Debt consolidation in Canada – how it works and why you may need it
There’s no sugar-coating – the journey to financial freedom is tough. The good thing is, there are effective ways to get out of debt fast. If one of your current goals is to be debt-free, debt consolidation is worth considering. Keep in mind that the only way to keep your finances in order is to learn how to save money and make smarter financial decisions. With that said, we’ll share some more information on debt consolidation to help you decide if this is for you.
What is debt consolidation?
Put simply, debt consolidation in Canada involves bringing together small loans, bills or money you owe from different sources into a single, new loan and then make one monthly payment. Since you are consolidating different types of debts together into a combined loan, the term debt consolidation is used. Remember, each loan has its own repayment terms and interest rates so, in reality, you cannot combine them. What happens is that you take a new loan to clear all the smaller loans you had and then start paying the new loan only.
Who issues a debt consolidation loan?
Debt consolidation is offered by banks, credit unions and other financial companies that deal with credit. When you apply for the debt consolidation loan and your application is approved, the company will deposit the cash to your account and it’s your responsibility to clear the debt or they pay out the debts on your behalf.
What are the benefits of debt consolidation loan?
There are many reasons to consolidate different debts into one payment.
- Simplifies the repayment process: You never have to keep track of multiple debts, there’s only one payment you need to make each month.
- Saves money: Sometimes you end up paying lower interest rates especially if you had high interest credit card debt.
- Can make life manageable: If you get a debt consolidation loan with a lower interest and amortization period then you can repay the loan in smaller monthly payments.
- Can get out of debt faster: With a lower interest rate, it means most of the monthly payment you make will be going towards repaying the principal hence you’ll be able to clear the debt faster.
How do they determine interest rates on debt consolidation loans?
There are two main factors that determine how much interest you’re likely to pay for debt consolidation:
- Your credit score: Banks and finance companies consider borrowers with a low credit score as more unlikely to repay debt as agreed in the agreement. Therefore, if your credit score is not good enough, lenders are not confident in your ability to repay the new loan as agreed. You are considered a higher risk borrower and hence they will offer you a much higher interest rate.
- Collateral: Other finance companies will offer you a debt consolidation loan with lower interest if you provide good security. There are only specific things that the bank can accept as security, mostly stuff that they can easily convert into cash such as real estate or a new vehicle.
Is a debt consolidation loan for you?
There are certainly downsides to debt consolidation. One thing that most people do not understand is that you have to deal with poor financial habits before consolidating debt. Most people take debt consolidation loans with a lower monthly payment compared to their previous payments. This means that they now have something extra to spend every month. They then continue to spend more money than what they earn instead of creating a plan to stop overspending and get their finances back on track. This makes their financial situation worse and in the long run, their credit score becomes worse and qualifying for a new loan is almost impossible.
Therefore, the important thing to do when you take steps to get out of debt faster is to create a budget and follow it making sure you work with how much you spend versus what you earn.
What are your options for debt consolidation?
There are different ways to go about consolidating debt:
- Home equity loan: This is often considered a second mortgage which you can qualify for if you have acquired equity in your home.
- Line of credit: There are unsecured and secured lines of credit offered by banks for borrowers with a good credit score and a good income.
Don’t be fooled!
Debt consolidation should help you to get out of debt, not put you in further debt. Therefore, be keen on people who try to sell you a debt consolidation loan that has hefty up-front fees.