Are you struggling to pay off your debts? You might consider a few options—financial services, credit counselling, or even bankruptcy. Debt consolidation offers debt relief, but promises of eliminated debt can lead some to choose it blindly.
What’s the Truth About Debt Consolidation?
Debt consolidation is a great option for some, but it’s not a perfect fit for everyone.
Here at Credit Canada, our certified Credit Counsellors have years of experience helping thousands of Canadians each year with completely free debt help services.
We’ve also supported many people through debt consolidation with success via our Debt Consolidation Program. But we know other debt-relief options might be a better fit, depending on their unique financial scenarios.
Whatever you’ve heard about debt consolidation might not be the whole story. We’re uncovering the truth about debt consolidation to help you make informed decisions to tackle your debt!
What is Debt Consolidation?
First thing’s first, what’s debt consolidation? Why would someone want to merge all their debts into one giant loan?
Debt consolidation, in general, means paying off multiple debts with a single payment—usually monthly —instead of making multiple payments to various lenders every single month. It doesn’t necessarily mean combining all of your debts into one giant loan.
For example, in a Debt Consolidation Program or DCP, a client’s unsecured debts are combined into a single monthly payment, which then gets distributed to each of their creditors on the program.
The individual debts are paid off with every payment made. A DCP also includes other benefits, such as interest relief and lower monthly payments, but the “debt consolidation” portion of the program consolidates a client’s debts into a single monthly payment.
Then there are debt consolidation loans.
What is a Debt Consolidation Loan?
Debt consolidation loans merge or consolidate multiple debts into one debt. Instead of making payments for each debt, debtors only have to make one single payment that goes towards paying off the debt consolidation loan.
Here’s the appeal: You can access lower interest rates with a consolidation loan. Eventually, that’ll help you pay off your debts faster. And, having only one single payment makes managing debt a whole lot easier.
But there are some caveats when it comes to debt consolidation loans.
If you have poor credit, you may not qualify for a debt consolidation loan. Or, if you do, it might be at an interest rate that defeats the purpose of the loan in the first place.
Bottom line? You may not find debt relief with a debt consolidation loan, so it’s not for everyone. If you’re considering a debt consolidation program in Canada, keep reading.
Next up, we’ll cover common myths to uncover the truth about debt consolidation.
Common Myths About Debt Consolidation
Sometimes it can be confusing navigating your way out of debt. With so many different options, each with varying degrees of benefits and costs, it can be difficult to know what to do. Here we demystify some common myths about debt consolidation.
Myth #1: Debt Consolidation Destroys Your Credit Score
Take a deep breath: Debt consolidation doesn’t destroy your credit score. But, it can affect your credit temporarily.
If you are considering a DCP, in most cases, your credit rating will show an R7 on your credit report for each debt on the program, and for two years following completing the program.
Most people who qualify for a DCP have experienced multiple missed payments, have had their accounts sent to collections, and/or have maxed out their credit, so the R7 rating has little-to-no impact on their current status.
Two years after completing the DCP, the debts (and their R7 ratings) are purged from the client’s credit report. Some clients start to see improvements in their credit rating and credit score much earlier, or as soon as they’ve completed the program.
Debt consolidation loans, on the other hand, affect your credit in three different ways:
- Hard Inquiry: Your application for a debt consolidation loan triggers a “hard inquiry” on your credit report. These inquiries occur whenever a lender checks your credit, which includes your credit score and credit history. A soft inquiry occurs when you check your own credit report or credit score, for example. Soft inquiries have no impact on your credit report.
Hard inquiries remain on your credit report for 1-3 years. Too many hard inquiries may lower your credit score and can indicate to lenders that you’re experiencing financial difficulties and in need of credit.
- Payment History: On the flip side, a debt consolidation loan can improve your credit score by making it easier for you to create a positive payment history. First, the debts that the loan was used to pay off will appear paid in full on your credit report. Second, if you secure a lower interest rate that makes your monthly payments more manageable, you can start making your monthly payments on time. This results in an improved credit score over time.
- Credit Utilization Ratio: Your credit utilization ratio compares how much credit you’ve used versus how much is available across all your credit accounts. A debt consolidation loan may improve this ratio, as it pays off multiple debts to free up credit.
