A consolidation loan can save you money if you can qualify for a low-interest rate loan. Consolidating credit card debt with an annual interest rate of 29% into a new loan that charges 7% or even 15% can provide a substantial financial benefit. However, consolidating outstanding bills and credit cards into a 49% loan through a low-credit financing company is not a good idea even if it does lower your monthly payment. Companies like Easy Financial and Fairstone may be willing to approve you for a bad credit debt consolidation loan, but getting such a high-cost loan will not necessarily solve your debt problems.
Avoid longer-term loans
Even low rate consolidation loans can only pay off debt faster if you keep your monthly payment high. The higher your monthly payment, the more you put towards principal or debt reduction each month. This has a snowball effect – the faster you pay off your balances, the less you pay in interest, allowing more to be applied to the balance owing next month. This helps you get out of debt sooner.
Let’s look at an example.
Owen consolidates 5 credit cards into a new $20,000 debt consolidation loan at 9%. Arda does the same. Owen chooses to set his payment at $636 a month. Arda lowers her payment to $415 a month. Owen will pay off his consolidation loan in just three years. Arda will not be able to pay off her debts for five years and will pay more than $2,000 in extra interest as a trade-off for lowering her monthly payment.
The key takeaway is to remember that whether you save any money and get out of debt sooner with a debt consolidation loan depends entirely on the terms and conditions of your loan agreement.
How are debt consolidation loan interest rates determined?
Credit score and collateral are the two primary factors in establishing an interest rate on a debt consolidation loan. The higher your credit score, the lower your interest rate will be. Those with an average credit score may qualify for a loan at between 10% and 15%. If you have a low credit score, a history of payment delinquencies, or other negative marks on your credit report, you may be charged a rate of up to 40%.
In general, traditional lenders like banks and credit unions will provide lower rate loans. Private lenders and financing companies will cost more.
Secured versus unsecured consolidation loans
The interest rate will also be lower if you can provide collateral to secure the loan. Secured loans, like a Home Equity Line of Credit or second mortgage, are lower risk for the lender than unsecured loans. Of course, just having security does not mean your rate will be low. Other factors, like your income and credit score, will still affect your consolidation loan interest rate.
Fixed-Rate versus Variable-Rate Loans
Interest rates can be fixed over the term of the loan or can be variable, meaning your rate can change at any time, as can your monthly payment. In most cases, a variable rate loan will be lower than a fixed-rate loan. This is because you are assuming the risk of future rate changes rather than your loan provider.
In addition to a monthly interest rate, your lender may charge you a processing, application fee or balance transfer fee. Most traditional banks do not charge loan fees; however, there may be costs associated with getting a mortgage appraisal or registering the collateral against your loan.
What types of debt consolidation loans should I consider?
The type of loan you can get will affect the cost, so choose carefully. You may also not qualify for every option, depending again on your credit score and if you have any security to offer.
Here are 9 common types of consolidation loans available in Canada.
The first loans are secured consolidation loans, while the latter are unsecured loans. The loans are ranked based on the interest rate commonly charged, from lowest to highest, although there will be some variability based on your situation. Generally, the best interest rate on a debt consolidation loan will be on a secured debt consolidation loan, such as a mortgage, and the highest interest rate applies on a high-risk unsecured loan.
If you own a home and have equity built up, you can use that equity to pay down your credit card debt by refinancing your existing mortgage. The best time to do this is when your mortgage comes up for renewal. If you try to change a mortgage mid-term, a penalty will apply, which will lower the savings you can achieve by consolidating.
Another way to use your home equity, is to take out a second home equity loan or second mortgage. Most traditional lenders will only lend up to 80% of the value of your home. There are secondary and private mortgage lenders who may loan up to 95% of your home’s appraised value; however these are high-risk loans and come with a high-interest rate. We generally recommend against borrowing against your home equity above 80% without first considering an interest-free consumer proposal.
Home Equity Line of Credit
A home equity line of credit or HELOC is a line of credit rather than a term or fixed loan. HELOCs provide a lot of flexibility in how you use your home equity. You receive an approved credit limit and draw only the amount of money you need. Payments are often interest-only, which can be attractive for your budget. However, the downside is you are not paying down your debt balances. If you use a HELOC to consolidate debt, be sure to create a formal repayment plan to get out of debt.
Secured consolidation loan
It is possible to secure a consolidation loan with almost any asset you own, not just your home equity. You can use savings, investments, stocks, and bonds as collateral. It is not possible to borrow against your RRSP in Canada except for the specific purpose of buying a new home or financing your education.
