Interest Rates on Debt Consolidation Loans
Interest rates on unsecured forms of borrowing, like credit cards and personal loans, are often double-digit.
It is not unusual for people to pay creditors over 30 percent per year on these loans, with some short-term loans bearing an annualized rate of more than 100 percent.
Given these high rates, many people find that unsecured credit can become unmanageable.
They wind up paying high fees that eventually become unsustainable.
If you find yourself in this position, there’s good news.
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You can often consolidate all your high-interest debt into a single loan, usually at a much lower rate of interest.
Personal loan and credit card companies will often charge between 14 and 30 percent per year for money you borrow.
Banks and credit unions, however, offer consolidated loans at between 7 and 12 percent interest.
Borrowers with good credit history can sometimes use debt consolidation to slash the interest rates that they pay by more than 10.
Lower interest reduces the total amount that you have to pay back to creditors, speeding up the process of getting out of debt and getting back to financial health.
What Is The Difference Between Fixed- And Variable-Rate Consolidation Loans?
Debt consolidation loans come in two flavours: fixed- and variable-rate.
Fixed-rate consolidation loans keep the rate of interest that you pay the same, regardless of monetary policy (or your circumstances).
If the debt consolidation loan advertises a 9 percent rate, you will pay this until you no longer owe any money.
Variable-rate consolidation loans are different.
Here the amount you pay varies according to the rates set by the banks.
If rates go down, so will yours.
Similarly, if rates rise, you will likely pay more.
For customers, variable-rate consolidation loans are riskier than fixed-rate.
Lenders, therefore, offer lower rates of interest to compensate.
Typically, you can get a better deal on a variable-rate option, but you give up the certainty you get with a fixed rate in exchange.
Knowing which to choose is a personal choice and something that you should discuss with a credit counsellor.
How Do Debt Consolidation Loan Companies Set The Interest Rate?
You can think of interest rates as the price of money.
It is the fee you pay to get cash now instead of waiting to earn it.
Interest rates capture all sorts of economic considerations.
For instance, most people would prefer to have money today instead of in five years.
People across the economy, therefore, charge a fee to forgo spending.
Similarly, lending money is risky.
The interest rate compensates creditors for sending you money instead of keeping it under the proverbial mattress.
When you go to a bank or credit union for a consolidation loan, these take both the time value of money and risk into consideration.
Imagine if you were a completely risk-free borrower, and there was a 100 percent chance that you would repay the loan.
The bank would still charge interest to compensate themselves for the other things they could use the money for (such as buying stocks or purchasing goods today).
The rates you’d pay would still be low, but they would nonetheless exist.
Now consider what happens when the lender perceives you as risky.
The bank needs to charge a higher fee to compensate itself for the fact that you might not pay it back.
Naturally, the rate you pay goes up.
The rate you pay, therefore, is the time value of money plus your level of riskiness.
If you have an excellent credit rating, you’ll pay less – maybe just 7 percent.
If you have had debt problems in the past, you will likely pay more (but often still less than on regular unsecured credit).
What Types Of Debt Consolidation Loans Are There?
So far, we’ve discussed debt consolidation loans as if they are simply cash payments you can use to pay off your existing, high-interest debts.
In a certain sense, that is true.
But the nature of those cash payments can vary considerably from product to product.
Some debt consolidation loans are unsecured (meaning that you do not forfeit your assets if you fail to repay them).
Others work by tapping into your existing assets in exchange for cash.
Consumer loans are the most straightforward debt consolidation product – and the most intuitive.
Banks or credit unions provide you with a new, unsecured loan to pay off your existing debts (usually at a lower interest rate).
You then pay back the loan in installments over several months or years, just like a car loan.
Some debt consolidation loans take the form of a second mortgage.
These work the same as a regular mortgage, except you’re just re-borrowing the money you paid to the bank on the first.
Second mortgages are a secured form of debt because the lender can repossess your home if you fail to pay instalments.
Interest rates, therefore, are lower.
Home Refinance Loans
Home refinance loans work similarly to a second mortgage.
You can think of this as the bank buying a chunk of your property from you temporarily.
They give you cash, which you can then use to pay off your outstanding credit.
Again, home refinance loans are a form of secured credit, so interest rates are lower than unsecured debt consolidation.
Home Equity Line Of Credit And Revolving Credit
A home equity line of credit is a product that allows you to take out cash secured against the equity in your home (the ownership you’ve built up from paying off your mortgage).
A revolving line of credit is a facility that replenishes the amount that you can borrow every time you pay off part of the debt.
So if you have a revolving home equity line of credit of 50,000 CAD and pay off 5,000 CAD, you still have access to loans up to 50,000 CAD.
Most of these debt consolidation products come in variable- and fixed-rate options.
If you are not sure which option is best for you, you should speak to debt consolidation experts who can point you in the right direction.