How the Debt Consolidation Process Works
A lot of what we do at Home Equity Solutions resolves around helping households consolidate debt. There are some misconceptions and there is a bit of misunderstanding surrounding debt consolidation in Canada and we would like to clear some of that up.
We will start by explaining just what debt consolidation is then we will describe how it works with the use of a helpful example.
What is Debt Consolidation?
I realize that this is not an interactive medium, so I am pretty much just asking myself that question, but, in my defense, it makes for a great segway.
If you find yourself sitting on debt across one or more financial vehicles (credit cards, back taxes, business loans, car loans, etc.) it can become difficult to manage - both financially and logistically.
While fewer Canadians are holding on to credit card debt compared to ten years ago, the average debt is higher. As of 2012, 34% of households in BC were holding on to credit card debt, with an average debt load among those families of $8,300.
Credit card debt, as well as car loans and other forms of unsecured debt (i.e. not backed by collateral), typically comes with very high interest rates.
What's worse, is that if you miss two payments in a row, many credit card companies will deem you be to be in arrears and will charge you up to 28%!
When you consolidate your debt, you essentially take out another loan at a lower interest rate.
The funds from this loan are used to pay off your other loans. This makes managing your debt easier and, more importantly, lowers your interest rate and your monthly payments.
Additionally, a higher proportion of your monthly payment then goes to principal, allowing you to raise your credit rating and lower your debt faster.
At the conclusion of the loan (they are typically 6-12 months); the goal is to roll the debt once more into a traditional mortgage or other, lower, interest rate loan.
The important thing to think about when looking into debt consolidation is to find notably lower interest rates. Furthermore, it is important to keep in mind that you are not going into debt to get out of debt. You are simply transferring debt. This actually lowers the number of loans you have and helps you reduce your debt more quickly.
How Does Debt Consolidation Work?
This section will describe how to consolidate debt properly.
The key to consolidating your debt is to find a lower interest rate. Remember, debt consolidation is merely a transfer of debt from one or more vehicles to another.
If you are sitting on a fair amount of unsecured debt (such as credit card debt), then you will may be able to obtain an equivalently sized secured loan. Secured loans have notably lower interest rates than unsecured loans, because they are safer from the lender's perspective.
The image below provides an excellent example.
Scenario 1 - Credit Card Payments
- This scenario resembles a client we had recently, but we have tweaked some of the numbers in the interests of anonymity
- The individual (let's call the person Jamie) had $45,000 in debt across two credit cards, with interest rates ranging from 19% to 21% (pretty typical for most credit cards)
- High interest rates make paying anything more than the minimum payment difficult
- Even while sticking to minimum payments, Jamie still shelled out $10,600 in a single year and only around $1,700 would actually towards paying down the debt!
Scenario 2 - Debt Consolidation Loan Payments
- In this scenario, Jamie takes out a debt consolidation loan and uses it to pay all of the debt on the two outstanding credit cards
- The debt consolidation loan carries a much lower interest rate than Jamie's credit card debt
- At this point, Jamie has the option of lowering the monthly payments and paying out just $3,949
- We don't recommend this, however. If you want to consolidate debt properly, the best thing to do, and what Jamie did, is to maintain the same monthly payments
- This is admittedly difficult to do, but the results speak for themselves. When Jamie maintains the same monthly payments, principal payments go from $1,700 under the first scenario to almost $6,700 in the second scenario. That's almost $5,000 more!
But Wait, There's More!
Apologies for the cheesiness, but I didn't want you to leave yet, because it gets better.
As you lower your interest rates and pay down your debt, you raise your credit rating. As you raise your credit rating, you qualify for even better interest rates, making it even easier to pay down your debt. It's a virtuous cycle.
It's a remarkably simple and beneficial process. You take out a loan with a lower interest rate than your current debt. You use the new loan to pay off your old debt, leaving you with just a single loan at a lower interest rate.
The lower interest rate allows the same payments to pay down your debt much faster. This lowers your debt, raises your credit rating, and helps you qualify for an even better rate. The process then starts again until you are in the lowest rate you can get!
If you are interested in debt consolidation and other related topics and would like to learn more, feel free to check out some of our other blog posts:
Interested in consolidation your debt? You can apply online. It's quick, easy, and you are under no obligation!