Another option is to borrow against your car if you own the vehicle outright or have equity built up from paying down your car loan. Often called car title loans or auto equity loans, some lenders specialize in allowing you to borrow against the value of your car. Beware, these can be one of the most expensive forms of secured consolidation loans and can create a rollover trap of car loan debt.
Unsecured line of credit (LOC)
If you have good credit, you may qualify for an unsecured line of credit to pay off your credit card debt. While you have flexibility in terms of your payments with a LOC, it is always better to make more than your minimum payment, because you want the debt to go away. Also, know that the interest rate can change as the prime rate changes. If the prime rate goes up, your minimum payments will increase. A line of credit can be a trap if you don’t have a handle on your finances.
Unsecured debt consolidation loan
An unsecured loan has no security, which makes this a riskier loan for a lender. That means that to qualify for an unsecured consolidation loan, you will need a good credit history and credit score, positive net worth, and a good income. Unlike an unsecured line of credit, this is a term loan with a fixed monthly payment and defined payback period.
Use Credit Cards to Consolidate Debt
You may be able to take advantage of a low-interest credit card or promotional offer to consolidate debts. You can accomplish this through a balance transfer from high rate cards to low rate credit cards. The downside of this approach is that promotional rates may only be temporary and again, you need to make more than the minimum payment if you want to eliminate your debt.
Payday loan consolidation
Payday lenders today offer more than the typical two-week payday loan. Many promote larger loans and lines of credit, often up to $35,000, money which can be used to consolidate other debts, including payday loans. These loans, like those from other financing companies, often bear an interest rate of at least 39%-49%.
How do I qualify for a debt consolidation loan?
Lenders will apply a variety of criteria to decide whether you can be approved for a debt consolidation loan. Your ability to pay back the loan will be a top concern.
Factors that affect your eligibility for a debt consolidation loan include:
- Your credit score and credit history
- Your assets and net worth
- Your employment history
- The stability of your income
- Your debt to income ratio
What’s a good debt-to-income ratio?
Your debt-to-income ratio is calculated as the total monthly debt payments (including your mortgage or rent) divided by your total monthly gross income.
Ideally, your debt-to-income ratio should be less than 36%. Most lenders will not extend credit if your debt-to-income ratio is above 43%.
You can confirm your ratio with our debt-to-income ratio calculator.
What credit score do I need?
Traditional lenders generally require a minimum score of 650 or more. At the low end of that range, you will still pay a premium rate, and you should still compare the cost of your loan with that of a debt management program or consumer proposal. If your score is above 700, or good, you will likely qualify for a low-rate loan.
A score between 550 and 650 may qualify you for a debt consolidation loan from a second-tier lender but expect to pay very high-interest rates. If your score is below average, consider looking at alternatives like a debt management plan or consumer proposal.
If you have very bad credit, generally 550 and under, you will not qualify for a debt consolidation loan and will need to explore other debt consolidation programs like a debt management plan or consumer proposal.
Should I get a co-signer?
If you are unable to qualify on your own, you can ask a friend or family member to co-sign your consolidation loan. A co-signer is someone with good credit who guarantees your loan. This means, however, that if you don’t pay, the co-signer is on the hook. If there is a risk that you will lose your job, or otherwise be unable to repay your consolidation loan, it may not be worth risking a friendship or putting your parents’ financial future at risk as well.
Should I get a joint consolidation loan with my spouse?
If you are married and your spouse has a better credit rating than you, you may qualify for a lower interest joint consolidation loan to consolidate your debt. But, beware, consolidating debt with your spouse does not solve your debt problem. You are simply extending the joint legal obligation to your partner. Your spouse would then also be 100% liable for the debt and the consolidation may affect their credit score negatively.
What Are the Steps to Get a Debt Consolidation Loan?
When you apply for a debt consolidation loan, you will be asked for information about your income, expenses, current debt payments, credit history, how long you have lived at your current address, and more.
Hard hit versus soft hit
Before you apply, it is important to know that hard inquiries affect your credit score. A hard inquiry happens when you apply for a loan. Every hard inquiry or ‘hit’ is recorded on your credit report. Soft inquiries do not affect your score, including checking on your own score. Be sure to understand what your lender is pulling if they tell you they will run a pre-approval or preliminary qualification. Ask if it will be a hard hit or soft hit. Only apply for a debt consolidation loan if you feel, based on the process we describe below, you have a high chance of being approved. If you are uncertain, consider postponing your application until your situation improves or review your other debt relief alternatives.
