Some issues with debt consolidation.
If you have bad credit, being approved for a debt consolidation loan brings a new set of challenges. There are lenders who specialize in offering debt consolidation loans to people with poor credit, but at a tremendous financial cost. Making multiple applications with the goal of finding any lender who can help, can actually hurt your credit rating. In desperation, you may turn to poor alternatives to keep your bill payments afloat.
Credit Capacity Versus Credit Score
Before deciding whether or not to take out that new debt consolidation loan, it’s important to distinguish between two very different concepts that can affect which option is best for you.
Your credit score is an assessment of how much risk your lender would be taking if they loaned you money. Based on a number of factors in your credit history, a low number means there is a high chance that you will default on your loan at some point. It doesn’t mean you will, it means you are more likely to do that than someone with a better score. Even if your loan application is accepted, a low score will likely mean you have to pay a higher interest rate because you are perceived to be a higher risk.
While a credit score will determine whether or not the bank will lend you money and at what cost, credit capacity answers the question of how much money they will lend you.
First your lender will look at your income. Most lenders will want to make sure your debt payments don’t use up too much of your income. They will measure something called your Total Debt Service Ratio (TDSR). This is basically calculated as:
(All annual loan payments, mortgage payments + property taxes + utilities) ÷ Total annual income (including taxes)
Most lenders recommend that this ratio stay below 36%. However, if you are looking for a consolidation loan, you are probably at the higher end of this range and perhaps even higher.
Just as with a low credit score, all things being equal, a higher TDSR means a higher interest rate. Even if you have a great credit score, if your total debts push you into the 40% range, you are going to pay a high cost for a traditional debt consolidation loan. A higher TDSR also means a higher risk to you that you may not be able to keep up with your payments over the term of the program.
Repair Any Credit Score Issues First
If you feel you have enough credit capacity, in other words, ability to keep up with your payments, but have a poor credit score because of some past history, here’s what you can do to improve your credit score before applying for a debt consolidation loan. Remember, the higher your credit score the lower your interest rate will be so it’s well worth the effort and time it takes to work on your credit score.
- Get a copy of your credit report. Find out what is on it. You cannot start addressing the problems if you don’t know what they are. In most cases you can obtain a copy of your credit report for free from both Equifax and Trans Union.
- When you get your credit report, review it to determine if it contains any errors or negative comments. An error may include a debt that you have already repaid. A negative comment may result from a department store credit card that you stopped using ten years ago, but if it had a $10 balance owing, it may still show up on your credit report. If you find an error, contact the credit bureau and offer proof that you do not owe the money. You may need a letter from the creditor indicating the payments were made, or you may provide cancelled cheques to indicate payments were received. You may also send a letter to the credit bureau explaining your side of the story; your comments can be attached to your credit report.
- Pay off any small unpaid bills. If a $200 debt on an old credit card shows up as a black mark on your credit report, save up $200, contact the credit card company and arrange to make payment. Ask the creditor to remove the negative credit report from your credit record. Paying your debts is the most effective way to repair credit in the short term.
- Don’t bounce any cheques. Don’t overdraw your account at the bank (even if you have overdraft protection). Show the credit system that you are a responsible money manager and that when you borrow money, it’s because you want to, not because you have to.
- Pay down your debt balances. Even if your credit report indicates that you have made all of your regular monthly payments, a potential lender may look unfavorably on high levels of debt. The solution is to pay off as much of your existing debt as possible before applying for a new loan. We recommend that you pay off your highest interest debts first, so pay the 18% interest credit card off first, and then repay the 16% interest credit card.
- If you cannot pay off your debts in full, consider filing a debt management plan, a proposal to your creditors, or even personal bankruptcy. While each of these things has a serious impact on your credit report, they are all improvements over a number of individual bad items.
Should You Consider Debt Relief?
It’s all well and good for your lender to look at your credit score and credit capacity to assess how much they are willing to lend you to consolidate your existing debts, but you need to assess your own situation for yourself to see if this is the right option.
Here are some circumstances under which you might want to consider a debt relief program, such as a debt management plan or consumer proposal, rather than taking out a new debt consolidation loan:
- Your TDSR is above 36% or you are just making minimum payments each month, and even that is a struggle.
- Your only source of new credit is credit cards, finance companies, payday lenders or other high-cost providers.
- You have debts that don’t qualify for debt consolidation (such as taxes), or you can’t qualify for a loan large enough to cover them all.
- Your repayment plan will last too long. In general, most debt relief options will get you out of debt in five years, excluding your mortgage. Use this as a benchmark.
- You need creditor protection from potential wage garnishments or collection calls.
Now that you have some idea of what type of program can help you become debt-free, you’ll need some ideas on how to find a reputable financial institution or company that can help you get out of debt.