Since credit cards and other forms of consumer debt often have double-digit interest rates, it is little wonder that debt consolidation is such a popular debt relief option in Canada. Taking out a good debt consolidation loan can often save 5 percentage points or more on your debt interest payments.
Depending on your credit history, your interest rate savings could even surpass 10 percent. Your bank or credit union may charge a 7% – 12% interest on debt consolidation loans. Other finance companies may charge 14% or more for secured loans, and up to over 30% for unsecured loans.
How much can you save with debt consolidation?
The average interest rate on credit cards in Canada is approximately 19%. At that rate, a $10,000 debt could generate up to over $6,200 in interest charges on a standard 2.5% minimum payment schedule. With some minimum payment schedules that only pay the interest plus 1% of the balance, the interest charges could add up to over $15,000.
Cutting the interest rate down to ten percent with a debt consolidation loan can help you save thousands. With a 60-month unsecured loan at 10% APR, you’d pay just over $2,700 in interest.
What’s more, you would pay off the debt faster and have slightly lower monthly payments.
As with other debt relief, a little education goes a long way. Learn how to pay off your debts, increase your credit score, and see improvements in your credit report.
There are many debt consolidation loans, and the way they calculate interest differs.
Fixed-Rate Vs. Variable-Rate Loans
You do not typically have to take loan rate types into account when you enroll in a debt settlement plan, but you need to know about them when researching debt consolidation loans. You have two major options to choose from for consolidation loans: fixed-rate loans and variable-rate loans.
Fixed-rate loans have an interest rate that remains the same for the length of your loan term. No matter how market conditions fluctuate, your payment remains the same because the interest rate never changes.
Variable-rate loans, on the other hand, have an interest rate that changes periodically. Every time the rate changes, your minimum loan payment increases or decreases according to the rate change.
Both variable-rate and fixed-rate consolidation loans are available whether you negotiate a debt consolidation loan yourself.
How Are Debt Consolidation Loan Interest Rates Set?
You can predict interest rates on debt consolidation loans based on the prime interest rate and the bond market. When your consolidation loan is a mortgage product, banks set the variable rate by taking the prime interest rate and subtracting a few percentage points from it.
Fixed-rate mortgage loans that you might get are set by the bond market. Banks take the going rate for bonds and add one or two percentage points to calculate your rate.
Consumer debt consolidation loans can follow the above mortgage loan patterns they have their own rules set by the bank. In any case, you generally pay a higher rate of interest if you have bad credit.
Assessing the savings benefit of debt consolidation
Consolidating debt becomes less beneficial at higher interest rates. If you can qualify for a loan at 5% APR or even 10%, that offers significant savings. The total interest charges will be lower and the monthly payments may be lower as well. However, the higher the APR, the less beneficial that consolidation becomes.
This table shows the cost savings of debt consolidation loans at different interest rates, versus minimum credit card payments as well as the cost of making fixed payments on your credit card for a $10,000 debt.
|Repayment method||APR||Monthly payment||Total interest charges|
|Credit card, minimum payments||19%||$408.33 to start||$6,201.80|
|Credit card, fixed payments||19%||$410||$2,737.96|
|Fixed-rate 24-month loan||5% APR||$438.71||$529.13|
|Fixed-rate 36-month loan||10% APR||$322.67||$1,616.19|
|Fixed-rate 60-month loan||15% APR||$237.90||$4,273.96|
Types of Debt Cosolidation
Similar to other types of debt, debt consolidation loans come in different shapes and sizes. There are many ways you can consolidate your debts
This means it is not secured by an asset or collateral. If you default on the loan creditor can sue you for payment, but your home or car can not be taken away.
A personal loan is one of many consumer loans. While most consumer loans have an explicit purpose, buying a home, car, or education, a personal loan can be used for anything. Also unlike a mortgage or auto loan, a personal loan has no collateral in cases of failure to pay. This makes them great for debt consolidation.
