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Debt Consolidation

What is Debt Consolidation and How Does it Work

January 16, 2020

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Learn the A – Z of debt consolidation in Canada

If you have seen the Hollywood movie “Confessions of a Shopaholic”, the process of debt consolidation will make a lot of sense to you. When you are in deep with credit card debt, paying the minimum monthly amount due only lets you scrape through from one installment to another. However, these payments will not help you clear your debt, or bring you out from the deep, dark financial hole that you may be in.

The truth is that spending or saving habits are not the only culprits here. Climbing interest rates and crawling economic growth rates have further tightened our cash flows. A recent Equifax research study suggests that Canadian consumers continue to steadily pile up their debt. Delinquency rates are also on the rise, and Canadians 55+ are no exception to that. In fact, the average non-mortgage debt per Canadian consumer at the end of Q1 2019 was $23,496.

Whether it is the ever-increasing cost of living, or weak financial literacy, if you or a loved one find yourselves drowning in a pool of various debts, it is time to give some serious thought to debt consolidation.

What is debt consolidation?

Debt consolidation is a financial solution that rolls multiple, high-interest debts into a single debt with lower-interest payments. If you are dealing with a reasonable amount of debt, or simply want to reorganize multiple bills that carry varying interest rates, due dates and payment amounts, you may be the ideal candidate for debt consolidation in Canada.

However, debt consolidation is not a magic wand that will make all credit card debt, mortgage debt and other loans disappear. While it may help reduce your overall debt and help you to pay off your dues faster, it only works when:

  • Your debt is not excessive: Typically, your total debt excluding a conventional mortgage does not exceed 40% of your gross income
  • You have good credit: Your credit scores are good enough to qualify for a 0% credit card
  • You plan to keep your debts in check: You are going to prevent running up multiple debts again and have a steady cash flow to cover the payments towards your debt consolidation loan

Debt consolidation involves taking a new loan to pay off all other debt and liabilities you may have. Essentially, you combine multiple debts into a single, larger piece of debt that usually comes with lower interest rates, lower monthly payments, or both. While smaller loans have higher interest rates, the consolidated loan usually offers more favourable payoff terms.

Debt consolidation loans fall into two broad categories:

  • Secured loans that are backed by one of your assets. For example, you could offer your house or car as collateral for the new loan.
  • Unsecured loans that don’t need any collateral. Remember, these may involve lower qualifying amounts and higher interest rates and may also be more difficult to obtain.

How does debt consolidation work?

Debt consolidation is all about simplifying your finances. Here are some examples to show how debt consolidation works in Canada.

Scenario 1: Reduce your monthly payments, interest and tenure

Let’s say you have 3 credit cards and owe a total of $20,000 at 20% annual rate compounded monthly. (While the average credit card interest rates in Canada are around 19%, on certain cards, they could go as high as 29.99%). Basically, you will pay $1,017.92 per month for 24 months to completely nullify your debt. This works out to $4,430.08 being paid in interest alone over time. If you qualify for and take a debt consolidation loan with an annual interest rate of 11% compounded monthly, you will pay $932.16 for 24 months to bring the debt to zero. The total interest paid overtime would be $2,371.84.

Moving to a debt consolidation loan will help save $85.76 per month, and $2,058.16 over the lifetime of the debt.

The table below gives a good indication of how the math works:

Loan Details

Credit Cards (3)

Consolidation Loan

Annual Interest Rate % (compounded monthly)

20%

11%

Total Balance Due Across All Cards

$20,000

$20,000

Term

24

24

Bills Paid/Month

3

1

Monthly Repayment

$1,017.92

$932.16

Total Interest Component

$4,430.08

$2,371.84

Total Overall Payment

$24,430.08
($1,017.92*24)

22371.84
($932.16*24)

Source:https://www.thecalculatorsite.com/finance/calculators/credit-card-payment-calculators.php

Scenario 2: Keep monthly payment the same, save on tenure and interest

Let’s assume you have 3 credit cards that have reached the maximum spending limit at $7,500 each, and you are spending $350 a month for each card’s minimum payment. With a 28% APR, you would be spending $1,050 a month for 31 months and will pay $9,054.72 in interest over this tenure. However, if you qualify for a debt consolidation loan, you could transfer the balances of these 3 credit cards into one loan at a more reasonable interest rate of 12% APR. If you continue to repay the same $1,050 a month towards this loan, your total interest will come down to $2,949.36, approximately 1/3rd of the amount that you would have paid by holding 3 individual cards. That way, you will be able to retire your entire debt 6 months sooner than before.

