Consolidation Loans: the Good, the Bad, and the Ugly
When a person needs to deal with debt that is becoming unmanageable, they often think of a debt consolidation loan. Although most people are familiar with the term, you might not be familiar with exactly what it entails. Depending on your situation, a debt consolidation loan might be a good idea. In other cases, you might be better off considering other options.
The best and fastest way to find out what’s right for you is to call a Licensed Insolvency Trustee. You can make an appointment for a free, no-commitment consultation, and they’ll review your situation, explain the options, and help you decide which is the best one for you. But for those of you (like me) who like to research things on their own first, here’s the good, the bad, and the ugly of consolidation loans.
What Is A Debt Consolidation Loan?
A debt consolidation loan is when you take out a new, larger, loan in order to pay off a bunch of other, smaller, debts. People usually use a consolidation loan for one or both of the following purposes:
- To merge all of their different loans, credit cards, and other outstanding bills into one loan so they are dealing with just one payment and one creditor, which is easier and reduces the chance of forgetting to pay something on time.
- To reduce the overall amount they’ll have to pay by getting a lower interest rate. This way, more of your monthly payment is used to pay down the initial balance instead of interest, so you can pay the debt off faster.
Debt consolidation loans are often offered by big banks, and can be unsecured or, alternatively, secured in the form of an additional mortgage on your home. If it is a secured loan, you can usually get a lower interest rate than you would with an unsecured loan.
There are other lenders who specialize in consolidation loans, but their interest rates may be higher as they are typically sought out after banks have turned you down.
Another method of debt consolidation is to obtain a new credit card offering a low interest rate and using it to pay off other credit cards.
The GOOD, The BAD, And The UGLY
The Good:
- A debt consolidation loan can make it easier to keep track of what you owe and keep on top of payments, as you only have to deal with one loan. And you only have one creditor to negotiate with if you need to adjust your terms down the road.
- If you were getting annoying or nasty collection calls from your creditors, you won’t have to deal with them anymore once you pay them off using the consolidation loan.
- A debt consolidation loan can work wonders for speeding up the rate of re-payment if the interest rate on the consolidation loan is lower than the old debt and you keep your payment level the same.
- If you've managed to keep up a good credit rating, using a debt consolidation loan to deal with your debt can protect your credit rating. You might see an initial dip in the rating due to using new debt instead of remaining loyal to your old creditors, but as long as you keep up with the payments on the debt consolidation loan, you should see it improve again fairly quickly.
The Bad:
- You may not qualify for a debt consolidation loan. Debt consolidation lenders will consider your credit history, your income, and the overall amount of your debt compared to your ability to pay it. If you’re at a point where you’ve defaulted on debts or you have a high debt level compared to your income, you may not be offered a loan.
- Consolidation loans can be deceiving. You’ll need to pay attention to the interest rate that is being offered, and the fees that are being charged – sometimes consolidation loan interest rates are higher than what you are already paying, and sometimes they start out low and then increase later (such as introductory credit card interest rates). So people who take out consolidation loans sometimes end up paying more overall and staying in debt longer.
Note: It can be tempting to agree to a payment timeline that’s stretched out over a long period of time to reduce your monthly payment, but the longer you take to pay it, the more interest you pay. And there can be penalties if you want to pay it out early.
- Taking out a secured consolidation loan is less risky for the lender, but riskier for you. Unsecured debt is easier to get relief from (ie. in the form of an insolvency filing) if you need it, whereas secured debt has to be paid or you could lose the asset is is secured against.
- You can end up going even deeper into debt if you’re not careful, as you may end up with a larger amount of credit available, and it can be tempting to use that credit. For example, when a credit card is paid off, the credit card often remains available. Even though you’ve taken on new debt with the debt consolidation loan, your credit card lender may not reduce your credit limit on your old card.
- Debt consolidation lenders can sometimes be harder to deal with than other creditors. If you come to a point where you can’t pay the loan, you could find they are less willing to negotiate new terms than your previous lenders might have been.
The Ugly:
- A debt consolidation loan may not solve your debt problems, and can even make them worse. Simplifying your debts, having a lower monthly payment, and having extra credit availability from now-paid-off credit cards can make you feel like you have things under control. But if you’re spending more than you earn, it’s false and temporary comfort, as you’re likely to end up further in debt.
If you can’t afford to pay off your existing debt while paying all of your ongoing expenses, you need to consider other options, such as a Consumer Proposal, which stops all interest and can allow you to get a portion of your debt forgiven.
Consider Your Options Carefully
A consolidation loan can be a positive step to deal with your debt but there are pitfalls to avoid and risks to be aware of. If you’re looking at taking out a consolidation loan, carefully study the terms of the agreement, calculate how much it is going to cost you, and make sure you’ll be able to pay it off without going further into debt to pay your ongoing expenses. If you need help deciding or want information about other options, call the best resource for information on dealing with debt, a Licensed Insolvency Trustee.
