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The Pros and Cons of Debt Repayment Methods You Need To Know

by:
Randolph Taylor

The average Canadian owes nearly $23,000 in personal debt—and that's not including mortgages! If you’re in the same boat, you may be thinking about debt relief options. But which one is right for you? You might be wondering, “Do I need a debt consolidation loan or program? Should I consider debt settlement? And what’s up with those snow-themed debt repayment options?” Well if you’ve got debt, we’ve got answers!

Pros and Cons of Six Debt Relief Strategies

1. Avalanche Method

This debt repayment strategy involves paying the most money you can towards the debt with the highest interest rate first, regardless of how much money is owed, while still maintaining the minimum payments on all your other debts. Once that debt has been paid off, you move onto the debt with the next highest interest rate, and so on, while rolling in the payment you were making towards the previous debt you paid off.

  • PROS: This method will likely save you money in the long-run because you’ll save in interest fees. This is a good strategy if you're more motivated by overall savings rather than the immediate gratification of watching a balance shrink fast.
  • CONS: Because your focus is based on interest and not the size of the debt itself, there’s a chance you may be paying off your biggest debt first, which can take longer to pay off and achieve a win, leading to frustration and loss of motivation.

2. Snowball Method

This debt repayment strategy involves paying as much money as you can towards your smallest debt, regardless of the interest rate, while maintaining minimum payments on all your other debts. Once the smallest debt balance has been paid off, you roll the money you were paying towards that first debt into your payment for your next smallest debt, and so on.

  • PROS: Paying off your smallest debts first provides quicker wins. In a field study of consumers using avalanche and snowball methods, the Journal of Consumer Research reveals that the snowball method is more likely to lead to success because of the instant gratification related to paying off a debt balance in full quicker.
  • CONS: You could end up paying a bit more in interest in the long-run because you're paying the debts with the smallest balances first, which leaves the larger debts to get paid off later.  That means those larger debts will still accrue interest—and some of those larger debt balances might have higher interest rates, too! 

3. Payday Loans

Payday loans are short-term loans—usually no more than two weeks—meant to help you cover sudden expenses if you have no emergency fund, such as an urgent car or home repair. It is meant to be paid back when you receive your next paycheque.

  • PROS: Payday loans are quick and easy to obtain, generally requiring nothing more than proof of age (18 or older), proof of employment (such as a pay stub), a chequing account, and a valid phone number. Some payday loans can even be acquired online.
  • CONS: Payday loans are an extremely expensive way to borrow money. Costs are typically based on a set dollar amount per $100 borrowed (for example, $21 per $100). That is the equivalent of an annual percentage rate (APR) of 546%. Failure to repay the loan can result in additional late fees, collection calls, court, and even wage garnishment. In addition, many borrowers have been known to fall into a payday loan cycle, borrowing every time they’re short (a recent report found that an individual’s average payday loan debt is nearly $3,500).

4. Debt Consolidation Loan

A debt consolidation loan involves taking out a loan, usually through your bank, to pay off all your debts. Depending on the amount you’re able to acquire, you can pay off all your debts in one fell swoop so that you only owe on one large loan through the lending institution at one set interest rate.

  • PROS: You only have one monthly payment to make, usually with a lower interest rate than you’d be charged on each debt individually (if you can’t obtain a lower rate, this is not a good strategy). The loan can be used to pay off both unsecured debt (such as credit cards) and secured debt (such as a student loan or car loan).
  • CONS: Debt consolidation loans are very difficult to get without good credit. They are also not a recommended strategy for debt relief-seekers because in the event you’re able to keep your credit cards, now with zero balances, many people find themselves racking up credit card debt again, on top of having the large loan repayment to make.

5. Debt Consolidation Program

A Debt Consolidation Program (DCP) is an arrangement in which a credit counsellor at a reputable, not-for-profit agency works with your creditors to help you pay off your unsecured debt over time. Your credit counsellor will put together a proposal that outlines how much you can safely pay on a monthly basis towards your debts, based on your monthly expenses.

  • PROS: DCPs enable you to make just one affordable monthly payment to the agency, which distributes payments to your creditors. Interest rates are greatly reduced or even eliminated, and you’ll have a set completion date to look forward to. A reputable agency also provides valuable money management advice.
  • CONS: Some creditors may not be willing to negotiate making a DCP less valuable. In addition, only unsecured debts can be included in the program and your credit report may be negatively affected during the time you are on the Program.

6. Debt Settlement Services

Debt settlement is not like a debt consolidation loan or debt consolidation program in which you ultimately pay back your creditors what is owed to them. Debt settlement services usually offer the ability to “settle your debt for pennies on the dollar.” But it's often too good to be true.

  • PROS: You may save money.
  • CONS: Debt settlement services have been the focus of consumer alerts from the Financial Consumer Agency of Canada for shady practices, including large upfront fees, failure to take action, high-pressure sales tactics, complicated contracts, and false claims. Even if you do find an honest debt settlement service, your credit score will take a severe hit because you’re not paying your creditors back the full amount you owe. Plus, I’ve seen cases where clients were taken to court or sued by their creditors and lenders regardless, even though they they went through a debt settlement service. The debt settlement company wasn’t able to do anything to stop the legal action, despite the client paying them.

So which method is right for you? Our Debt Calculator may be able to help you figure it out, but if you’d still like to talk to a certified expert (aka credit counsellor) for free financial advice, contact us at 1.800.267.2272. We can review your options with you and answer any questions you might have. Don't be shy!

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Topics: Debt Management, Debt Consolidation

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