If you find yourself juggling multiple payments to different lenders, or struggling to meet your minimum payments each month, it might be time to consider consolidating your debts. This article covers the types of debt consolidation loans commonly available in Canada and helps you decide which option is right for you. At the end, we provide other consolidation options available through non-lenders.
Benefits of taking out a debt consolidation loan
What types of debt consolidation loans are there?
Should you use your home equity to consolidate?
Unsecured debt consolidation loans
Qualifying for a debt consolidation loan
Does a debt consolidation loan hurt or help your credit score?
What are some other debt restructuring options
Benefits of Taking Out a Debt Consolidation Loan
With a debt consolidation loan, you apply for one new large loan and use the proceeds to pay off all your other smaller ones. By doing so, you swap several debt payments each month with one single payment on your new loan.
Advantages of these loans include:
- Easier debt management: only one monthly payment.
- The possibility of a lower interest rate, reducing your total debt repayment costs so you can eliminate your credit card debt faster.
- Lower monthly payments which can help balance your budget
- Improved credit score by eliminating excessive debt, changing your utilization rate and improving your credit profile
There are some disadvantages or downsides to consider as well.
You might have to provide collateral, which means that if you don’t make your payment promptly, you stand to lose your home or car. Your financial institution may also require you to close your accounts with stores and credit card companies to make sure you don’t increase your debts while you’re paying off your debt consolidation loan. Your lender may ask for a co-signer, someone who will guarantee to repay the loan if you are unable to and if you have very poor credit or collateral, you may not qualify for a loan at all.
Types of Consolidation Loans
Consolidation loans are available through your bank, credit union, financing company or mortgage lender. Depending on your credit score and available assets you have to offer as collateral you can choose to consolidate your debts with either a secured or unsecured consolidation loan. There are several types of loans to consider and each has distinct advantages and disadvantages.
Home equity loan, second mortgage or home equity line of credit
One option for homeowners is to refinance through a home equity loan, second mortgage or secured line of credit (known as a HELOC).
To qualify for a home equity loan you must have available equity. Equity is the difference between the appraised value of your home and the current outstanding mortgage balance. Traditional lenders will typically only lend up to 80% of your home equity. Private or alternative lenders may be willing to loan up to 90% of the value of your home but the cost will be much higher.
You will also need to have sufficient income to pass a stress test which means qualifying for a rate that is the greater of either the Bank of Canada qualifying rate or the new mortgage interest rate plus two percentage points.
The interest rate on a secured home equity loan will depend on your credit score and available equity but is generally much lower than that of an unsecured consolidation loan. Sub-prime mortgage lenders may be willing to lend you a high-ratio mortgage, however, the interest rate on these loans can be 10% to 30% above traditional mortgages.
Don’t forget to factor in any additional fees and charges, including appraisal costs and lien registration costs, that your lender may apply when determining how much you can save.
Another factor you want to consider is the length of your loan or amortization period. The maximum amortization for a regular mortgage in Canada is 35 years. CMHC mortgages must be paid off over 25 years. A longer amortization period means a smaller monthly payment, however, beware you are paying more interest over the life of the mortgage.
Lastly, look at the flexibility in your payment structure. Options like the ability to prepay or make additional payments without penalties can help you pay off your debt sooner. The ability to skip a payment can be beneficial if your financial circumstances change.
HELOCs are a special type of home equity loan that often allow interest-only monthly payments or only require a small reduction in principal of 2% to 5%. They also allow you to re-draw up to your available credit limit. If your objective is to get out of debt, avoid the temptation to make ultra-low payments or use your HELOC like an ATM.
Unsecured line of credit or consolidation loan
Even if you don’t have assets available you may be able to qualify for an unsecured line of credit or debt consolidation loan. While banks will provide debt consolidation loans many people seeking this option do so through a financing company often because they have a below-average credit score.
Interest rates on an unsecured consolidation loan are higher than that of a loan secured by some form of assets. The rate you pay will depend on how good your credit rating is. If you have poor credit you can expect to pay rates of between 20% and 30%, plus fees.
With a line of credit, your monthly payments are generally quite low – interest-only plus 1-2% of the outstanding balance. This can make managing your budget easier however the downside is you are not paying down your debt. Lines of credit also pose a risk because your credit is always available. You can draw down on your credit at any time. This can be dangerous if your goal is to eliminate debt.
It is also possible to consolidate several high-interest credit cards into one lower-rate card by applying for a credit card that’s specifically designed for balance transfers. As with a line of credit, you are only required to make the monthly minimum payment however doing so will not help you get out of debt. If you choose this approach be sure to make an aggressive plan to pay off your new credit card as fast as you can because while the rate might be lower than your current credit card rates, it will still be high.
