For quite a few years now, financial and debt advisors have been encouraging Canadians to consolidate their expensive credit card and overdraft debt into much more reasonable line of credit debt.
If you are trying to pay off your debt faster, using a line of credit instead of credit card debt makes perfect sense. Lines of credit and term loans charge dramatically lower interest rates.
- A typical bank credit card charges 18-21% interest on the outstanding balance, store cards charge 29-31% interest. If you are carrying $10,000 on a 20% credit card your monthly interest cost is $167.
- A typical unsecured line of credit for a high risk borrower might charge prime plus 4-6%. Converting your $10,000 borrowings to a 9% line of credit (prime of 3% plus 6%) lowers your monthly interest cost to $75 per month, a savings of $92.
It is easy to see why the conversion makes sense.
But things don’t always go as planned. In our last study on the average insolvent debtor, we found while bankrupt debtors were transferring their credit card debt into lines of credit and term loans they were still going bankrupt. Why?
Unfortunately, we’ve discovered that people are making some very expensive mistakes when they consolidate their credit card debt to lines of credit. Here are the top three that we have identified:
- They don’t cancel their credit cards. This is the biggest mistake you can make. If you don’t cancel most, if not all of, your credit cards when you pay them off using a line of credit you run the risk of running up debt on your credit cards again. This may double your debt and make your financial situation much worse than it was before.
- They only make the minimum payments on the line of credit. Switching to a line of credit can save you thousands of dollars in interest charges, but only if you pay down the debt. If you only pay the interest (or your minimum payment) on your line of credit you will never get out of debt. A better strategy is to use the $92 you saved to pay down your debt faster. In other words, pay $167 a month towards your line of credit debt. Now your are reducing your debt balance faster. And because your balance falls, the amount you pay against principal increases each month. To try this calculation out for yourself try our Debt Repayment Calculator.
- They use the line of credit like a giant credit card. Lines of credit usually have much higher upper limits than most peoples’ credit cards. That means they can be used for much larger purchases. This can be a very expensive mistake if you never pay off your balance. If you want to make a major purchase, like a home entertainment system or home appliances, save up first. If it’s something even larger like a trailer or boat, save up or consider using a secured term loan which will force your to pay it off in a set period of time and at a lower interest rate.
These are the three most common and expensive mistakes people make when they convert their credit card debt into lines of credit. Paying off your credit card debt with a lower cost line of credit is an excellent strategy, but you need to be careful not to fall into one of these traps.
If you have a lot of credit card debt and are considering debt consolidation, talk to a trustee. They can help you decide if this is your best approach or if another debt relief option would be better.