The goal of debt consolidation loans is to lower your debt burden. Consolidation loans enable you to combine multiple debt payments into one loan with a lower interest rate and potentially lower monthly payments. Assuming everything else remains constant, there are two tactics to do this;
As such, the holy grail of debt consolidation is refinancing your debt into a lower interest rate loan with a longer term length. The key is paying off a high interest loan using another with a lower interest rate. For example, you may use a HELOC with a 6% interest rate to pay off multiple credit cards at a 19.99% interest rate.
This article will walk you through everything you need to know about consolidating debt. This includes the type of loans available, how to get one, and the best alternatives. By the end of this article, you'll have a clear understanding of the type of loan you need and an action plan to get it.
*Estimated interest rate
|Average Interest Rate||Funding Range||Term Length|
|Balance Transfer Card||0.00% - 2.99%||$500 - $15,000||6 - 12 months|
|Secured Loan||5.88%||Up to 85% of home value, 50% of car value||6 months - 20 years|
|Unsecured Loan||9.50%||$1,000 - $50,000||6 - 60 months|
Source: StatsCan, December 2022
Many balance transfer credit cards offer temporarily low interest rates. These generally have a promotional rate of 0 to 2.00% for roughly seven months. As a result, these cards are a great place to start. However, there are two limitations to balance transfer cards;
It's also important to note that missing a payment will end the promotion and increase to the standard rate, typically 19.99%. If you don't miss payments your rate will still increase at the end of the promotional period. However, you can still meaningfully reduce your monthly payments or pay off the principal while the promotion lasts.
If you still have debt at the end of the promotion, you'll need to transfer it to one of the following options to avoid the 19.99% interest rate.
Many lenders allow you to choose one of two options for debt consolidation. The difference between a personal loan and a line of credit is how you receive the money.
A personal loan gives you one lump sum repaid over a fixed term, while a line of credit allows you to borrow up to a certain amount at a variable rate. You may then make multiple withdrawals from the line of credit and only pay interest on what you use. In short, a personal loan provides more structure, and a line of credit has more flexibility.
These loans use collateral that you own to reduce the risk for the lender. Common examples include debt consolidation using a home equity line of credit (HELOC). The advantage is that lenders are willing to offer lower interest rates and larger loan sizes than other debt consolidation loans.
The main disadvantage is that the lender could foreclose on your home if you fail to make payments. Therefore, these loans can create significant debt if used without caution. Another example of a secured loan with a higher interest rate is a car title loan.
These debt consolidation loans don't require collateral, making them available to more borrowers than secured loans. However, they typically have stricter requirements and higher interest rates because lenders are taking on more risk.
For debt consolidation, these loans are best used in small amounts and for short loan periods. A good credit score will lower the interest rate and debt service ratio.
The high-level overview of a debt consolidation loan is using a low-interest-rate loan to pay off higher-interest-rate loans. For this to happen, the lower interest rate loan amount should ideally match or exceed the balance of the old loans.
However, even transferring some high-interest debt to a lower-rate loan will average down your interest rate. After this, you switch to a lower interest rate on your loans. The remainder of this section explains the process step-by-step and provides some examples.
If you can't qualify for more loans or are hesitant to pay around with different types of debt, there are alternatives for you. This section will cover your various options to reduce your debt load. Some borrowers may get creative and combine an alternative with a debt consolidation loan.
A consumer proposal is a binding agreement with your lenders. The process involves a licensed insolvency trustee who will determine the amount of debt you can afford to pay back. You’ll then finalize an agreement with your creditors to set up a payment plan.
Debt settlement is a debt relief option that allows debtors to pay a lump-sum payment lower than the outstanding debt amount. For example, if your balance is $10,000 you can negotiate to settle the debt with $7,000. This can be used if you have extra money or trouble repaying debt.
A debt management plan (DMP) is another solution to help debtors manage their debt repayment. With this plan, debtors work with a debt counsellor who will negotiate lower interest rates and monthly payments on their behalf.