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What are the risks of debt consolidation?

Key Takeaways

  • Debt consolidation helps you reduce the number of bills you have, the amount of interest you’re paying, and often, the amount of time it takes for you to pay off your debt.
  • A debt consolidation loan often requires you to have a good credit score, and proof of consistent income. With this, you can get a lower interest loan, and save the money that was previously going towards interest payments.
  • Credit card balance transfers have a low or 0% APR for the introductory period, but revert to their regular higher interest rates in 6-18 months.
  • Minimum payments on LOCs only go towards interest, so you need to ensure you make regular extra payments towards paying off your principal. 
  • You can get a HELOC even with a poor credit score, but it is a secured form of credit that uses your home as collateral. This increases your risk exposure, so if you can’t make payments, your home may be at risk of foreclosure. 
  • Do your research on company legitimacy. Check all paperwork and understand the financial solution you’re signing up for.
  • Work on building healthy money habits, create a budget, and start building an emergency fund.

What is debt consolidation?

Debt consolidation helps you combine higher interest debt into a single monthly payment at a much lower rate of interest. Typically, this means a reduction in the number of bills, interest paid, and time before becoming debt-free. It can be used for a variety of unsecured loans.

There are different ways to approach debt consolidation, like:

  • Debt Consolidation Loans
  • Credit Card Balance Transfer
  • Line of Credit (LOC)
  • HELOC
  • Debt Management and Credit Counselling

Each of these has its own specific requirements and risks. It is important to consider all these factors before deciding what type of debt consolidation works best for your situation.

Learn more about debt consolidation.

Risks of debt consolidation loans

Debt consolidation loans involve taking on a lower interest loan to pay off your higher interest rate debts. Often, you end up paying less interest while reducing the total amount of your monthly payments. 

However, there are some things you should keep in mind before signing up for a debt consolidation loan:

  • To qualify for a low-interest debt consolidation loan you need a good credit score and proof of reliable income. Without both of these qualifiers, you may not be approved.
  • Getting approved for debt consolidation loans without the above qualifiers likely means being offered a loan at relatively higher interest rates. This is especially true if your credit score is rated lower than “good” to “excellent”. This leaves you paying more interest over the course of the loan. That’s even if your payment amount remains almost the same as before the loan.
  • Assess the difference between your current and possible payment amounts before moving ahead with the debt consolidation loan. In some cases, the new monthly payment may be higher than what you’re currently paying. In this case, you need to check whether it is something that fits your budget. It shouldn’t end up increasing the debt you owe, or negatively affecting your budget.

Associated fees for debt consolidation loans

Debt consolidation loans are based on the bank’s variable rate, which depends on the prime interest rate or bond market. Usually, if you have bad credit, you are likely to pay higher interest rates.

Your lender (bank or credit union) may charge around 7% to 12% interest on a debt consolidation loan. Other lenders or financial institutions may charge more, going up to 30% for unsecured loans. Interest rates vary between different lenders, and may also change based on your credit score. Debt consolidation fees will also vary greatly. There can be annual fees, balance transfer fees, origination fees, and closing fees. This is one time when you don’t want to skip out on reading the fine print.

Risks of credit card balance transfer 

Some credit cards offer lower rates when you transfer over your account balances. These balance transfer credit cards tend to offer a low or 0% introductory APR when you open the account and transfer your balances. Often this introductory rate lasts for only a limited amount of time. This method of debt consolidation is beneficial if you have a lower amount of debt. 

These are some of the things to keep in mind before opting for a balance transfer credit card:

  • While low introductory rates are appealing, they are only offered for a limited duration. Usually between 6-18 months. This means that you need to ensure you are able to fully pay off the debt before the introductory period ends. Once it does, you would be charged relatively higher interest rates again, within the range of regular credit cards.
  • A lower amount of total debt would allow you to pay it off in full before the introductory APR period ends. That’s why this method is recommended only for relatively lower amounts of debt, in the range of $5,000 or lower.
  • Even with the 0% introductory rate, you still need to make timely payments every month. Keep in mind that penalty charges may still apply if you miss out on due dates or payments, and these charges are often quite high.

Associated fees for a credit card balance transfer

The balance transfer fee is usually 3% to 5% of the total amount transferred. If you have a debt of $5,000, and you’re charged 4% transfer fees, you would pay $200 in fees. A 5% transfer fee brings it to $250, which is still beneficial if the 0% introductory APR will help you get out of debt quicker. 

Risks of line of credit (LOC)

If you have a good credit score, there’s another option available to you – a Line of Credit, or LOC. You can directly apply to your existing bank, lender or credit union for a line of credit, and you can qualify directly based on your credit score. 

A line of credit often offers a low interest rate, so you can use it to pay off higher interest debt. Once you do, continue making regular payments towards the line of credit till it is fully paid off.

