Should You Consolidate Your Debts With a Line of Credit? Pros & Cons

Consolidating Debt With a Line of Credit

If you owe a lot of money to a bunch of different people, it can be stressful, especially if you make late payments.

Each creditor wants to know when you will repay them, and so they all correspond with you independently.

Thus, you continually have to juggle letters, repayment schedules, and interest rates, all of which drain your energy.

For that reason, many people consolidate their debts with a line of credit.

But what does this actually mean?

And what are the advantages and disadvantages?

A line of credit is essentially a financial tool that allows you to spend money that you don’t currently have.

It is similar in concept to an overdraft.

In a regular chequing account, you typically have a positive bank balance (a number above zero).

Thus, when you pay for things, you’re paying with money that is yours.

When you use your card, the bank debits funds from your account and transfers them to the merchant.

However, if your balance falls below zero and goes negative, your checking account suddenly flips into a credit account.

Banks call this facility an “overdraft,” but it is fundamentally just another form of borrowing.

Here the bank lends you money temporarily in the hope that you will eventually pay it back, plus fees.

Going down the overdraft route to consolidate debt, however, is both expensive and impractical.

Banks tend to charge high fixed fees when you go over the limit, increasing the amount that you must repay.

Lines of credit, however, are usually the better option because they offer a lower effective rate of interest.

Typically, the bank will agree to provide you with credit to cover your debts that reflects your level of risk.

Banks charge a “prime” interest rate for the lowest risk debtors – people who have a massive positive net worth, great credit histories, and stable, secure incomes.

As risk posed by borrowers rises, however, they add interest to the prime rate.

So, for instance, the prime interest rate on a line of credit might be 2.5 percent.

If, however, you have a poor credit score, they might add another 3 percent, bringing the total rate to 5.5 percent, to cover their potential losses.

Should You Use A Line Of Credit To Consolidate Your Debt?

Whether you choose a line of credit to consolidate your overdraft depends heavily on your personal characteristics and finances.

Lines of credit come with a host of benefits.

You can repay them flexibly, interest rates tend to be low, and they provide you with more freedom.

In addition, you can pay them off as fast or as slow as you like.

And you can use them to free yourself from the endless phone calls and letters from creditors.

They’re not perfect, though.

First, lines of credit rely on self-discipline.

Banks won’t harvest money directly from your paycheque to cover the cost of the loan, so you will need to set aside a certain amount each month voluntarily to repay the debt.

Second, the prime rate is subject to change.

If it goes up, then you’ll have higher interest rates in the future.

Hence, you need a combination of self-discipline and financial security to make debt consolidation work.