What is debt consolidation?
Debt consolidation is the process of combining multiple, smaller debts into a larger, single loan. It also carries the potential to save money on interest, making it easier and faster to dig yourself out of debt. A debt consolidation loan can be used to pay off the following unsecured debts:
- Credit card balances
- Overdraft balances
- Medical bills
- Payday loans
- Personal loans
- Other smaller bills and loans
How to consolidate your debts
You can get a debt consolidation loan from banks, credit unions, and other lenders. It can be a general-purpose personal loan or one designed specifically to consolidate debt.
The process of debt consolidation typically involves the following steps:
- Calculate how much you need. List all the debts you want to pay off.
- Shop around for the best loan. Use an online loan comparison website like BestLoansCanada to figure out which option is best for you. Consider factors like borrowing limits, repayment periods, and payment frequency.
- Submit your application. Before applying for a debt consolidation loan check your preferred lender’s eligibility requirements, then submit the necessary information and documentation.
- Finalize the deal and pay off your debts. Once the lender approves your application, they will deposit the funds into your bank account. Be sure to pay off your existing debts swiftly, as interest is calculated daily.
Tips for choosing the best debt consolidation loan
When comparing debt consolidation loans, consider the following factors to find the best option:
- Interest rates. It’s important to secure the lowest rate possible if you want to save money. Interest rates are usually fixed, but you can also get a variable rate. Additionally, some lenders allow you to pre-qualify, which gives you a better idea of what rate to expect based on your credit score.
- Fees and charges. A low interest rate makes your loan cheaper only if the fees and charges are low.
- Requirements and restrictions. The lender may have minimum income requirements, or you may need collateral (for secured loans). The lender can also restrict the types of debt you can consolidate.
- Loan details. Be sure to verify details, such as minimum and maximum loan amounts, repayment periods (weekly or monthly), and other terms and conditions to see if the loan suits your needs.
Pros of debt consolidation
- Single repayment. Keeping track of multiple due dates can be a hassle, but having only one repayment makes life easier.
- Simplify your budget. A single loan is easier to budget for, especially if you are no longer dealing with variable rate loans that may have fluctuating repayments.
- Save money on interest. A debt consolidation loan makes sense if the interest rate is lower than the average rate on your current debts. That way, you’ll pay less interest and save money.
- Close your account early. Once you secure a low interest rate, you can contribute more towards the principal, which clears your debt faster.
- Boost your credit score. If you previously had difficulties making your repayments on time, the smaller repayments should help. And in turn, on-time repayments will improve your credit score.
Cons of debt consolidation
- You might not qualify. Requirements such as collateral or a good credit score can stop you from qualifying.
- You might end up with more debt. When you’ve consolidated your debt, it’s sometimes tempting to keep reusing the credit available from the loans you’ve just paid off.
- It might not offer significant savings. There’s no guarantee you’ll get a lower interest rate. Also, the fees associated with closing your old accounts earlier may cancel any potential interest savings. Be sure to read the fine print and see what penalties there are for paying your existing loans early.
Additional debt consolidation options in Canada
Borrowers can also consolidate their debt with the following options:
Credit card balance transfer
Credit card debt consolidation involves using a low interest rate credit card to pay off the balances of one or multiple credit cards with a higher interest rate. But usually, there’s a catch.
These low rate cards tend to have a promotional period, and once it expires, you will have to pay a higher interest rate. So if you want to save money, you’ll have to make more than the minimum payment, so you can clear your balance before the promotional period ends.
Home equity lines of credit (HELOC)
A HELOC is also known as a second mortgage. It’s a secured loan since it uses the equity in your home (the difference between your mortgage and the value of your home) to guarantee the loan. HELOCs are usually obtained from the lender with whom you have the mortgage and have favourable interest rates because they carry less risk for the lender.
Debt recovery programs/plans
If you’re struggling to manage your multiple debts and can’t qualify for a debt consolidation loan, a debt repayment plan might help. However, you’ll first need to consult with a non-profit credit counselling agency to learn the pros and cons involved and determine if such a program is right for you.
If you wish to proceed, a Credit Counselor will negotiate with your lenders to eliminate or reduce interest and maybe consolidate your repayments into one affordable payment.
Debt consolidation FAQs
What is a debt consolidation loan, and how does it work?
A debt consolidation loan is used to pay off several debts at once. By replacing multiple debts with a single loan, you combine your debts in one place. This makes managing your debts easier since you now only have one single monthly payment.
Why was my application for a debt consolidation loan rejected?
Common reasons for a loan rejection include bad credit or inability to meet the minimum income requirements. To improve your chances of approval, you can fix your credit score, ask for a lower amount, or apply with a different lender. You can also opt for a secured or co-signed loan to reduce the lender’s risk.
What’s the difference between debt consolidation and refinancing?
Both are debt management strategies. But refinancing involves taking out a single loan to replace or pay off only one loan instead of multiple debts.
Is taking out a debt consolidation loan a good idea?
This depends on your financial situation. If you can get a low interest rate, it’s possible to pay off your debt faster and save more money. Plus, your life will become simpler since you will only need to make one monthly payment. However, a debt consolidation loan might be a bad idea if it leads you further into debt.
Will a debt consolidation loan impact my credit score?
Your credit score will be affected initially. That’s because the lender has to do a hard credit check when assessing your loan application. However, your credit score will recover quickly once you start making payments on time.
But, given that applying for a loan impacts your credit score, it’s important to avoid multiple loan applications in a short timeframe. When pre-qualifying, make sure the lender only does a soft credit check that won’t impact your credit score.
Can I take out a student debt consolidation loan?
If you have government student loans, it’s generally not a good idea to consolidate them with a loan from a private lender. That’s because loans from private lenders have higher interest rates.
Plus, you may lose tax benefits and access to student debt relief. However, if you already have several private student loans, debt consolidation can help.
Can I use a line of credit for debt consolidation?
Lines of credit are revolving lines of credit that allow you to keep borrowing without applying each time. While this can be an attractive arrangement, lines of credit typically have high interest rates. Additionally, it will take longer to settle the debt if you reuse credit while making minimum payments only.