A debt consolidation loan is a single loan that allows you to pay off most or all of your creditors at the same time, leaving you with only one outstanding loan. This type of loan may also offer you an interest rate that is lower than what you are currently paying to your creditors, reducing your overall interest costs.
– Financial Consumer Agency of Canada website
This is a good definition of a debt consolidation loan, but what are the implications of taking out a loan? It is common for Canadians to obtain a debt consolidation loan to pay off their existing unsecured debt including credit cards, personal loans, and lines of credit. Financial institutions, mortgage brokers and finance companies offer consolidation loans. Bill collectors often recommend that people with outstanding accounts obtain a consolidation loan through a mortgage broker or a finance company.
Due to poor credit, some people struggling with unsecured debt might not be able to obtain a consolidation loan or can only do so at exorbitant interest rates. For a significant percentage of people facing debt challenges a consolidation loan might not be an optimal debt elimination strategy. There are a number of important reasons why a person should consider alternatives to obtaining a consolidation loan.
Here are six reasons—one or more of which—might cause you to reconsider the merits of obtaining a consolidation loan.
- It might encourage an undisciplined borrower to go even deeper into debt
- Failure to repay the loan might result in the loss of equity in your home
- It is not attractive for people whose financial situation is deteriorating
- It is not attractive where the cost of borrowing is punitive
- It can be an expensive debt elimination strategy compared with some other options
- You might be better off to make a consumer proposal
These six factors will be addressed in more detail at the end of this article.
Is your consolidation loan secured or unsecured?
Many lenders will only consider a consolidation loan in circumstances where the consolidation loan is secured, usually with a second mortgage. Whenever a consumer obtains a consolidation loan which is secured he is essentially placing his security—typically the equity in his home—at risk. If the consumer is unable to repay a secured loan, then he effectively forfeits the security equal to his indebtedness.
How much will a consolidation loan cost you?
Anyone contemplating a consolidation loan should consider the total cost of borrowing including any fees. As noted earlier, consolidation loans are either secured or unsecured. Many lenders will only offer a consolidation loan which is secured. Lenders prefer secured loans—because of their limited financial exposure in the event of non-payment of the consolidation loan–and these types of loans typically have lower interest rates.
Consolidation loans often involve a second mortgage. These loans involve additional costs over and above the interest the consumer will pay on the second mortgage. These additional costs might include appraisal fees, legal fees, and mortgage broker fees, and can cost in the thousands of dollars.
In some instances, a consumer will obtain a consolidation loan which is unsecured. Unsecured loans have much higher interest rates to reflect the lender’s increased financial exposure in the event of non-payment of the loan. Some Canadians will pay as much as 25 to 35 percent interest on an unsecured consolidation loan.
Six Reasons You Might Not Want to Obtain a Consolidation Loan
- Might encourage an undisciplined borrower to go deeper into debt
One of the consequences of obtaining a debt consolidation loan is that the consumer obtains a reprieve from his creditors to whom he previously owed money. After the debt consolidation loan the consumer will have available credit with some of these creditors which was not available prior to the consolidation loan. This can be a real problem for consumers who do not use credit wisely. An undisciplined borrower might find that after obtaining a debt consolidation loan that he is abusing his new-found available credit to go further into debt.
- Failure to repay a debt consolidation loan might result in the loss of equity in your home
In some, but not all cases, a consumer is only able to obtain a consolidation loan by providing the lender with security—typically a second mortgage on their home. By taking out a secured loan, the consumer is putting that equity, the total amount owing under the consolidation loan, at risk. In the event of non-payment of the consolidation loan the consumer is effectively forfeiting an amount equal to their current indebtedness from their home equity.
- Not attractive for people whose financial circumstances are deteriorating
The ideal candidate for a debt consolidation loan is a person or household where their financial prospects over the next five years are bright. These individuals should not only be able to obtain a debt consolidation loan at a low interest rate but also the odds of successfully repaying the loan are good.
Conversely, a debt consolidation loan is less attractive where a person’s financial situation would appear to be deteriorating over the next five years. This may be the result of poor health, reduced income, or a marital split.
- It is not attractive where the cost of obtaining a consolidation loan is expensive
A consolidation loan will not be attractive where the cost of borrowing is exorbitant. As the total cost of obtaining a debt consolidation loan increases it becomes less and less attractive because it is an expensive debt elimination strategy.
- An expensive debt elimination strategy compared with some other options
A debt consolidation loan will cost a consumer somewhere between $1.04 and $1.35 to eliminate one dollar of their existing indebtedness. In contrast, in most cases in a consumer proposal an individual can eliminate one dollar of debt for about 30 cents on the dollar—three to four times less expensive than a debt consolidation loan!
Comparing a debt consolidation loan and a consumer proposal is not comparing apples to apples. Making a consumer proposal will have a dramatic impact on a person’s credit score and his ability to obtain credit for several years. There is no guarantee, however, that a person who obtains a debt consolidation loan will be able to successfully pay it off. Furthermore, a person with equity in their home who obtains a secured consolidation loan puts the equity in their home at risk.
- You might be better off making a consumer proposal
At some point a person’s financial situation may have deteriorated to the point where it simply makes more sense to make a consumer proposal than to obtain a debt consolidation loan. Why pay somewhere between $1.04 and $1.35 to eliminate one dollar of your debt under a debt consolidation loan when you could eliminate that debt for about 30 cents on the dollar by making a consumer proposal? And why risk losing equity in your home if the only way you can obtain a debt consolidation loan is by way of a second mortgage? A consumer proposal might just be the new start that you need to get back on your feet.
Before you apply for a debt consolidation loan you might want to speak to a licensed insolvency trustee and learn more about your various options, including a consumer proposal.