Debt consolidation is a financial solution that combines multiple bills into a single monthly payment at the lowest interest rate possible. This makes it easier to pay off debt because you only have one bill to worry about. It also helps you save money by minimizing interest charges. As a result, you are often able to get out of debt faster, even though you may pay less each month. The most popular way to consolidate is with a loan.

What is a debt consolidation loan?

A debt consolidation loan is an unsecured personal loan that you use to pay off existing debt. Unsecured means that you don’t need to put up any collateral to get the loan. You qualify solely based on your credit score.

Learn more about makes a consolidation loan unique »

How do debt consolidation loans work?

  1. You apply for a personal loan in an amount that will pay off all the existing debts you wish to pay off.
  2. The lender will approve you for the loan and set its interest rate based on your credit score.
  3. The money from the loan gets used to pay off your existing debts.
  4. This leaves only the consolidation loan to repay, giving you one fixed monthly payment.

More details about the process »

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What types of debt can you consolidate?

  • Credit cards
  • Retail store cards
  • Gas cards
  • Unsecured personal loans, including other consolidation loans
  • Unsecured lines of credit (LOCs)
  • Public utility debts
  • Child support arrears
  • Tax debt

You cannot consolidate secured loans. That’s any loan that has collateral, such as a mortgage or car loan.

Advantages of consolidation loans

One monthly payment

Juggling bills can be a challenge, especially when you have multiple credit cards. It’s easier to miss payments or overdraft your bank account. With consolidation, you no longer need to worry about sending payments to several different banks and creditors. You only have one bill due-date to remember

Lower interest rates

In the right circumstances, a consolidation loan can provide you will a much lower fixed interest rate. This reduces the amount of each payment that gets used to cover accrued monthly interest charges. As a result, you can pay down the principal (the actual debt you owe) faster.

Lower monthly payments

In many cases, consolidation will lower your monthly payment. The term of the loan determines the monthly payment requirement. A longer-term will offer lower monthly payments.

Good for your credit

All the debts paid off with the loan will show that they were paid in full. You avoid credit damage that can be caused by missed payments when you’re juggling bills. As long as you keep up with the loan payments, consolidation should have a positive effect on your credit score.

Less pressure from creditors

If you’ve fallen behind on some or any of your minimum payment requirements, creditors and collectors may be calling. They all want to be paid promptly. Consolidation pays off all those existing debts, reducing your financial stress. Any calls seeking payment will stop.

Better budgeting

Eliminating bills from your household budget frees up cash flow, so you can stop living paycheque-to-paycheque. It makes funds available to build an emergency fund and helps you cover emergency expenses without relying on credit.

Disadvantages of consolidation loans

Limited applicability

This solution does not work for everyone. You generally need a good to excellent credit score to qualify for an interest rate that makes this beneficial. At a minimum, you generally need a credit score of 650 or higher to qualify for this solution. Ideally, you want very good credit to qualify for the lowest rate possible. That requires a score of 720 or higher.

Does consolidation work with bad credit?

Rates on personal loans can range from 5 percent up to 45 percent. If the rate on the loan is comparable to your credit card rates, you won’t get as much benefit. In general, this solution offers the most benefit when you can qualify for a rate or 10 percent or less on the loan.

Learn more about rates on consolidation »

Lower payments depend on how much you owe

If you’re seeking lower payments to balance your budget, this solution may not work depending on how much you owe. Most lenders only offer terms of 12-60 months on debt consolidation loans. A longer-term will lower the payments. However, the amount also depends on how much you owe.

For example, let’s say you owe more than $50,000. You have excellent credit (800+) so you qualify for 5% APR. Even at the maximum term of 60 payments, your payments would be more than $900.

Always make sure you can afford the monthly payments on the consolidation loan before you decide to use this solution.

Will you qualify for debt consolidation?

Risk of more debt instead of less

In most cases, consolidating your debt using a personal loan will not close your credit cards. You pay off the balances, but the accounts remain open. This means you have the potential to run up new balances on those cards. If you do this before you pay off the loan, then the result is that you have more debt instead of less.

