Debt consolidation: How does it work in Canada?

Debt consolidation; debt management; consumer proposal

Debt consolidation is a popular (and legal) way to significantly lower your debt in Canada.

What is debt consolidation?

Debt consolidation involves taking out one big loan to pay off many small loans.

This means that you only have one monthly payment, often at a lower interest rate than you are paying now. This saves you money on interest fees and lets you pay off your loan faster.

For those that can’t qualify for a consolidation loan as the debt load is simply unmanageable debt restructuring may be a better option. This is a legal and ethical way to get out of your overwhelming debt situation.

Debt consolidation may be suitable for debts such as those relating to credit cards, public utilities or other consumer loans. However, not all debts can be combined into a consolidation loan — a mortgage cannot be included, for example.

How debt consolidation works in Canada

You can use your existing assets (such as your home) to have even more leverage with creditors. So debt consolidation can also involve a secured loan against an asset that serves as collateral, most commonly a house.

Using your house as collateral in debt consolidation can help you negotiate a lower interest rate. With an asset on the table, banks will see you as a less risky investment which means you increase your bargaining power with lenders.

The pros of debt consolidation

The interest rate charged by a financial institution for a personal loan is usually lower than the rate charged for a credit card. As a result, you will save money on interest payments.

This has many benefits:

  • You can use your assets (such as a home) to secure a lower interest rate.

  • You protect your credit rating.

  • Your creditors will be promptly paid in full by the bank.

  • You will only have to make one monthly payment to your financial institution, instead of a bunch of different payments to different lenders.

  • You will pay less of your money to interest, getting you out of debt faster.

  • As long as you follow the terms of your consolidation loan and make your payments on time, your credit rating should not be negatively affected.

The cons of debt consolidation

Debt consolidation does have a few disadvantages. You may save on interest charges, but will still have your debt. So, you will still have to work hard to repay the money you borrowed.

You may still have access to your credit cards.

Financial institutions will expect prompt payments and if you found the debt hard to pay before it may still be a challenge to repay the new consolidation loan.

Also, some people use a co-signer to get a consolidation loan. If you can’t make your payments, your co-signer will be left with your debt.

People often use their house as collateral. If you can’t make the payments, you’ll risk losing your home.

Over the past five years, there are fewer and fewer unsecured consolidation loans given. This is because the bank that gives you the loan takes on all the risk of losing it if you cannot pay it.

Using banks for debt consolidation

While large banks like RBC offer debt consolidation, often their unsecured interest rates might not be much lower than your current loans and it may be hard to qualify for an unsecured consolidation loan. Large banks are risk-averse—so they will frown on consumers with low income, high debt levels, and blemished credit reports.

If you manage to get a debt consolidation loan from a large bank, you need to be very careful with your payments. As the Government of Canada warns, “financial institutions may not be as flexible as your creditors. If you run into further problems, financial institutions will generally be less understanding and may refuse to accept a late payment.”

In other words, credit cards will be flexible if you miss a payment. They make money on your missed payments. But a large bank will be less forgiving, especially if you use a secured asset (like your house) with your loan.

When should you apply for debt consolidation?

You should use debt consolidation for the following situations:

  • You are trying to pay down credit card debt. This carries high interest and debt consolidation is a logical tool to use.

  • You have consumer debt (such as a small collection of debts from retail stores, a high-interest car loan, and other high-interest loans).

  • You have lots of equity in your home. There’s no sense in not using that leverage to save you money. 

Creditors will also look to see if your income can easily support the monthly debt consolidation payments.

I have bad credit. Can I still qualify for debt consolidation?

Unfortunately, it’s much harder to get a consolidation loan if you have bad credit. Creditors use your credit scores and payment history to determine risk. If you have not always been able to pay your existing debts most lenders will see this as a red flag.

But if you can offer security or a strong co-signer the lender will be more willing to work with you. Make sure you fully understand the interest rates and fees before agreeing to a consolidation loan as with bad credit these can be substantially higher.

What are the requirements to qualify for a debt consolidation loan?

Usually creditors are looking for a few things:

First, they want to see an acceptable credit rating (but your credit rating does not always need to be perfect).

They also want to see regular income so they know you will be able to manage the monthly payment.

You need to show a reasonable level of monthly expenses (might be time to cancel the lease on the Lamborghini).

In short, financial institutions want you to demonstrate that you can make the monthly consolidation payment, in addition to paying for your regular monthly bills and expenses.

A blemished credit rating will likely diminish your ability to secure a consolidation loan, therefore it is best to review all your options to deal with your debt and act as soon as possible.

Debt consolidation vs. debt settlement. What’s the difference?

Most of the debt repayment options that people know about are designed to benefit the company lending you money. Creditors do not always care about you or your struggle to climb out of debt. They only want their investment to pay off.

Lending money is about returning a profit. Be careful about the advice you receive—and who is giving it. For example, a non-profit credit counsellor might offer a program to settle with your creditors by paying 100% of the debt.

This is wonderful for your creditors. In fact, creditors often fund the ‘non-profit’ credit counselors as the counselors recommend that you pay back everything you owe in full.

Creditors get their money back in full. But for you, the consumer, it will negatively impact your credit rating, as you did not pay back the debt based on the original terms and conditions and there may be a better option.

With the option to settle, you may be able to actually reduce the amount of money that is owed but the effect on a credit rating is often negative since you are not paying the debt back in full or on the original terms and conditions agreed when the credit was advanced.

This negotiation process requires the creditors to agree to the new payment amount and the new payment terms.

So debt settlement can reduce the amount of money you owe but can harm your credit rating.

Without a good credit rating, it becomes very hard to rebuild your finances. Debt settlement can be a good short-term solution for you, but can also have negative consequences on your future finances and you could end up right back where you started. If you are considering any type of debt settlement you need to make sure the

If you are considering any type of debt settlement you need to make sure the option you chose not only deals with the debt but provides a comprehensive credit rebuilding and financial rehabilitation program otherwise you can be left with bad credit for up to a decade and vulnerable to future financial failure.

Debt settlement when done right is an excellent option, it can bring your long-term financial goals closer and make them achievable but done wrong with no plan for financial rehabilitation it will push your financial goals much further away.

There are four basic options available to Canadians in deep financial trouble: debt consolidation, credit counselling, consumer proposals, and bankruptcy.

If you have a manageable amount of debt and a good credit rating (plus an equity in an asset like a house and good income), debt consolidation is an excellent choice.

For other situations, consumer proposals and even as a last resort bankruptcy might be a better fit.

It’s critical to understand your options and get your own independent advice, as we always say in the debt advisory business, you either represent the creditors or you represent the debtor.  It seems impossible to do both.

Adopted from Debt Consolidation 101 by Paul Murphy