Here are the 10 steps involved in applying for a debt consolidation loan:
- List all your debts. Before you apply, make a list of all your creditors, their outstanding balances, interest rates, and monthly payments. Include both secured and unsecured debts regardless of whether you plan to consolidate all of them or some of them.
- Devise a realistic income and expense budget. This step is essential in determining how much you can afford to pay every month. Potential lenders will want to know that you can make payments on a debt consolidation loan, so remember to include documents that can confirm your income, such as recent pay stubs and your most recent tax return.
- Calculate your debt-to-income ratio. If your ratio is over 43%, then a conventional debt consolidation loan is most likely going to be out of reach.
- Know your credit rating. Lenders will certainly be interested in your credit rating, so you should know this, as well. There are two credit reporting agencies (Equifax and TransUnion) in Canada, and you can get a free credit report from each of them annually.
- Apply but not too often. Once you have researched the type of debt consolidation loans with the best interest rates available to you, contact potential lenders, and apply for a loan. If you are turned down, ask why so you can address the issue like improving your credit score. Avoid repeat or multiple applications, as this will lower your score even more.
- Complete the application. Once you have provided all the necessary documents, such as tax returns, proof of collateral, and a list of your current debts, lenders will evaluate whether they can risk offering you a debt consolidation loan and at what interest rate.
- Compare interest rates for savings. Calculate the current weighted average interest rate of the debts you plan to consolidate. We have a free debt repayment worksheet that can help you do this. Compare this number to the interest rate offered by your debt consolidation loan lender to ensure you are saving money.
- Know the details of any offers you might receive. Don’t sign an agreement until you thoroughly understand the terms of the loan. If you are unsure about any details, ask questions, and get clarification in writing.
- Make the payments. Once you sign a loan agreement, you are legally bound to adhere to the terms. Make the payments you agreed to in writing.
- Continue to check your credit and debts. You or the lender should pay off your creditors as agreed, but there could be errors or discrepancies with payouts. Be sure to contact all the parties involved to resolve such issues as quickly as possible. Also, follow up again in a few months to ensure that all credit card balances and other included debts are at zero as they should be. Get a copy of your credit report and monitor what activity appears going forward at least twice a year.
How does a debt consolidation loan affect my credit score?
A consolidation loan can have both a negative and positive effect on your credit score going forward, depending on the choice of loan and how you manage your accounts after consolidation.
How will a consolidation loan improve your credit score?
Three factors that positively impact your credit score when you consolidate debt through a consolidation loan are a lower credit utilization, better loan diversity, and improved payment history.
By converting maxed-out credit cards into a consolidation loan, your utilization rate will improve as you make payments. You will also show less reliance on revolving consumer credit.
As you make your consolidation loan payments, you build a new and better payment history and continue to reduce your credit utilization, which improves your credit score over time.
Can a consolidation loan hurt your credit score?
Many are surprised to learn that their credit score often temporarily declines immediately after applying or being approved for a debt consolidation loan. There are several reasons why this happens:
- As mentioned, any new credit application is a hard inquiry and will lower your credit scores by a few points.
- Similarly, having a new credit account shows an increased need for credit and will hurt your credit score in the short term.
- Length of credit history is also a credit score factor. By having a brand-new loan, you lower your average age of credit.
- Your lender may require that you close credit accounts you have with stores or credit card issuers. Closing accounts can temporarily lower your score by reducing your available credit and thus increasing your utilization rate.
Getting a consolidation loan can permanently lower your credit score if you continue to use your old credit cards. Racking up further debts will harm your credit score. In addition, if you default on your consolidation loan payments, your credit score will get worse.
What are my other debt consolidation options?
While a debt consolidation loan is an excellent strategy to convert multiple high-interest credit card payments into one lower monthly payment, it is certainly not the only debt consolidation option for those looking to manage debt. Consider these alternatives to a debt consolidation loan.
Debt consolidation program with a credit counsellor
A debt consolidation plan, also called a debt management plan, is good if you can afford to repay 100% of your balances owing plus their 10% fee over 5 years.
Consumer proposal with a Licensed Insolvency Trustee
If you have too much debt to repay, you can make a consumer proposal to settle your debt for less than the full amount owing through a Licensed Insolvency Trustee. A consumer proposal is a good option if you have some equity in your home but not enough to deal with all your debts or you will risk your home with a high-ratio mortgage above 80%.
If a debt consolidation loan will reduce your monthly payments, lower your interest rate, and allow you to get out of debt faster, a debt consolidation loan is probably a good idea. On the other hand, if you don’t qualify for an attractive interest rate or you are not sure you can afford the monthly payments, contact a Licensed Insolvency Trustee to talk about these other options.