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Is Debt Consolidation a Good Idea?

Is Debt Consolidation a Good Idea?
debt consolidation

We all know that the cost of living is going up in British Columbia. A simple trip to the grocery store in 2024 will make that abundantly clear. As the 2024 Consumer Debt Report by the Credit Counseling Society delineates, almost half of Canadians, especially in the younger cohort, increased their debt load over the past year and many Canadians have become increasingly more anxious about their financial situation over the 4 years the Society has been conducting this study.

While a good proportion of those in debt have taken action by making lifestyle changes such as: cutting discretionary spending, selling personal items, getting a second job, obtaining financial advice or changing their living arrangements, others have had to dip into their savings or take out loans of one sort or another, including heavy credit card use.

Depending on your circumstances and the type of debt you are carrying, a debt consolidation loan could help you to get on top of your debt, making repayment more manageable. In this article we’ll look at the pros and cons of debt consolidation, giving you a good foundation from which to decide if this strategy could help or not.

What is Debt Consolidation?

Debt consolidation allows you to pay off multiple debts such as credit cards, student loans or car loans, with one new loan — hopefully at a lower interest rate. It works like this: you take out a new lower interest loan, use the new lower interest loan to pay off old higher interest debts, (often credit cards) and then you pay off the new loan. As you can already see, debt consolidation makes great sense if you have several high interest loans that you need to pay down. However, this strategy will only work if your credit score is okay and you qualify for a lower interest loan.

Types of Debt Consolidation Loans

There are a few different types of loans that are typically used for debt consolidation, depending on your type of debt, your available credit and any real estate assets you could leverage.

Credit Card Balance Transfer

If you have run up the balance on several credit cards from different banks, one strategy is to consolidate all this credit card debt under a new card with a high credit limit and a low-interest promotional rate. Then you will need to pay off as much of it as you can while the promotional rate is still in effect — which could be a few months to a couple of years.

Second Mortgage or Home Equity Loan

A Second Mortgage such as a Home Equity Loan or a HELOC allows you to leverage your home as an asset to borrow against. Of course, using your home as collateral, always comes with the risk, however slim, of being forced to potentially sell your home if you default on payments.

Debt Consolidation Loan

This is a lower interest, unsecured personal loan taken out in order to pay off other high interest debts. Often a personal loan that is obtained for this purpose will have a fixed interest rate, fixed monthly amount and a set repayment plan.

Pros of Debt Consolidation

Depending on your situation, debt consolidation can help you in a number of ways, from making repayment more affordable to making the process quicker.

Pay Down Your Debt Faster and Save Money. If you can consolidate your current high interest loans under one lower interest loan, you’ll be accruing less interest allowing you to pay off the debt faster. You’ll also save money as you pay back your debt faster since you won’t be accumulating as much additional debt in the form of interest.

Streamline Your Finances. Having just one debt payment instead of several will dramatically simplify your life, making it less likely you’ll make late payments or miss a payment. It also makes it easier to plan for expenses in your life, since you’ll have a better idea of when you’ll be debt-free.

Set Repayment Plan. Personal loans for debt consolidation often have a set repayment plan, which is easier to deal with than less structured payment terms such as a credit card’s minimum payment terms. You’ll know exactly when the debt will be paid off, allowing you to put in place a workable financial plan.

Improve Your Credit Score. While applying for a new loan can temporarily reduce your credit rating, in time debt consolidation can give it a boost in a number of ways. It can reduce the credit utilization rate from revolving credit such as credit cards to an appropriate amount (under 30%). As well, as mentioned above, consolidating your debts makes it easier to make your payments on time, building a great credit history and increasing your credit score over time. Reducing the amount you owe, in itself, will also provide a boost to your credit score.

Cons of Debt Consolidation Loans

There are some risks that come with debt consolidation loans, especially if the terms of the consolidation loan aren’t that much better than your original loans, or if you aren’t very disciplined with your finances.

Doesn’t Fix Underlying Financial Issues. Debt consolidation should be entered with the aim to get finances under control and with a good budget in place. If you continue the spending habits that got you into debt in the first place, a debt consolidation loan won’t fix your debt problem, and may even increase it.

There May Be Added Costs. Fees such as origination fees, balance transfer fees, closing costs or annual fees may apply. Check to make sure you understand all the extra costs related to the new personal loan before you enter into it.

Interest Rates Might Not Be Worth it. The best interest rates for personal loans are usually given to those with excellent credit scores. If you have a lower credit score and are a high risk for lenders, you might not be offered a very good interest rate.

You Could Damage Your Credit Score if you miss payments. Make sure you’re comfortable with the repayment schedule before you commit to the loan’s terms.

You Could Pay More in the long term. Even if the interest rate is lower than your original debts, if the life of the loan is very long, you could end up paying more.

When is Debt Consolidation Most Beneficial?

Debt consolidation won’t work for everyone, but for some people, under specific circumstances, it’s a great tool. If you have a large amount of debt with a clear plan to improve your finances, debt consolidation could work well. This is especially true if you can qualify for a low interest loan and you have enough cash flow to comfortably cover the monthly payments. On the other hand, if you don’t qualify for a low interest personal loan and you haven’t made the commitment to get your finances in order, a debt consolidation loan isn’t likely to help.

Still Not Sure if Debt Consolidation Would Work for You?

Everybody’s situation is unique and whether this strategy would be beneficial or not could come down to the details, but if you’re a homeowner, who has equity in your home (minimum 20% not including the debts you would ideally like to add in), give us a call and we can discuss your specific situation and work it out! 

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