The main benefit of a personal loan is that it forces you to pay off your debts by a specific date. Unlike an unsecured line of credit or HELOC where you can make interest-only payments, with a personal loan, you make payments that comprise both interest and principal.
Depending on what your budget allows, you could go with a personal loan term between one and five years or longer. The benefit of a shorter loan term is that you’ll pay off your debts sooner. However, the monthly payment will be higher, so you have to make sure you’ll be able to handle the higher fee.
A personal loan can be a great way to take advantage of today’s low-interest rates. Locking into a fixed rate can protect you from higher interest rates while simultaneously paying down your debts. You can combine your debts into one single payment while saving on interest at the same time.
Personal loans make the most sense for those who may lack financial discipline. By being forced to make certain monthly payments, you’ll be unable to spend on things you can’t afford.
Unsecured Line of Credit
An unsecured line of credit is unsecured because it doesn’t have any asset backing it. For that reason, it tends to come with a higher interest rate.
Unsecured lines of credit offer a flexible way to pay down your debt. A line of credit is a revolving form of credit. It works a lot like a credit card. You have credit available to you up to a certain limit.
This offers you a lot of flexibility as you can use your line of credit as you see fit. However, that also leaves you open to the temptation to spend.
A line of credit can be great in theory if you’re financially disciplined. Otherwise, you could end up with more debt than before. This has the potential to hurt your credit history.
That’s because anytime your outstanding balance on revolving credit goes above 50 percent of your credit limit, it tends to drag down your credit score. The desire to help your credit score by taking out an unsecured line of credit can end up hurting it.
You can unlock some of the equity in your home but this can be a dangerous path. Leveraging your home to pay off unsecured debt should not be done if you have substantial debt. If you have trouble paying your bills, your home may be taken a repayment.
Home Equity Line of Credit
You can unlock some of the equity and put it to work for you with a HELOC if:
- You’re purchasing a home and making at least a 20 percent down payment, or
- You already have a home and have at least 20 percent equity in the property
A HELOC is considered a secured line of credit. That’s because, unlike an unsecured line of credit, it has an asset backing it. For that reason, there’s a lower risk to the lender. If you are unable to meet your payment obligations, the lender can sell the asset that’s acting as security.
HELOCs enable you to get the lowest debt consolidation loan rates. You can expect to get an even lower rate on HELOC than you would on an unsecured line of credit. You can expect to pay anywhere between Prime Rate, plus 0.5 percent, plus one percent.
However, a HELOC isn’t without its downsides. If you’re not financially disciplined, you could find yourself with even more debt than you started with.
A HELOC is a revolving line of credit, which may not be available if you have a poor credit history. Revolving credit means once you pay down a portion of your loan, that amount is immediately available for you to borrow from again.
Scenario: You are approved for a $50,000 HELOC. You use $20,000 of that to pay off some consumer debt, leaving you with $30,000 in available credit. If you make a $10,000 payment to the HELOC, you now have $40,000 in available credit to use however you want.
Revolving credit differs from a traditional loan where you borrow once, repay the loan, and “finish” the loan.
Also, HELOC may come with fees. Watch for fees like origination fees and other fees. That may make a low rate less attractive. You can use a debt consolidation calculator to help determine if it’s worthwhile to take out a HELOC even with the fees.
Home Refinance Loan
Many people refinance their homes and borrow more than they need so they can roll higher interest consumer debt into their less expensive mortgage. Refinance loans can have either a fixed or variable interest rate.
With a second mortgage, you borrow against the value of your home but retain the initial mortgage. This leaves you with two mortgage payments each month. However, it may be worth it if you can get a substantial interest reduction on the loan you use to pay off your consumer debt. The rate on a second mortgage can be fixed or variable.
Is a Debt Consolidation Loan Right for Me?
As you can see, when weighing the benefits of a debt consolidation loan, you need to consider the monthly cost savings as well as the total cost savings. Using a debt calculator can help you estimate how much you can save with different solutions. It can also be helpful to talk to a debt relief specialist, who can help you understand your options and find the best solution for your needs.