Be aware of promotional rates and their limitations. If you miss a payment your rate may escalate immediately and may be higher than what you were paying on your original credit card balances. In addition, promotional rates only tend to last for a few months so pay off as much of the principal as you can during this time.
This may include consolidating through a home equity loan, second mortgage, line of credit, or unsecured debt consolidation loan. The idea is that when you consolidate your debt, your combined interest rate will be lower than the effective rate on all your smaller individual debts.
Qualifying For A Debt Consolidation Loan
Three basic factors will determine whether you will be able to obtain a debt consolidation loan: your credit rating, your income and any collateral you might be able to provide.
To assess your application, your consolidation lender will want some information about you including:
- Your monthly budget;
- Your latest tax returns and pay stubs that show how much money you are earning each month;
- Your latest loan statements, indicating exactly how much money you owe;
- An appraisal of your home or any assets you are offering as security for the loan;
- Your most recent credit report and possibly other information about your credit history.
Debt Service Ratio / Debt-to-Income Ratio
The bank or credit union that is considering loaning you money will want proof that you are capable of paying the money back. Your lender will look at your monthly debt-to-income ratio – the percentage of your salary you use to pay your mortgage costs or rent, plus your other monthly expenses.
Lenders prefer to see a total debt-to-income (also called the total debt service ratio) smaller than 36%-42% depending on the provider and loan type. You can use our debt-to-income calculator to determine your current ratio. If you are applying for a mortgage, you will also need a gross debt service ratio (your housing costs only divided by your net income) under 42%.
Turned Down? Find Out Why.
Don’t panic if you don’t get the loan. Find out why you came up short. Maybe you can come back in six months or so and try again if you can find a way to reduce your debt or bolster your credit rating.
Limit Your Applications.
It’s not a good idea to apply for a debt consolidation loan at every financial institution in town, especially if you’ve already been rejected a few times. Your credit rating will suffer if several denied applications show up on your credit report.
If you are approved for a debt consolidation loan, your lender will advance you new money to pay off debt that you already owe and want to consolidate. You can use this money to pay off credit card debt, bill payments, payday loans, consolidate car payments, etc. You now make one monthly payment to your new lender rather than multiple payments to all your existing creditors.
How does a debt consolidation loan affect your credit score?
Your credit score is a number that is calculated based on your past credit history. How a credit score affects your credit depends on how you influence the factors used by the credit bureaus to calculate this score.
While a new loan application will hurt your credit score in the short term, however, a consolidation loan improves your credit score by:
- paying off several outstanding accounts
- improving your utilization rate
- converting revolving credit into a term loan
- improving your payment history by enabling you to make payments in full and on time
- lowering your overall outstanding balances over time.
If, however, you take out a bad credit consolidation loan and still have more credit than you should (by continuing to draw on your line of credit for example), these benefits will be mitigated until your balances start to decline. And of course, if you miss payments on your new consolidation loan, your score will decline again.
What are Your Other Debt Restructuring Options
If you find you don’t qualify for a debt consolidation loan, or you still cannot afford the monthly payments, there are two additional debt consolidation programs available in Canada to help you eliminate debt.
You can research a debt management program through a credit counselling agency. This solution is administered by an accredited credit counselling service, who’ll work with both you and your lenders to create a plan to repay your debts, in full, within five years or less. This solution is best suited to people who have a low amount of debt (usually less than $10,000) and enough income to repay their debts, but just need extra time and lower interest rates to do so. If you have substantial credit card and other debts, you may do better with another debt relief approach such as a consumer proposal.
Consumer proposals are a formal, legally binding agreement between you and your creditors that you’ll pay back a portion of what you owe. Your proposal terms enable you to negotiate a single, lower, monthly payment which you pay to the consumer proposal administrator. Your proposal administrator deals with your creditors and forwards their share of the settlement offer. At the end of the program all your debts are eliminated.
Talk to a licensed debt professional about your debt consolidation options
Exploring all your options is the best way to ensure you make the right choice for your financial future. Your bank only offers debt consolidation loans. A credit counsellor can only do debt management plans. Only a Licensed Insolvency Trustee is obligated by law to help you explore the financial implications of all means of consolidating your debt and achieving a monthly payment that you can afford and that will ultimately eliminate your debt.
Consultations are free. You have no obligation. So explore your options by booking a free appointment with a local, licensed debt professional to find out more.