Many Canadians are juggling different debt payment obligations and it can often become a struggle for many. Sometimes keeping your head above water can be a real challenge, and if this is the case for you, you might be considering how does debt consolidation work?
Consolidating your debts is one way for Canadians struggling with debt to get their financial matters under control.
For certain individuals, debt consolidation can solve their money problems, although it isn’t a solution for every financial situation and you must have an understanding of debt consolidation before you can decide if it works for you.
We’ve written this article to provide a brief understanding on debt consolidation, and some of the pros and cons for you to consider.
What is Debt Consolidation?
At the heart of it, debt consolidation is the process of paying off all, or some, of your debt with 1 new loan with that you take out. High payments and interest rates and managing payments on many different loans, with different due dates and deadlines can cause stress and missed payments or late payments that can hurt your credit rate.
High interest rates can cost you hundreds of dollars in extra debt repayments each month.
Consolidating your debt can end the stress of managing many loans and save you thousands of dollars in interest charges over the life of the loan. It’s much easier to manage one loan, although there are other benefits of a debt consolidation loan as well.
What are the Benefits of Debt Consolidation?
There are four main benefits of consolidating your debts:
The main benefit of a debt consolidation loan is that you will have a lower interest rate, which means you can save hundreds or thousands of dollars each month if you are consolidating high interest debt such as credit card debt into a low interest loan. If you are only making the minimum payments, your debt won’t be going down and if you are over the limit on your credit cards you could be paying extra fees.
A lower interest rate will save you money and allow you to pay off your debt more quickly as more of your payment is going towards debt repayment, and not interest payments.
Another benefit of consolidating your debt is your monthly payment will likely be lower, which frees up other funds so your finances can get back on track. Minimum payments on high interest credit card debt and other high interest debts can quickly get out of control and you can start missing payments and getting further into debt. Missing even one payment can quickly spiral out of control, as your payments will increase each month as 1 missed payment can lead to a domino effect.
A third benefit of a debt consolidation is that your debt repayment becomes easier to manage as you only have 1 payment to make. Many people considering debt consolidation have many different credit card bills, lines of credit payments, and other debts to keep track off. Having 3, 4 or even more payments to juggle, all with different deadlines throughout the month can quickly become unmanageable, and as stated above, missing even one payment can quickly escalate into a serious debt problem.
By cutting your debt payments to one each month, you end the juggling and worries about getting out of debt.
Finally, another benefit of consolidating your debt is you can end the stress and worry of managing all your high interest debts. A debt consolidation loan allows you to stop juggling high interest payments and focus on 1 low interest payment. You don’t have to worry about missing payments that can hurt your credit score and cause your debt situation to spiral out of control.
How do I Qualify to Get a Debt Consolidation Loan?
While getting a debt consolidation loan is fairly easy and straightforward, you must meet certain criteria in order to qualify for a debt consolidation loan. Mainly, as a debt consolidation loan means you are taking on more debt, you must have a decent credit rating and credit score to have your debt consolidation loan application accepted.
When you apply for debt consolidation, the lending institution will examine your credit report, payment history and your credit score to determine if you are a good candidate for a debt consolidation loan.
Another thing that a lender will look at is your monthly income. The lender must see that you have a regular source of sufficient income to cover your debt repayment commitments.
Do I Need to Have Assets for Security?
While it might be beneficial to have an asset – such as a car with some value – to put up as security to qualify for a debt consolidation loan, it is not necessary in many cases. Usually only subprime lenders, who charge a high interest rate, will accept household assets as security; getting a high interest debt consolidation loan defeats the purpose of consolidating your debt in the first place.
How Can I Consolidate my Debts if My Credit is Not Good?
Fortunately, you can still consolidate your debt even if you have a less than good credit score and payment history.
If you have a high interest rate credit card and a low interest rate credit card, an easy method to consolidate your debt with poor credit is to transfer a balance from your high interest credit card to a lower interest credit card.
By choosing to go this route you must be very careful that you don’t start using your high interest rate credit card that now has no balance, or a lower balance that could make it tempting to start using it again. If you transfer a balance from one card to another, you could end up with more debt if you are not careful.
You should also be very careful about taking advantage of any special interest rate offers from your credit card companies.
Taking Out a Second Mortgage
Another option you could take advantage of to consolidate your debt if your credit is not perfect is to take out a second mortgage on your home if you are a homeowner.
You are likely to qualify for a second mortgage loan as you can use your home as collateral, which will also help you get a low interest rate on your loan.
Lastly, you can ask your friends or family members for a loan, or to co-sign for you on your loan application. You must be careful if you go this route however, since the co-signer will end up taking on the responsibility of the loan payments if you default on your payment responsibilities.
Before you get trusted friend or family member to sign off on a loan with you, make sure they have a full understanding of the terms of the loan, the payments required, and your financial situation so they are aware of the risk they are taking on so they can make an informed decision.
Getting a trusted friend or family member to co-sign for you can help you save thousands in interest charges and get you out of debt as quickly as possible, although there are risks that you must balance.
Are There Any Drawbacks to Debt Consolidation?
Yes, there are certain drawbacks to getting a debt consolidation loan. The main drawback is that you are taking on more debt. If you do not manage your debt carefully and in a responsible manner, then you may end up deeper in debt than before.
If you pay off all of your credit card debt with a debt consolidation loan, it can be very tempting to keep using your credit cards that now have no balance.
When you are not diligent and responsible in managing your debt, you can end up back in credit card debt. You will also now have a large payment to make towards your debt consolidation.
The purpose of consolidating your debts will be wiped out in this case, and you might have to consider bankruptcy if you can’t keep up with your debt obligations.
Before you take out a debt consolidation loan you should consider making a budget and examining your spending habits because without a plan, you will likely end up more in debt than you were before.
Controlling Your Spending
It is important that you control your spending and make better financial choices if you take out a debt consolidation loan, especially if you have gotten a family member or close friend to co-sign on your loan.
Without changes to the root cause of your money problems, you will find that you are trapped in debt again in a matter of time.
If you are taking out a debt consolidation loan to pay off credit card debt, you will have little or no balance on the credit cards, which will free up spending money on these cards and the temptation can often be too great to avoid using these cards after paying off their balances with a debt consolidation loan.
Controlling Credit Card Use
Bankruptcy Canada recommends that you contact your credit card provider to close your credit cards, substantially lower your credit limit, or to temporarily freeze the activation of your credit before you get a debt consolidation loan.
You could also put your cards away in a safe place and never take them out for a period of some months as you adjust to living without credit freely available.
You will find that it is much easier than you thought to live without credit, and once you have broken the habit of using credit cards you can contact your bank or other credit card provider to reactive your credit, or increase your credit limit.
Another drawback of a debt consolidation loan is you could possibly lose your home. If you use your home as security to qualify for a debt consolidation loan, and the value of your home falls below the value of the loan, you could have your home foreclosed if you fall behind on your payments.
Is Debt Consolidation Right For Me?
Taking out a debt consolidation loan is not right for everyone in debt, although it can be the right debt relief choice for individuals with a decent credit score, or the ability to have a family member or friend co-sign on their loan, who want to lower their debt repayments, save on interest fees, and get out of debt quicker.
Debt consolidation is also for individuals who are struggling to manage many different monthly payments.
As stated above, you must have a plan and dedication to change your spending habits when taking out a debt consolidation loan, otherwise you will free up more credit to use that will lead to more serious debt problems in all likelihood.
Before taking out a debt consolidation loan, you can seek professional assistance to find out if a debt consolidation loan is the right choice for you, or if other debt relief vehicles could help you get out of debt in a quicker, easier and cheaper way.