Excessive personal debt can be scary for people to deal with—especially when you feel like you’re on your own. There are different debt solutions to consider, like debt consolidation, and one of the big questions many Canadians have is how debt consolidation can affect their credit.
Canadians often have a lot of questions about debt, and it’s no wonder, especially when you consider that the household debt ratio (the ratio of debt owed versus how much disposable income households have) in Canada rose to 170.7% as of Q3 2020. The good news is there are different debt relief options available.
In a struggling economy, nobody wants to pay more for services simply because of a bad credit score. So, it’s only natural to have questions about how different debt relief options, like debt consolidation loans, can affect your credit score.
What is debt consolidation? What are different debt consolidation options? Can you consolidate credit card debt with bad credit? Let’s find out!
What is Debt Consolidation?
Debt consolidation is a practice where several smaller debts are combined (i.e. “consolidated”) into a single debt or payment. This can sometimes be referred to as “debt refinancing.”
In some cases, high-interest debt can be consolidated at a lower interest rate—making it easier to pay off since the debt won’t grow as quickly. Two common forms of debt consolidation are:
1. Debt Consolidation Loans
Debt consolidation loans are offered by lenders (such as a bank) to combine several smaller debts under a single loan. In basic terms, the bank extends the client a loan large enough to pay off their outstanding debts to their creditors.
The goal of a consolidation loan is to reduce the average interest rate of all the debts that are being paid off with the loan, and amortize the total debt load over a longer period of time. The purpose of a debt consolidation loan is to reduce the strain of the overall debt load on personal finances. The debt does not go away—it’s just owed to a single lender instead of a variety of different credit card companies, banks, and other businesses.
The terms of a consolidation loan, including consolidation loans used to consolidate credit card debt, are largely determined by the applicant’s credit score. Someone with a good credit score will be able to get a loan with a lower monthly interest rate, compared to someone with a lower credit score. Unfortunately, many people who need debt consolidation loans often have a low credit score and either cannot get a loan, or they get one with an extremely high interest rate (which defeats the purpose). Debt consolidation loans for bad credit do exist, but they typically have less-than-favourable terms compared to ones offered to people with stronger credit. In many cases, these high-interest rate loans cause more harm than good.
Additionally, these loans can make it look like the borrower has a lot of room on their credit cards, which can be tempting to use. It’s important to exercise strict discipline on credit card spending once you obtain a debt consolidation loan. Otherwise, you could end up back at square one with your debt, plus have this giant new loan to pay off as well.
2. Debt Consolidation Programs
Debt Consolidation Programs (DCPs) are an alternative to debt consolidation loans where several forms of unsecured debts — including credit card debt, payday loans and outstanding bills — are combined into a single monthly payment. This payment is processed through a debt consolidation service or program offered by a non-profit credit counselling agency, like Credit Canada.
DCPs are sometimes referred to as debt management plans (DMPs) or debt consolidation plans since they are virtually identical.
Under a DCP or Debt Consolidation Program, the debt relief provider consolidates a person’s unsecured debts into a single monthly payment. They’ll also negotiate with creditors to stop or significantly reduce the interest charged on the debts. This helps to make it easier to pay down the debt itself (the principal) instead of paying more towards interest.
Under a DCP, your debts aren’t shifted to another form of debt, as is the case with a debt consolidation loan. Instead, you pay down the total amount of your unsecured debts on the Program with every single monthly payment you make until they are completely paid off. DCPs create breathing room and provide a simplified plan to pay off your debts in a reasonable manner, so you can still take care of your monthly expenses. DCPs are a great alternative for anyone who cannot obtain a debt consolidation loan, has poor credit, or is unable to find a loan with a favourable interest rate.
DCPs do come with some restrictions. For example, you will be required to stop using all forms of unsecured credit, including credit cards; however, this isn’t usually a big deal for most people who sign up for a DCP because they are typically maxed out anyway. Plus, when you sign up for a DCP, you still have the option of getting a secured credit card.
Having a secured credit card while on a Debt Consolidation Program
Secured credit cards are very helpful in emergencies, renting a vehicle or hotel room, and they can also help build your credit.
A credit card company may ask you for a security deposit in order to be approved for one of their secured credit cards. The deposit required may not match the credit limit offered. For example, the required security deposit may be $75 but the limit on the card may be $500.
The security deposit is there as a form of collateral, in case you don’t make payments; however, the creditor will not use your security deposit as “payment” on the card. You must make your own payments on a secured credit card. Ideally, you will pay off the entire balance before the statement due date; however, you are permitted to carry a balance on a secured credit card. Having said that, this should not be your intention. You want to avoid carrying a balance and charge only items that you can afford to repay.
How Will a Debt Consolidation Loan Impact My Credit?
There are several things that happen when applying for a debt consolidation loan that can affect your credit:
- It Generates a “Hard Inquiry” Against Your Credit. When applying for any loan, the lender will do a “hard inquiry” on your credit so they can check your credit score and credit rating to assess risk. This can lower your credit score a little in the short term. If you check with a lot of lenders to get a debt consolidation loan in a short period of time, this could noticeably reduce your credit score.
- Debt Consolidation Loans Open a New Credit Line Item on Your Credit Report. If you obtain a debt consolidation loan, it will appear as a new line item on your credit report. Any “new” credit item could potentially lower your credit temporarily because it poses new risk. But the good news is that other debts on your credit report paid off by the debt consolidation loan will be up to date, and this can slowly improve your credit rating. As the new credit item (debt consolidation loan) gets older and you make your payments on time every month, this can also help improve your credit.