Overall, this arrangement will save you $9,255.36 ($6,105.36 in interest payments plus $3,150 for the payments that you don’t make for an additional 6 months).

The table below gives a good indication of how the math works:

Loan Details

Credit Cards (3)

Consolidation Loan

Interest %

28%

12%

Payments

$1,050
($350*3)

$1,050

Term

31 months

25 months

Bills Paid/Month

3

1

Principal

$22,500
($7,500 * 3)

$22,500

Interest

$9,054.72
($3,018.24*3)

$2,949.36
($983.12*3)

Total

$31,554.72

$25,449.36

Source: https://www.capitalone.com/credit-cards/calculators/payoff/

Why do you need debt consolidation?

There are many reasons why you might consider debt consolidation in Canada. Here are the most common reasons:

  1. Catch up with overdue bills: Once you get behind with bills, playing catch up could prove to be quite difficult. Having unpaid bills is not only stressful, but could also ruin your credit scores. A debt consolidation loan can help you pay off a multitude of overdue bills, such as income tax, phone, internet, city taxes, heating and hydro bills. It could put you back on your feet quickly and give you more financial stability.
  2. Escape the cycle of payday loans: Many retired Canadians turn to payday loans to get through their monthly expenses or to cover an unexpected bill. The problem is, payday loans can quickly spiral out of control and lead to growing debt or damaged credit. A debt consolidation loan can pay off these high-interest loans, and help you escape the cycle of debt.
  3. Pay off credit card debt: With every online site and retailer posting huge discounts (like Boxing Week or New Years special promotions) to lure consumers, it is easy to get sucked into binge shopping and rack up considerable debt on your credit cards. Since interest rates on cards are 20% and upwards, simply making minimum payments could also put a financial strain on you, especially if your income does not cover these expenses. However, transferring your credit card balances onto a debt consolidation loan could drastically improve your payoff terms.
  4. Eliminate high interest loans and lines of credit: Personal, unsecured loans and lines of credit often have high interest rates and short payment terms, leaving you with hard-to-cover monthly payments. Consolidating this debt into a lower interest rate loan, with a longer payment period could potentially free up more of your monthly income.
  5. Own your vehicle outright: Monthly car or truck payments can be a struggle when you are on a fixed income. Consolidating your high-interest, short-payment-term car loan will not only allow you to fully own your vehicle, but also make your monthly outgoings more manageable.

Are you the right candidate for debt consolidation?

Tired of seeing your credit card balances rise each month? Falling behind on several utility bills and payments?  Avoiding calls and letters from collection agencies? Feeling overwhelmed, or having sleepless nights due to your ever-increasing debt?

While thoughts of how to repay the mounting debt may be haunting you day and night, ask yourself whether you are ready, willing and committed to:

  • Turning your financial life around?
  • Making a serious change in your spending habits?
  • Preparing a monthly budget and sticking to it?
  • Making a timely, monthly payment for retaining the privileges of a debt consolidation program?

If you cannot answer all the above questions with a “yes”, then debt consolidation may not be the right solution for you. Committing to debt consolidation and a debt management program requires time, patience and determination. It also requires you to thoroughly assess your income, expenses and spending habits vis-à-vis the features of the debt consolidation plan. You may have to use a debt consolidation calculator to know whether the fees, payment terms and tenure of a debt consolidation loan can put you in a better financial position than your current one, or will it leave you worse off.

One of the other ways to consolidate your debt, without worrying about monthly repayments is to take out a reverse mortgage loan. With a reverse mortgage, you can qualify for up to 55% of the value of your home in tax-free cash. This will put more disposable income in your hands, while you continue to stay in your home, and retain the ownership of your property. Another benefit is that you don’t need to have the perfect credit score to qualify for a reverse mortgage loan. You just need to be 55 years or older and own your home; the rest is a factor of the assessed value and location of your home.

Remember, debt consolidation is an early stage solution that works when your debt is not excessive, and your credit scores are moderate-good. However, if your debt has reached huge proportions, or if you are unable to qualify for a debt consolidation loan, you may have to consider credit counseling, debt settlement, or in the worst-case scenario, file for bankruptcy.

Best ways to consolidate debt in Canada

If you are looking for a structured debt consolidation plan, there are two primary options:

  1. A 0% interest, balance-transfer credit card: Transfer your accumulated debts onto this card and pay the full balance within the agreed tenure.
  2. Fixed-rate debt consolidation loan: Take out a new loan, use the borrowed funds to pay off all your other debts, and continue to repay the new loan installments over a set term.

