Pros and Cons of Debt Consolidation
Is debt consolidation a good idea? Are you considering consolidating your debts or looking for an answer to your debt problems? Learn more about the factors to consider to determine the best solution.
Have trouble meeting your financial obligations, whether paying off loans or bills? If only there were a way to get it all under one roof… Well, there is! It’s called debt consolidation – sometimes called debt restructuring – and can make paying off your debts easier. But what is the process of debt consolidation? And is it a good idea for your situation?
The answer to that last question is simple: it depends. Here are the factors to consider regarding the pros and cons of debt consolidation. This will help you determine if this option is right for you.
What is debt consolidation?
Debt consolidation loans are usually used to pay off debts accumulated on credit cards, lines of credit, overdrafts, and high-interest loans such as payday loans. Here’s how it works: a person behind on loans or bills takes out a new loan to pay off their arrears. The funds from this new loan are then used to pay off all unsecured credit accounts. Often this loan has a lower interest rate than all or most other credit products.
What is the difference between debt consolidation and debt settlement?
Debt consolidation is different from debt settlement and a consumer proposal.
It involves applying for a consolidation loan from a lender such as a bank, credit union, or other financial institution. The lender will then evaluate your application for a loan based on factors such as your credit score, income, and the availability of an asset to secure the loan repayment. Then, the lender will decide whether to approve your loan and determine the interest rate you will have to pay based on the information in your application. If you make all your payments on time, your debt consolidation loan should not negatively affect your credit score. On the contrary, it may even improve it.
Debt settlement involves making a formal offer to your lenders called a consumer proposal. This mechanism allows you to settle your debts with your lenders by reducing the amount owed and offering them a partial repayment without interest through a trustee in bankruptcy. A consumer proposal is a bankruptcy alternative, but both significantly negatively impact credit scores.
The pros and cons of debt consolidation
There are probably more Canadians caught in a debt spiral than you think. According to Manulife Bank’s 2018 Debt Survey, more than half of Canadians feel that their debt prevents them from doing what they want, including saving for retirement. When you’re feeling overwhelmed by your debt, consolidation can seem appealing.
Debt consolidation has both advantages and disadvantages. Here are some advantages:
- Only one payment needs to be made each month.
- Lower overall payments.
- Because of the lower interest rate, more of your payment goes toward the principal.
But debt consolidation also has its drawbacks. It could cause you problems in the following situations:
- If the lender deposits your consolidation loan funds directly into your account, you may be tempted to spend them on things other than paying off your debts.
- If you fail to close an unconsolidated credit product after paying it off, you may be tempted to take on more debt despite the consolidation loan you just took out.
- The consolidated payment you make each month could be used as an excuse to continue your bad financial habits. Consolidation loans would become a cure-all for excessive use of your credit cards and lines of credit.
Is debt consolidation the right solution to your debt problems?
Debt consolidation can be a real lifesaver if you feel you are sinking in a sea of debt and monthly payments. It can help you simplify your finances by allowing you to make one lower monthly payment that will fit more easily into your monthly budget.
However, for these benefits to be realized, your loan application must be accepted, and you must qualify for an interest rate lower than those applicable to your unconsolidated debts. It’s also important to think twice before using debt consolidation as a way out of bad financial habits. Some people are tempted to reapply for credit after debt consolidation and then apply for a new consolidation loan when they start to fall behind. Anyone who undertakes debt consolidation should have a strong commitment to controlling their debt in the future.