- Improved Credit Utilization Rate. The rate of how much credit you’re using versus the amount of credit available to you may improve when you have a debt consolidation loan because the loan pays off all your debts. For example, if you paid off several unsecured credit cards with the debt consolidation loan, your credit cards will appear with zero balances, thus freeing up more credit. This can help improve your credit score a little, as long as you don’t start racking up more debt on those credit cards.
In the short term, debt consolidation loans can temporarily lower your credit score. However, there is one way you can positively impact your credit score in the long run: Improving your payment history.
A major part of your credit score is your history of payments on your debts. With a Debt Consolidation Program or debt consolidation loan, making a single monthly payment that goes towards all your unsecured debt (and building a strong history of payments) is easier than making a dozen different payments to a dozen different creditors and lenders. As long as you’re consistent with your payments, you can, over time, build a positive payment history and improve your credit.
How Will a Debt Consolidation Program Impact My Credit?
A DCP or debt management program will also impact your credit; however, because most people who sign up for a DCP already have bruised credit, this isn't a major factor.
When you sign up for a DCP, your debts will have an R7 rating, and then two years after you've completed the Program the debts, along with their R7 ratings, will be purged from your credit reports. However, many of our clients see a jump in their credit score as soon as they've completed their DCP.
When you complete a DCP with Credit Canada, we send you all the information and forms you need to update your credit file with the two credit bureaus — Equifax and TransUnion. The process is simple and straightforward, and yields great results when it comes to our clients' credit ratings and credit scores.
Can I Consolidate My Debt with Bad Credit?
Consolidating credit card debt with bad credit can be a bit difficult. If you have bad credit and apply for a debt consolidation loan, you may end up getting denied for the loan or get offered unfavourable terms on the loan that limit the benefits of applying for one in the first place. Worse yet, the lender’s check of your credit can lower your credit score a bit further, making future attempts to qualify for a loan even less fruitful.
Debt consolidation options for bad credit scores are available though.
Take, for example, Debt Consolidation Programs (DCPs) offered by a non-profit credit counselling agency, like Credit Canada. DCPs are available even with extremely low credit scores, making them a viable option for debt consolidation with bad credit.
Debt Consolidation Scams to Look Out For
Before searching the web for “debt consolidation loan for very bad credit” or “guaranteed debt consolidation loans,” it’s important to be aware of debt consolidation scams that some Canadians may fall prey to.
There are many unscrupulous individuals who may try to take advantage of Canadians living with debt (or in the process of recovering from debt) by offering them so-called easy solutions that “fix” their credit score or get rid of their debt overnight. If you hear about a “fast” fix for debt or credit, be sure to approach it with a healthy amount of skepticism, because there is no such thing as an easy credit fix or solutions that magically make your debt disappear without any drawbacks.
Two examples of debt-related scams that Canadians should really watch out for include:
- Credit Repair Scams. Credit repair scams prey on people who need to improve their credit fast. Whether you’re trying to buff up your credit to apply for a consolidation loan, business loan or mortgage, these scammers will try to take advantage of you. Warning signs include:
- Offering to remove bad information from your credit history (unless the information is inaccurate, they cannot do this, and if it is inaccurate you can remove it yourself at no cost);
- Making instant approvals with no credit checks (meaning they don’t have the information they will need to actually help you);
- Requesting upfront fees;
- Asking for unusual forms of payment (such as gift cards); and
- Advising that you shouldn’t reach out to a credit bureau (who may warn you about the scammer).
- Loan Scams. Some scammers may pose as legitimate lenders who offer unsecured debt consolidation loans for people with bad credit. These individuals are often looking to steal your money—taking your consolidated loan payments without actually paying out your creditors. Some warning signs of a loan consolidation scam include:
- Requiring large “upfront” payments, even if they’re just “processing fees” to start the process (it's illegal to request a payment when no contract has been signed);
- Unsolicited “pre-approved” loan offers (real lenders don’t just call people to congratulate them on being approved for a loan—so this should be an immediate red flag);
- Lots of complaints or no presence online (check the Better Business Bureau’s Scam Tracker or Google Review pages to see what people are saying, if anything, about the lender); and
- Incomplete contracts or no contracts at all (scammers don’t like leaving paper trails and may use contracts that have blanks they can easily fill or simply provide no paperwork at all).
Is Consolidating Debt a Good Idea?
With all of the above in mind, you may be asking yourself, “Is consolidating my debt a good idea?” The answer is: it can be.
When you partner with a reputable lender or non-profit organization, debt consolidation loans and programs can offer significant benefits that well outweigh the risk of a temporary drop in your credit score. Some things to look for in a reputable Debt Consolidation Program or debt consolidation lender include:
- Unbiased debt advice. How much the people offering the Program or loan know about personal finance and their ability to provide clear direction that’s easy to understand and follow.
- Their understanding of your situation. Anyone can fall into debt, whether due to a job loss, illness or some other unexpected life event. Having a partner on your side who completely understands how you got to this point can help immensely in addressing your debt concerns, and in so doing, help you become debt-free forever.
- How reasonable the program/loan is. To pay off your debt successfully, the interest rate on your new loan needs to be less than what you’re currently paying on your individual debts, including any fees. If you go the Debt Consolidation Program route, you should be paying an affordable monthly payment and saving a ton in interest charges.
How to Pay Off Credit Card Debt
Do you need help addressing rising debt, like credit card debt? Regardless of the way you decide to handle your debt, having a trusted, experienced, unbiased, and reliable certified Credit Counsellor on your side can help. As a non-profit credit counselling agency, all of our counselling services are free at Credit Canada, and you can meet with your Credit Counsellor as many times as you need to. Book a free appointment to know your debt consolidation options and start consolidating your debt today. Call 1.800.267.2272 or click here to learn more.