Charla Smith & Company is a Calgary-based Licensed Insolvency Trustee, serving the southern Alberta region. We regularly help individuals navigate their options for dealing with overwhelming debt. If you would like a free, no-commitment consultation to review your options, contact us.
Disclaimer: This publication provides general information and should be seen as broad guidance only. The information contained herein cannot be relied upon to cover specific situations and you should not act, or refrain from acting, upon this information without obtaining specific professional advice relating to your particular circumstances. Charla Smith & Company Ltd. does not accept or assume any liability or duty of care for any loss arising from any action taken or not taken by anyone in reliance on the information in this publication or for any decision based on it.
Frequently Asked Questions
The cost of a debt consolidation loan is not just about the monthly payment. You will pay interest on your debt, and you may also be charged fees upfront or while you are paying it off. The total cost of your debt consolidation loan is the overall amount you will pay by the time it is finished.
If you are offered a specified payment timeline with specified monthly payments, you can simply multiply your monthly payment by the number of months included in the timeline (and add any upfront fees you have to pay).
However, in some cases, you will have only a minimum monthly payment and you can decide how much to pay each month (such as in the case of a line of credit or a credit card you’ve used to pay your other balances). And often in these cases, your interest rate can fluctuate, either due to fluctuations in the prime rate or because an introductory interest rate expires. In this case, it is much harder to estimate how much it will cost you, and the amount you will pay overall depends on how much you choose to pay each month. If this is your situation unless you have some good spreadsheet skills you may need some help, such as contacting a Licensed Insolvency Trustee, to figure it out.
For illustrative purposes, I'll provide a few examples of the costs of a consolidation loan which show that the cost can vary substantially with different consolidation loans. These examples will be based on the assumption your consolidation loan amount is $25,000 and you can afford to pay up to $600/month.
Consolidation loan with $500 in up-front fees and an interest rate of 25% and a payment timeline of 10 years.
- Your monthly payment would be approx. $580
- By the end of the 10 years, you would have paid close to $70,000, including the initial fee and nearly $44,000 in interest
Line of credit with no upfront fees and an interest rate based on the prime rate which happens to be 5% at the time you take it out (a very good deal - you must have a very good credit rating and a good relationship with the bank). Let’s assume the prime rate goes up by 0.25% each year, and therefore so does your interest rate.
- Your minimum monthly payment would start out at approximately $104, which pays only the interest.
- You choose to pay $600 per month, so it will take you almost 4 years to pay it off and you will have paid nearly $28,000, which means you will have paid nearly $3,000 in interest on top of the original loan
- Note: If you only ever pay the minimum monthly fee (ie. the interest), you will never pay the debt off. Over the course of 20 years you will pay more than $30,000, and you will still owe the original $25,000
Credit card with an introductory 0% interest rate. It charges a 3% fee for balance transfers, and the interest rate increases to 20% after 12 months. There is also a $50 annual fee.
- The 3% balance transfer fee will amount to $750.
- If you pay $600/month starting right away, you will pay it off within nearly 5 years and you will have paid nearly $34,000, including the transfer fee, annual fees and nearly $8,000 in interest. Note: If you pay only $100/month for the first 12 months, then increase it to $600 when the introductory period is over, it will take you nearly 7 years to pay it off and you will have paid approx $43,000, including the transfer fee, annual fees, and over $17,000 in interest.
Other options besides a consolidation loan include an informal proposal to each of your creditors, a debt settlement program, the Orderly Payment of Debts program, a Consumer Proposal, and Bankruptcy. Be careful where you get your information about these options. Inaccurate and biased information is abundant, particularly on the web. A good, reliable resource to check out is the Government of Canada’s website, or check out Everything You Need to Know About Debt Settlement where we compare options.
Licensed Insolvency Trustees are a reliable resource, as they are specifically educated in this area and are licensed and regulated by the government, and are required to review all of your options with you. If you would like to talk to a Licensed Insolvency Trustee, we offer free consultations. During a Financial Assessment, we take an in-depth look at your debt and all related factors such as employment situation, family circumstances, spending habits and patterns to help us determine the best options to achieve debt relief.
Check out our blog post that explains about options for settling your debt, or contact us for a free consultation.
A Consumer Proposal is a legal process available to insolvent Canadians with no more than $250,000 in debt (not including a mortgage on a principal residence) to negotiate an extension of time and/or a reduction of debt with all your creditors at once.
A Licensed Insolvency Trustee is required to file a Consumer Proposal. We'll work with you to determine whether a proposal is the best option, and to develop a proposal that is both achievable for you and beneficial for your creditors. For more details on the features and benefits of a Consumer Proposal, visit this page or our Consumer Proposal blog or contact us.
Licensed Insolvency Trustees (or LITs) are the only people who can provide bankruptcy or Consumer Proposals as an option for dealing with your debt. They are uniquely qualified to provide these services and give you advice about your debt. For more information, see our blog post: What is a Licensed Insolvency Trustee?
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