Is it a good idea to get a new loan to consolidate credit or pay off credit card debt?
Debt consolidation loans are one option to pay back debts. A consolidation loan provides you with one payment a month at a lower interest rate than your current credit cards. If done correctly, loan consolidation can also help you improve your credit score. There are downsides, however, which is why you should consider all the pros and cons of managing your debt with a consolidation loan before you make that application.
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How does a debt consolidation loan work?
One way to consolidate your debt is by using the proceeds of a new consolidation loan to pay off the current outstanding balance on any problem debt.
If you can borrow a large enough loan, you can consolidate many types of debts, including credit cards, payday loans, lines of credit, utility bills, cell phone bills, even income tax debts. It is also possible to rollover car loan debt into a consolidation loan, although this is not always a good idea. Similarly, in Canada, it is not normally advisable to consolidate student loan debt.
There are two types of consolidation loans to consider when refinancing old credit:
- An unsecured consolidation loan through a bank, credit union, financing company or credit card balance transfer, for example; or
- A secured consolidation loan like a second mortgage, home equity loan, or home equity line of credit.
Below are the benefits, and potential dangers, of the most common consolidation loan options.
Pros and cons of debt consolidation loans
It is important to remember that you are choosing to roll multiple old debts into a new loan. You are taking on additional financial risk, which can have unexpected consequences if not done properly.
A debt consolidation loan should carry a lower interest rate to help make the monthly payment more affordable and save you money on interest payments.
Secured loans generally provide the lowest interest rate and are easier to obtain if you can provide the required collateral. However secured loans can be dangerous because you put any pledged property at risk. If you can’t make your monthly payment, your lender will seize your house or car to collect on any unpaid loan balance.
An unsecured debt consolidation loan is harder to get if you have bad credit. The interest rate is also much higher as the lender assumes more credit risk with an unsecured loan. Lenders may be much stricter when looking at your debt-to-income ratio if you are applying for an unsecured loan to ensure you have the financial capacity to make the required monthly payments.
A line of credit often has the benefit of interest-only payments. Making minimum payments that barely pay down principal balances can result in a payment that is low enough to balance your budget and make managing your finances easier, but it can keep you in debt longer. A line of credit style loan is usually a variable-rate loan, which means your monthly payment will increase if interest rates rise.
You can also keep your monthly payments low by lengthening the loan term or amortization period on your consolidation loan. However, extending the amortization period, or length of your loan, reduces some of these savings. With a longer-term loan, your monthly debt repayment may be much smaller; however, you pay more in interest over the life of the loan. There is also an increased chance that something catastrophic, like an illness or job loss, can reduce your household income and cause you to miss payments.
When does a debt consolidation make sense?
A debt consolidation loan can be a successful way to get out of debt if:
- You have a good credit score and can qualify for a relatively low-interest rate loan;
- You have enough income to afford the monthly payments and avoid any risk of default;
- You understand why you got into debt in the first place and adjust your budget habits;
- You have a plan to pay down your consolidation loan
- You don’t run up new debt balances again.
One of the biggest credit card dangers is consolidating and eliminating old credit card debt then racking up balances again. Avoid getting back into debt by using only one card for payments going forward, and paying off credit card charges in full every month.
A debt consolidation loan can help you improve your credit score if you don’t take on more credit than you can repay, avoid high-interest subprime consolidation loan options, and make all payments on time. Your lender may ask that you have a co-signer if they are concerned about your credit history. If you default on your loan repayment, your co-signer will be liable for the remaining balance.
Debt consolidation is a poor choice if you have more debt than you can handle.
Most lenders suggest that you keep your debt-to-income ratio below 40%. This calculation is the ratio of all your monthly debt payments as a percentage of your monthly take-home pay. While lenders might be comfortable with a ratio under 40%, we recommend you keep your debt servicing ratio below 30%. A lower ratio provides insurance against unexpected expenses, or temporary income drop, derailing your ability to keep up with your consolidation payments.
If you have a lot of debt or poor credit, you may end up paying a higher interest rate than you are paying today. This can easily happen if you apply for a consolidation loan with a finance company or high-interest lender. It does not make sense to consolidate a 19% credit card into a 39% or more high-cost installment loan no matter how low the monthly payment.
Debt Settlement vs Debt Consolidation Loan
What should you do if a consolidation loan is not for you? Consider an alternative consolidation option like a consumer proposal.
A consumer proposal is an option that combines your debts into one monthly payment while also providing debt relief. Working with a Licensed Insolvency Trustee, you make a legal debt settlement offer to your unsecured creditors to repay what you can afford. A consumer proposal generally provides the lowest monthly payment of any consolidation option.
In addition to dealing with credit card debt, a consumer proposal can eliminate debts that are not easy to pay off with a debt consolidation loan, including student loans, large tax debts, and multiple payday loans.
If you have more debt than you can consolidate with a personal loan, you are better off talking with a trustee about your debt relief options before taking out a loan.