Consolidating Debt The Smart Way

how to consolidation debtsOne of the money solutions all financial advisors sometimes refer to is debt consolidation.  For those unfamiliar with the term, it means taking out a new loan (or line of credit) that is large enough to pay off all of your existing borrowing.  The reason you might do this is two fold:

  • it should reduce your overall interest charges as the new loan is generally at a lower rate of interest than credit cards and other forms of borrowing;
  • it simplifies your financial situation because it reduces the number of different debts from many to one.

Debt consolidation sounds brilliant on paper.  Unfortunately, if not used properly it can lead to more financial trouble further down the line. Here are 3 common mistakes to avoid when consolidating your debt.

Don’t Leave Debts Out

The most common mistake that people make when they consolidate their debts is they don’t consolidate everything.  For various reasons, one or two items get excluded and then instead of a single monthly payment dealing with all of their debts, the individual now has one large debt and a few other assorted debts. By itself under-consolidating isn’t doomed to failure, but it’s like going to the dentist to have a cavity filled, but the dentist only fills it half way.  It is not going to take too long for that cavity to become a problem again.

Before you talk to your bank about a new loan, make a list of everyone you owe money to. Make sure you can borrow enough to consolidate all your existing unsecured debts. All credit cards, unsecured lines of credit, payday loans, even past due bills.

Some debts it may make sense to exclude might be:

  • your existing mortgage or other term loans where changing the terms may come with costly penalties;
  • term loans that carry a lower interest rate than the consolidation loan you are being offered.

Close Consolidated Accounts

A second problem with consolidating your debt is more subtle and far more dangerous.  One of the assumptions financial planners make when they suggest a consolidation is that the individual consolidating will stop using all of the credit tools that have been paid off by the new loan.  Of course no one verifies that this has been done, and even if it is, it is a simple task to call the credit card company up and ask them to re-issue a card.  In a large number of cases, instead of paying down a person’s debt, consolidating has the net result of doubling their debts.  Instead of canceling the old accounts the borrower uses them again and so within 12 months or so they know owe twice what they owed before the consolidation.

Once you consolidate your debts:

  • cancel all credit cards except one or two for convenience use. When you do use these cards, pay the balance off  in full each and every month;
  • keep all other accounts current. Don’t fall behind on bill payments and start the cycle over again.

Avoid Desperation Loans

A third concern with consolidating your debts as a solution to money problems is that it is often recommended by financial advisors, but may not be approved by the banks people deal with.  In other words, a person sits down with a planner that shows them in detail the advantages of consolidating their debts, only to be rejected for a new loan when they apply to their bank.

If you are refused a consolidation loan due to poor credit or the interest rate seems too high:

  • shop around. Beware of companies offering ‘low to no credit’ consolidation loans at very high costs.
  • explore other options like credit counselling or perhaps a consumer proposal.

Both of these are valid strategies to deal with financial problems and to some degree, both work like consolidation loans, but they don’t depend on your ability to qualify for new credit.  With a consolidation loan all of your debts are paid out in full by the new loan.  With credit counselling or a consumer proposal, you work out a repayment plan with your creditors. Credit counselling programs require you to repay your debts in full, while a consumer proposal allows you to settle your debts for less than you owe.

Category: Debt Consolidation |

Oct 8, 2014


About Ted Michalos

Ted is a Licensed Insolvency Trustee and Chartered Accountant with more than 20 years experience. He is a co-founder of Hoyes, Michalos & Associates Inc., one of the largest personal insolvency practices in Canada focused on helping individuals deal with their debt.

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