You can apply for a debt consolidation loan from financial institutions, such as banks or credit unions:

  • Unsecured debt consolidation loan: In this case, they usually lend around 10% of a borrower’s net worth (assets minus debts). However, if you need a debt consolidation loan of $50,000, but your net worth is only $50,000, the bank will likely decline your request, and only offer you a $5,000 unsecured loan (10% of your net worth).
  • Secured debt consolidation loan: If your net worth is not favourable as per the eligibility criteria, the lender may ask for some security for the loan, such as a vehicle without a loan on it. In this case, they will lend you up to a maximum “black book” value of your vehicle (a database of conservative vehicle values less than the fair market price of the vehicle). You could also use other personal assets, such as investment accounts, jewellery, and collectibles or fine art to offer security to the lending institution.

In addition to a balance transfer card and secured or unsecured debt consolidation loans, there are several other ways to consolidate your debt on your own. Essentially, you borrow at a lower cost, pay off your high-interest debts, and continue to make one monthly payment for the new loan.

Here are some of the other options for debt consolidation in Canada:

  • Use a personal loan
  • Borrow and withdraw from a retirement account
  • Apply for a second mortgage, refinance or a Home Equity Line of Credit (HELOC)
  • Use a reverse mortgage loan
Reduce your financial stress – find out how much cash you can get with a reverse mortgage

Pros of debt consolidation

  • Simplify your payments: Making just one debt payment each month will be far more manageable and less confusing than multiple debt payments with different interest rates and different due dates each month. Or look for a debt consolidation option like a reverse mortgage where there are no monthly payments required.
  • Secure lower interest rates: Using assets (such as your home) will help you secure a lower interest rate.
  • Get out of debt faster: The lower the interest rate, the sooner you can get out of debt. You will pay less money towards interest, and more towards your actual loan. However, it’s important to check the payment schedule and tenure offered by your lending institution. You want to see that while your monthly payment burden may reduce, you don’t end up paying more in the long run.
  • Protect your credit scores: Since all your creditors will receive payments quicker, your credit scores are not likely to be impacted. In fact, complying with the terms of the consolidation plan and making timely payments could further boost your credit rating.

Cons of debt consolidation

  • Risk of further debt: Once you commit to a debt consolidation plan, modifying your spending habits and staying within your monthly budget is imperative. Debt consolidation only reduces your interest payment and overall repayment tenure, not the principal that you owe. Essentially, if you continue spending excessively, you risk going deeper into debt.
  • Assets and co-signers in jeopardy: If you had to provide collateral or bring in a co-signer while taking out the consolidation loan, you may be jeopardizing your asset, as well as your co-signer. If you fail to make timely payments or honour the terms of your debt consolidation plan, you could end up losing your asset, or your co-signer may have to bear the burden of paying your dues. While this is true for most debt consolidation tools, when it comes to reverse mortgages, your loan is repayable only when you pass on or decide to sell your home. Essentially, you don’t pay any monthly instalments or interest, and yet you can make the most of the tax-free cash in hand, without jeopardizing your assets.
  • Loss of special provisions: Some debts, such as student loans, have special provisions, including interest rate discounts and rebates. You will lose these benefits as soon as you consolidate this loan with your other debts.
  • High processing fees: Structured debt consolidation plans come at a cost. Many lenders can charge hefty initial processing fees, as well as monthly charges, which could continue to add to your financial burden, instead of reducing it.

Is a debt consolidation loan the right solution for you?

Simply put, debt consolidation is about one affordable payment, once a month, (or one time), to one source. Like every financial solution, it has its advantages and disadvantages. Whether debt consolidation is right for you depends on the amount of debt you have accumulated, your age and income sources, and your ability to make payments. Know that a larger loan with a financial institution can require prompt payments. If you were struggling to pay your debts before, it could very well be challenging to repay your consolidated loan if you don’t choose the right one.

However, if you are a Canadian 55+ and own your home, the CHIP Reverse Mortgage® from HomeEquity Bank could be an excellent option for consolidating your debt. You can get up to 55% of the value of your home in tax-free cash (either lump sum or planned advances), and are free from the burden of monthly payments or interest payments until you decide to sell your home, or if you and your spouse pass away. With a reverse mortgage, the interest rates are a fraction of what you pay with the average credit card. Which is why the CHIP Reverse Mortgage could be a great way to consolidate your much higher interest rate loans, minimize your accumulating debt, reduce financial stress, and increase your disposable income without having to sell or lose ownership of your home.

Want to know more about using a reverse mortgage as a debt consolidation tool? Call us toll-free at 1-866-522-2447 to speak to one of our mortgage specialists.

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