It is important to remember how a line of credit works and what type of terms you’re signing up for:

  • Any payments you make towards a line of credit only go towards paying off your interest. To make a dent in paying off your principal, you need to pay larger amounts, greater than the minimum they charge you. Otherwise, you will only be paying off the monthly interest, without making any progress in your original debt.
  • It is also important to note the type of LOC you’re signing up for, and whether it is a fixed rate or variable rate LOC. If you’re opting for a variable rate LOC, the interest rate can change at any time. This means that the amount you owe – even the minimum monthly that only covers interest – may change any time the rates change. If you choose to go this route, make sure your budget can accommodate any such rate changes. 

Note:

The average interest rate in Canada is around 10.89% for unsecured lines of credit. It can even go up to 40%. 

Risks of HELOC

A Home Equity Line of Credit (HELOC), unlike the previous options listed for debt consolidation, is a secured form of credit. This means that the lender uses your equity in your home as a guarantee that you will pay back the borrowed funds.

Due to it being a secured form of loan, you can qualify even with a poor credit score. As you are willing to put up collateral, you may even get a lower interest rate. However, it tends to increase your risk exposure:

  • While the interest rate is lower due to it being a secured loan, your home equity is used as collateral. This greatly increases your risk exposure as it puts your home at risk. This means that if you are unable to make your full payments in a timely manner, you may have to face a foreclosure for your home.
  • It is generally advised not to opt for a secured form of credit to pay off your high interest unsecured debt. It may work in certain cases, for example, if you’re refinancing or if you have a relatively small amount of higher interest debt. In such cases, if you want to switch it over to reduce higher interest charges, and are confident of being able to maintain timely payments, it may be a viable option.
  • HELOCs can be subject to variable interest rates, so your monthly payments may fluctuate over time. Just like with a regular LOC, you must ensure that your budget has the space to accommodate any such fluctuations in required payments.

Note:

The average interest rate in Canada is around 7.07% for secured lines of credit.

Risks of debt management and credit counselling

A debt management plan allows you to set up a consolidated repayment plan, as opposed to traditional debt consolidation. This can be done through a credit counselling agency. 

To qualify, you usually need to show a stable income. You don’t need a good credit score to qualify, nor are there minimum or maximum amount limits on how much debt you can include in this approach.

As for any approach you consider for debt consolidation, there are risks to keep in mind:

  • The credit counselling agency works with creditors to try and reduce, or even eliminate, the interest charges on your balances. However, the adjusted payment schedule is reflected on your credit report with a note. It does not damage your credit score like a debt settlement or a consumer proposal would.
  • If you opt for an adjusted plan, you may find it hard to be approved for new credit while the repayment plan is ongoing, and sometimes for a short while after.
  • When you opt for a debt management program, it does not freeze your interest due or other charges. This means that creditors may still be able to contact you. The credit counselling agency would work with your creditors as far as possible to create a plan that is acceptable to all parties. 

Associated fees for a debt management plan

Depending on the agency you choose, a debt management plan can include various fees such as a setup fee, a monthly fee, an application fee, and more. There may also be a fee for each creditor that you include in your debt management plan. Be aware and compare the cost of fees to the potential savings in interest payments. If the fees end up at a higher total than your potential savings, you may want to check another agency or explore other alternatives. That being said, it’s worth mentioning that you can request for fees to be reduced if you can’t afford it. They may be willing to consider these requests on a case-by-case basis.

Things that could go wrong with debt consolidation

Sometimes, life takes a different direction than what you planned for, so the only thing you can do is be aware and prepared. Here are some issues people have faced while dealing with debt consolidation in general:

Debt solution confusion

It is important to note that debt settlement is not the same as debt consolidation. With debt consolidation, you pay back everything you owe – the only difference is that you’re opting for a lower interest rate. You would still be paying the full principal amount that you owe. With debt settlement, you only pay back part of the principal.

Due to this important distinction, the risks associated with debt settlement are relatively greater:

  • A debt settlement plan can hurt your credit, as you only pay part of the principal. The negative effects on your credit report can last for up to 6 years.
  • Some debt management companies may mislead customers into signing up for debt settlement when they think they’re signing up for debt consolidation. Before signing any documents, make sure you’re clear on the difference and double-check what you’re signing up for.
  • It’s advisable to do your research on the company you’re signing up with. It’s also a good idea to request information and paperwork for the solution you’re considering. Make sure you know the terms and specifications before you sign anything or confirm your participation in a legally binding way.

Once you have decided you want to go ahead with debt consolidation, there are some things you need to account for.

Company legitimacy 

Do your homework before you sign up with a debt consolidation company. Verify their legitimacy on the Canadian Government website and ensure their good standing. Do not simply go by advertising or social media. Be wary of any agencies that try to push a solution that may not be best suited to you. For example, if they persuade you to opt for a longer timeline, it might be more expensive in the long run.

There are illegitimate companies that pocket your money instead of sending it to your creditors as they should. You not only lose the money but also have to handle a damaged credit score. 