In order to avoid making your situation worse, you need to balance your budget to avoid new credit card charges. You should be able to cover the loan payments plus all your daily expenses, as well as money for savings. This will permit you to avoid new credit card debt while you pay off the loan.

May take up to 5 years

Consolidating debt and paying it off with a loan isn’t necessarily a quick fix. The term could be as low as 12 months, but it can also take up to 60 months (5 years). If you’re seeking a fast resolution to your situation, this may not be the best option.

In this case, you may want to consider options such as bankruptcy. Bankruptcy can give you a fresh financial start in as few as nine months if it is your first time filing. You will face significant damage to your credit. However, if you are seeking the fastest exit possible, bankruptcy may be the best choice.

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Debt consolidation alternatives

There are other solutions that offer many of the same benefits you receive from a consolidation loan. These options also allow you to pay off your debt in full, with a single monthly payment at a lower interest rate.

Credit card balance transfers

A balance transfer credit card is a card that’s designed to consolidate existing credit card debt at a lower interest rate. Balance transfer cards offer a lower rate when you move balances from your existing accounts to the transfer account.

In many cases, these cards offer a 0% APR introductory rate when you first open the account. This means you have about 6-18 months to pay off the consolidated balance interest-free. You qualify for this solution based on your credit score, so you need good or excellent credit to make this work.

In general, this solution only works for a limited amount of debt. In most cases, you should have $5,000 or less to use this solution. This will allow you to pay off the full balance before the 0% APR period ends. Once that period ends, you’ll generally be back to paying the same high rates.

Lines of Credit (LOCs)

Another borrowing option available to people with good credit is a personal Line of Credit (LOC). You apply for a LOC through your bank or credit union and get approved for a revolving credit limit based on your credit score.

A LOC is like a credit card in that you have an open line of credit up to a certain limit that you can borrow against as needed. The monthly payments are typically equal to the accrued monthly interest charges, which means the payments are generally low.

However, the problem with a LOC is that if you only pay off the accrued monthly interest charges each month, you never pay off the balance. You can use the LOC to pay off your credit card balances, but you will still be in debt. It really does not solve the problem.

Home equity borrowing options

There is also a range of borrowing options available to Canadian homeowners. With these options, you borrow against the equity in your home, which is the current appraised value of the home minus the remaining balance on the mortgage.

Borrowing against home equity can be beneficial because you can qualify for a lower interest rate even with a weaker credit score. However, it also creates more risk for you as a borrower. If you default on the payments, you may be at risk of foreclosure.

In general, it is not recommended to use home equity solely for the purpose of paying off unsecured debt. However, if you refinance or have a HELOC and want to use some of the funds to pay off a few credit cards, it may be in your best interest to do so.

Debt management plans

There is one last option that consolidates debt into a single monthly payment which does not involve borrowing. Instead of taking out new financing to pay off your existing accounts, it sets up a consolidated repayment plan.

You set up a debt management plan through a credit counselling agency. The only real requirement to qualify is that you have the income to make monthly payments. Those payments are generally lower than what you pay on all your individual accounts. There is no credit score requirement or maximum debt amount you can include.

The credit counselling agency helps you find one monthly payment that works for your budget. Then they contact and work with your creditors to eliminate or reduce interest charges applied to your balances. You complete the plan in 60 payments or less.

Since you pay back everything you owe, you avoid the credit damage of solutions like debt settlement, consumer proposals, and bankruptcy. However, it will be noted in your credit report for two years that you paid off your debt on an adjusted payment schedule.

This can be a great option for people who can’t qualify for debt consolidation loans, but who still want to pay back everything they owe.

Which consolidation option is right for you?

Warning: Debt settlement is not consolidation!

Debt consolidation should not be confused with debt settlement. Consolidation solutions pay back everything you owe in a more efficient way with lower interest. Settlement options work by focusing on paying back only a percentage of the principal you owe. This results in greater damage to your credit that lasts for six years.

Some companies purposely try to mislead consumers into thinking they’re signing up for debt consolidation. If you’re seeking professional help to pay off your debt, make sure you know what you’re signing up for before you sign up for anything and start making payments.

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