Remember, debt consolidation, whether it’s a loan or a program, doesn’t mean anything absolute for your credit score. Your repayment behaviour after you obtain the debt consolidation loan or sign up for a DCP will dictate your credit score’s fate.
Myth #2: Debt Consolidation Always Results in Lower Interest Rates
Debt consolidation loans should have a lower interest rate to make them worthwhile. However, not everyone qualifies for lower interest.
You might not have good enough credit or a low enough debt-to-income ratio for a lender to approve a low-interest debt consolidation loan.
But when it comes to a DCP, it’s a different story.
A DCP only makes sense if the interest rate on each debt included in the program can be negotiated to a lower rate, or stopped entirely. This is to provide the client with some breathing room and a payment plan that allows them to catch up on payments and start making a real dent in their debts.
If the certified Credit Counsellor who negotiates on the client’s behalf cannot lower the interest rate on their unsecured debts, they will explore other debt solutions with the client. Therefore, a client will always experience interest relief via a DCP, regardless of their credit score.
Myth #3: All Debt Consolidation Loans are the Same
While all debt consolidation loans merge multiple debts, they may not all function in the same way.
When most people think of a debt consolidation loan, they typically imagine going to their bank and asking for one big loan to pay off all their debts. But there are slight alternatives or variations that financial institutions, such as banks and credit unions, may offer.
Here are three different types of debt consolidation options to consider:
Personal loans and lines of credit: Private lenders, credit unions, and even major banks offer personal loans specifically for debt consolidation. In this case, the bank or lender will pay off all of your debts and you’ll pay them one single payment every month until the debt is paid. You might also consider using a line of credit to pay off your debts, especially if it has a lower interest rate.
However, you’ll need good credit to access an unsecured loan or line of credit. Otherwise, you might need to present collateral for approval. Or you may need a guarantor who will pay the loan or line of credit in case you default.
HELOCs: If you have a mortgage, you may have access to a Home Equity Line of Credit (HELOC). This line of credit increases its available value every time you make a mortgage payment. HELOCs often have lower interest rates than other forms of debt, like credit cards.
Credit card balance transfer: Some credit cards offer a low (sometimes 0%) interest rate for you to move your existing credit balances onto one card. Normally, the low-interest rate is temporary. It’s important to do the math. If you think you could benefit from the temporarily low-interest rate with enough time to pay off your debts before the higher rate kicks in—it’s worth considering!
Myth #4: Debt Consolidation Eliminates Debt
That’s the goal, right? And debt consolidation can help you eliminate debt. It’s just not a sure thing.
Here’s an example: What if you consolidate all your balances into one loan (via a debt consolidation loan), but start spending all the newly available credit on your paid-off accounts? Fast forward a year later and now you have double the debt you started with.
A debt consolidation loan only eliminates debt if you take extra care not to create more debt. That means not using the credit cards that have been paid off with the loan, and any other forms of credit, which will have all zero balances. You need to focus on paying off the debt consolidation loan and not add more debt, otherwise, you can end up in worse financial shape than before.
With a DCP, one of the requirements is to stop using all forms of unsecured credit, so accumulating more debt while on a DCP is more difficult. Every client gets a specific end date of when they will complete the program and be 100% debt-free.
Myth #5: Debt Consolidation is Bankruptcy
Debt consolidation is not the same as bankruptcy. While debt consolidation might result in lower monthly payments, you’ll still need to pay off your debts.
Bankruptcy, on the other hand, relieves you of most or all of your debt. However, there are fees involved, which a Licensed Insolvency Trustee (LIT) will clearly explain to you. Plus, a bankruptcy stays on your credit report for 6-7 years, and if you file more than once, they stay on your credit report for 14 years.
Explore Debt Relief Options with Credit Canada
Now that you know the truth about debt consolidation, you have the knowledge to decide whether it’s right for you. Looking for support? Don’t worry, that’s why we’re here.
Credit Canada provides free professional credit counselling services to help you navigate your debts and find long-lasting debt solutions.
Debt consolidation is one of many debt repayment strategies to get you back on track with your finances. Ready to learn more? Contact us today for a free consultation.