Keep an eye out for companies that:

  • Employ high pressure tactics
  • Don’t take the time to figure out a solution suited to you
  • Promise a large amount of debt reduction even before they have verified your finances or know whether it is possible for your specific situation
  • Offer a quick fix for your credit score
  • Represent themselves as part of a government program or initiative

For each of these potential pitfalls, the solution is to do your homework, check out the government website, and ask the potential agency detailed questions about their services and qualifications. 

Life happens

Sometimes, things go wrong even when people plan to do things right. In some cases, after signing up for debt consolidation, unforeseen circumstances may arise.

A longer illness that leaves one unable to work like they used to, or an unexpected job loss might mean a change in income. This may lead to a situation where the monthly payment may no longer be manageable. It is best to talk to your lender with full transparency. They may be willing to work with you to modify it. The important thing is to show your willingness to make those payments, even with your changed circumstances. 

Often, you may already have debt insurance coverage, but not know the particulars. Go through your documentation carefully and check whether your loan is insured in cases of job loss or disability. You may find that your existing insurance coverages may cover a portion of your debt. If the remainder is still difficult to manage, once again your best bet is to speak to your creditor. You may be able to come to a mutually beneficial agreement.

Money management during debt consolidation

Once you opt for debt consolidation and start paying down your debt, you need to make sure you have a budget in place. While you work on paying down your debt, you should also work on building stronger financial habits. This will help keep you on track in the future and make sure you don’t face debt again.

Understand your finances

Even with a debt consolidation loan, you aren’t out of debt yet. It’s a great first step towards improving your finances, but you need to consider what financial habits led you to such a situation in the first place and try to take measures to change those habits. 

Track your spending

A good way to pay attention to your finances is by tracking where your money is going. You can make a note whenever you do a transaction, or go through your credit card statements, or bills and receipts – pick whichever way works best for you. The goal is to understand where your money is going, and if some categories are more of a money pit than you expected. This will help you be more mindful about those categories and rein in your spending. 

Stay on track financially

By not preparing a budget and staying mindful of your finances, you risk the possibility of going further into debt. Your old credit cards are still active and freed up with the consolidation, so you need to make sure you don’t use them again unless you are able to pay them off in full every month. 

Stay informed

A general tip for debt consolidation is to always ensure you have the right information before you sign up for anything. For example, some debt consolidators may advise you to stop making payments, as in the future you will only have to make one monthly payment. However, this advice may not always be beneficial, and indeed, can be damaging in some cases. This is because creditors often start charging fees as soon as you stop the payments. These fees and/or penalties can add up quickly. This can be even worse if you stop payment to multiple creditors before the debt consolidation payments have been properly set up. 

Stay up to date on your taxes

Once you have all the facts, make an informed decision based on your personal situation and finances. Another thing to be mindful of is tax implications. Often, when debt is forgiven, the gain is treated as income from the perspective of your tax returns. This is often the case when you repay less than the full amount.

By opting for a solution that requires paying the full principal, this may not apply to you. It is important to be mindful of whether the instrument you opt for has any tax implications. Consult a tax expert if you are opting for a financial instrument where you repay less than the full principal.

What if it’s too late for debt consolidation?

Maybe you’ve considered the pros and cons, and are unsure whether debt consolidation is right for you. Here are some alternatives to consider before you decide.

Credit counselling vs debt consolidation

Debt consolidation combines your debts into a new lower interest loan, whereas credit counselling helps you consolidate your debts into a debt management plan. A debt management program is a structured repayment plan where the counsellor will work with the creditors on your behalf. 

With a debt management plan, the credit counselling agency will help you work out a schedule that is acceptable to you as well as your creditors. The counsellor can also negotiate with these lenders to reduce, or sometimes eliminate, the interest you’ve been paying. 

Since you’re still paying back the full amount, it doesn’t damage your credit score. There will, however, be a note on your credit report that shows you were on an adjusted payment schedule for your debts. This note stays on your report for two years. This is a viable option if you can’t qualify for a debt consolidation loan, but still want to pay back everything you owe and be debt-free without negatively affecting your credit score.

Consumer proposal vs debt consolidation

To qualify for debt consolidation, you need to be able to afford the monthly payments and have a good credit score. If this is not possible for you and you have a high amount of unsecured debt, you may want to consider a consumer proposal. With this, your debt can be reduced by 70% or even 80%. 

However, you need to be able to show that you’re not in a position to pay off all your debt. It will also affect your credit score more severely than debt consolidation. A consumer proposal will add an R7 rating to your credit report as well.

Bankruptcy vs debt consolidation

If none of the other alternatives seem feasible, you may consider bankruptcy. If you are able to afford the monthly payments, debt consolidation is better than bankruptcy in many ways. An important one is credit score – while debt consolidation does not affect your credit score much, bankruptcy can severely diminish it for many years. 

While a debt consolidation loan provides a lower interest loan to help you pay off debts, bankruptcy is a legal process which relieves your debt. It is, however, a last resort, and not often considered as an alternative if other options are more feasible. If your home or property has been put up as collateral and is at risk of seizure, or if you are genuinely unable to pay your debts, bankruptcy may be worth looking into. 

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