Pros and Cons of Debt Consolidation in Canada

Managing multiple debt payments can feel overwhelming. If you’re struggling to keep track of various credit card bills, loans, and other unsecured debts, you might be wondering if debt consolidation is the answer. While consolidating your debts into one payment can seem attractive, it’s important to understand both the benefits and risks before making this decision.

What Is Debt Consolidation and How Does It Work?

Debt consolidation combines multiple debts into a single new loan or credit product. Instead of juggling several payments with different interest rates and due dates, you make one monthly payment. Most lenders will review your credit report to determine suitable loan terms for new borrowers.

In Canada, common debt consolidation methods include:

• Debt Consolidation Loans: A new loan to pay off existing debts, typically offering lower interest payments than your current debts.
• Balance Transfer Credit Cards: A credit card that offers a low or 0% introductory interest rate for transferring balances.
• Home Equity Loans: Using the equity in your home to secure a loan and pay off debts. Lenders often offer better loan terms and lower rates with this option due to the security.
• Debt Consolidation Program: This can be a debt management plan through a credit counselling agency or a consumer proposal through a Licensed Insolvency Trustee.

The goal of debt consolidation is to streamline payments, reduce interest, and make debt management easier.

Most unsecured debts, including credit cards, personal loans, and lines of credit, can be consolidated. However, secured debts like mortgages and car loans typically cannot be consolidated.

What Are the Pros of Debt Consolidation?

Debt consolidation can be beneficial in several ways. Here are some of the main advantages:

• Single Monthly Payment: One payment makes budgeting easier and reduces the stress of managing multiple due dates. It also minimizes the risk of missing payments, which can hurt your credit score.
• Lower Interest Rates: The main reason for pursuing debt consolidation is to secure a lower interest rate. If you have high-interest credit card debt, consolidating it into a lower-rate loan can save you money over time.
• Fixed Payment Schedule: Unlike credit cards with varying minimum payments, a consolidation loan offers consistent, predictable monthly payments. This makes budgeting easier and provides a clear timeline for becoming debt-free.
• Simplified Debt Management: Having all your debt in one place means less paperwork and fewer payments to track. This can reduce stress and make it easier to stay on top of your finances.
• Improved Credit Score Over Time: Consolidating debt can improve your credit score if you make consistent payments on the new consolidated loan. This is because paying off multiple credit card balances can lower your credit utilization ratio.
• Potential for Faster Debt Repayment: With a lower interest rate and a structured repayment plan, you may be able to pay off your debt faster, especially if you stick to a disciplined payment schedule.

What Are the Disadvantages of Consolidating Debts?

Despite the benefits, debt consolidation is not without risks. Here are some potential drawbacks:

• Potential for Higher Overall Costs: If the term of your new loan is significantly longer, you might end up paying more in interest over the life of the loan, even if the monthly payments are lower.
• Asset Risk with Secured Loans: Many consolidation loans require you to use your home or other assets as collateral. If you default on payments, you could lose these assets.
• You May Be In Debt Longer: Extended repayment terms mean staying in debt longer. This is particularly true if you consolidate debt into a mortgage with a longer amortization period.
• Potential Credit Score Impact: While debt consolidation can improve your credit in the long run, hard inquiries and closing old accounts can cause a temporary dip in your credit score.
• Extra Fees and Charges: Some debt consolidation options come with fees, such as balance transfer fees, origination fees, or closing costs. These fees can add up and may offset any savings from a lower interest rate.
• Predatory Lending Options: Borrowers with bad credit may resort to predatory lenders, which charge extremely high interest rates and fees.
• Risk of Accumulating More Debt: Consolidating debt without changing spending habits can lead to new debt accumulation. It’s important to address the root cause of debt to avoid falling back into old habits.

What Is The Impact of Consolidation On Your Monthly Payment?

Debt consolidation can have a significant impact on your monthly payments, and understanding how it works can help you decide if it’s the right move for your financial situation. Here’s a closer look at what you can expect:

• Many debt consolidation loans allow you to extend the repayment period, spreading debt repayment over more years. This can make each monthly payment smaller, though it may mean paying more interest overall.
• If you qualify for a consolidation loan with a lower interest rate than your current debts, your monthly payment can be reduced without extending the term. This means more of your payment goes toward the principal balance rather than interest.

Be aware, though, that if you are only making minimum monthly payments on credit cards and lines of credit, your new consolidated payment may actually increase even if the interest rate is lower. This is because a term loan requires you to repay the principal over a set period, while minimum payments on credit cards focus mainly on interest payments.

If you struggle to keep up with your minimum payments, it’s time to consider debt relief options.

Try our quick debt repayment calculator to compare possible payment options under different consolidation methods.

When Is Debt Consolidation a Good Idea?

Consider debt consolidation when:

• You have high-interest debt, and a lower-rate consolidation option is available
• Your credit score is good enough to qualify for favourable terms
• You have a stable income to make the new payment consistently
• You’ve addressed the underlying causes of your debt
• You have a clear plan to avoid taking on new debt
• You can afford the monthly payments comfortably
• You’re seeking to simplify your finances by merging multiple payments into one.

Assess your current financial situation carefully before deciding to consolidate.

When Is Debt Consolidation a Bad Idea?

Debt consolidation isn’t for everyone. Here are scenarios where it may not be beneficial:

• Your income is uncertain or barely covers current expenses
• You haven’t addressed spending habits
• Your debt-to-income ratio exceeds 40%
• You’re likely to continue using credit cards after consolidation
• You can’t qualify for a better interest rate
• The extra fees outweigh the benefits

In these cases, consider alternatives like credit counselling or a consumer proposal.

Consider Alternatives to Debt Consolidation in Canada

If a debt consolidation loan isn’t the right choice for you, there are other options available that may offer better solutions depending on your financial situation. Two common alternatives are a consumer proposal and credit counselling. Each has its unique approach and benefits over traditional debt consolidation loans.

Consumer Proposal

A consumer proposal is a legally binding agreement between you and your creditors filed through a Licensed Insolvency Trustee. It allows you to reduce the total amount of debt you owe by up to 80%. The payments are based on what you can afford rather than the full amount of debt.

With a consumer proposal:

• Your debts are reduced, often significantly
• Interest stops completely
• You make one affordable monthly payment
• You keep your assets
• You get legal protection from creditors
• Collection calls must stop
• Wage garnishments end

In some cases, it can be better to settle debt than consolidate. Compared to a consolidation loan, a consumer proposal offers several advantages:

• No interest charges once filed
• Lower monthly payments than debt consolidation
• No need to qualify based on credit score
• Includes tax debt and most government debt
• Works even with a lower income
• Creditors cannot demand additional payments

Credit Counselling

Credit counselling provides professional guidance on managing your finances and may include a debt management plan (DMP). While credit counselling doesn’t reduce your debt like a consumer proposal does, it can offer advantages over traditional debt consolidation:

With credit counselling:

• You get help with budgeting and money management
• Potential for reduced interest rates through creditor negotiations
• You make one monthly payment through the credit counselling agency
• Learn financial management skills to avoid future debt problems

Advantages over debt consolidation:

• No new loan required
• May get better interest rate reductions than a consolidation loan
• Includes financial education and support
• No credit score requirements

At Hoyes Michalos, we can help you understand which option best fits your situation. As Licensed Insolvency Trustees, we’re qualified to administer consumer proposals and provide expert advice on all debt consolidation options. Contact us for a free consultation to explore whether a consumer proposal, credit counselling, or another option might work better than debt consolidation for your financial situation.

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