There are many ways to get out of debt—and some may be more useful to you than others. One debt relief option is the debt consolidation loan.
Many people have used consolidation loans to get out of debt while minimizing the impact to their credit and their lives. However, consolidating debt into a loan may not be the best choice for everyone, even when it’s been a good choice for many.
Under certain circumstances, the pitfalls of a high-cost consolidation loan may actually delay you on your journey to being debt-free instead of speeding you along. In such cases, it may be necessary to look into alternative debt relief options like a home equity loan, debt consolidation program (DCP), consumer proposal, or bankruptcy (which isn’t always as bad as it may sound).
For this Financial Literacy Month post, we’ll discuss some of the circumstances that might lead to a consolidation loan becoming “high cost,” the pitfalls of using such loans, and some alternatives you may want to consider.
What Is a Debt Consolidation Loan?
A debt consolidation loan is a service from a lending organization (like a bank or credit union) that is used to pay off your outstanding debt. Then, you can start making payments to your new creditor in place of all your other debts—which you eliminated using the money from the loan.
This debt consolidation option helps you:
- Simplify your debt repayments (since you only have a single creditor to track)
- Save money on interest (because consolidation loans often have lower interest rates than credit cards or other forms of debt—but it’s important to double-check this!)
- Minimize disruption to your credit score (compared to other debt relief options, since you’re demonstrating that you can pay your debts)
Overall, consolidation loans are great debt relief options—one of the first options that credit counsellors might recommend to clients with a good credit score and a moderate amount of debt.
To achieve the best results, it’s important to follow some good money management habits, like staying off of credit cards as much as possible, that help in many strategies for getting out of debt.
What Makes for a High-Cost Consolidation Loan?
So, what factors can turn a consolidation loan into a “high-cost” loan? There are a few factors that could make these loans too high-cost to be a viable debt relief option for some:
Having a Low Credit Score
Lenders are less likely to offer favourable loan terms to borrowers with low credit scores (since they see them as a higher-risk investment). So, people with lower credit scores may find themselves being offered loans with higher interest rates that maximise the bank’s return on investment. This makes the loan harder to pay off and increases its cost over time.
High Debt-to-Income (DTI) Ratio
The more money you have to borrow at once to pay off your debt, the harder it will be to pay back the loan. Bigger balances mean that slight differences in interest rates will have a bigger impact on how much you pay in total. If the loan amount is too high compared to your income, you may have to pursue other debt relief options (like a debt consolidation program, consumer proposal, or bankruptcy).
A Lack of Collateral
Some of the top-tier lenders with the best loan terms may require you to put down some collateral to secure the loan. This added security net gives the lender extra peace of mind to offer better terms, since they know they can recoup their costs if the borrower can’t pay. However, without collateral, it may be impossible to secure a loan from these organizations (or their terms may be much less favourable).
These factors can all influence the cost-effectiveness of a debt consolidation loan. This can lead to a few different pitfalls for those who want to use these loans to pay off their debt.
Pitfalls of High-Cost Consolidation Loans
There are a few different potential pitfalls to using a consolidation loan when the overall cost or the interest rate is too high. Here’s a short list of some of the drawbacks that you could encounter. It’s important to note that these are only potential issues and that not every borrower may experience these problems:
1. Paying More over Time
With unfavourable interest rates and terms, the costs of a consolidation loan can be much higher for you if your credit score is low rather than high.
For example, say you need to borrow $50k to pay off your debts. With strong credit, you could get an interest rate as low as 3%. With poor credit, annual interest rates may be in the range of 30-50%!
To simplify the math, we’ll assume that minimum payments are being made that maintain the balance without letting it grow or shrink.
At 3% interest, you’d be paying $1.5k in interest for the first year. At 35% interest, you'd be paying $17,500 for the first year! This would naturally make it take a lot longer to pay off the loan and increase the total amount you pay.
2. Increasing Your Debt
This is a potential pitfall that people may encounter even with a favourable consolidation loan.
Sometimes, when a person is able to clear their credit card debt (or other forms of debt) with a consolidation loan, they may be tempted to start spending on their credit cards again—even before they’ve paid off their loan.
Doing so can lead to increasing their total debt and negating the benefits of getting a consolidation loan in the first place. However, this isn’t unique to consolidation loans with high costs. This is a problem that could affect virtually any debt relief option.
This is why it’s important to work on your debt management skills and exercise strong discipline with all forms of credit when you’re trying to get out of debt. If you’re able to refrain from spending money on a credit card or other debt source until you’re in the clear, you’ll thank yourself later!
Alternatives to Consider if Your Consolidation Loan Would Be Too Costly
For many, debt consolidation loans are a great option for getting out of debt while preserving a high credit score and simplifying debt repayment.
However, if a debt consolidation loan would prove too costly, it might be a good idea to consider some alternatives.
Debt Consolidation Programs
DCPs are a great alternative to taking out a loan for those who don’t have the outstanding credit needed to get great loan terms. DCPs can also help to prevent the accumulation of debt since your Credit Counsellor will negotiate with your creditors to minimize or eliminate the interest on your debt while you’re on the program.
It’s important to note that while on a DCP, you will have to surrender your unsecured credit cards as part of the program. This can be a blessing in disguise since it helps you avoid adding more debt while you’re trying to pay off old balances.
Consolidating Debt into Your Mortgage
Instead of consolidating debt into an unsecured loan, you could roll it into your mortgage to take advantage of your home’s equity. Mortgages may have an even better interest rate than you could get with a regular consolidation loan, so this can help you save money in the long run.
However, it’s important to avoid racking up more debt. Also, you may end up delaying your timetable for paying off your home.
Submitting a Consumer Proposal
You could work with a Licensed Insolvency Trustee (LIT) to submit a consumer proposal to your creditors. If they accept, you only have to pay a part of what you owe.
This is a great option for when debt has spiraled out of control and you don’t have a way to pay it all off. Many creditors might accept a proposal because it lets them recover at least a portion of their investment—though they can refuse to accept the proposal.
Filing for Bankruptcy
Filing for bankruptcy is, for some, the only real option for getting out of debt.
While working with an LIT to file bankruptcy does have risks and drawbacks, many people find that it’s better than living with insurmountable debt. When all other debt relief options fail, declaring bankruptcy may be the best way to get creditors and collection agencies off your back.
Do you need help with debt management? Reach out to the Credit Canada team today for assistance and advice. We’ve helped thousands of people get out of debt—and we want to help you, too!