Debt Consolidation Loan

Here's our complete guide to everything you need to know about debt consolidation loans in Canada.

Key Points

Debt consolidation loans can be secured or unsecured.

A debt consolidation loan can lower your interest rate, make your payments more affordable, and combine your debts into a single payment.

Debt consolidation loans are available from various lenders, including banks, credit unions, and alternative lenders.

What is a debt consolidation loan?

A debt consolidation loan (secured or unsecured) is used to pay off debts with high interest rates. The goal is to combine several existing debts into a single, larger, but more affordable loan. By taking advantage of a lower overall interest rate, you can pay off your debts faster.

How does it work?

A debt consolidation loan works like any other loan. However, once your application is approved, you use the funds received to pay off the debts you want to consolidate, prioritizing those with high interest rates. These can include credit card balances, personal loans, or other eligible types of debt.

Note: Secured debts are generally excluded from debt consolidation loans. They are more complex and often require refinancing rather than consolidation.

Characteristics of a debt consolidation loan: overview

Loan Amount

The amount offered depends on the lender, your credit score, and your financial situation. That said, many lenders typically allow loans of up to $50,000 without collateral. If you have collateral, this amount can exceed $100,000.

Interest Rates

Rates can vary between 5% and 35%, depending on your financial situation and the type of guarantee offered. However, a debt consolidation loan is only advantageous if you obtain a rate lower than the rate of the debts you wish to consolidate.

Terms

The loan term typically ranges from 12 months to 5 years.

Types of debt that can be consolidated

You can consolidate unsecured debts, such as credit card balances, personal loans, and payday loans.

What are the eligibility requirements for a debt consolidation loan?

To qualify for a debt consolidation loan, you must meet the lender's criteria, which generally include the following:

• Good credit score: Most lenders require a good credit score. However, it is sometimes possible to qualify with a lower score if you reduce the risk in other ways, such as by providing collateral or adding a co-signer.
• Sufficient income: You must have a high enough income to cover the loan payments, after taking into account you're other expenses or financial obligations.
• Active bank account: The majority of lenders require an active bank account to verify your identity and income, as well as for depositing funds and repaying the loan.

Can you get a debt consolidation loan with bad credit in Canada?

If you have bad credit (below 559) due to past credit errors, you may still be eligible for a debt consolidation loan from an alternative lender. These lenders typically assess applications based on the borrower's overall financial health.

Where to get the best debt consolidation loans in Canada?

How to apply?

To apply for a debt consolidation loan in Canada, follow these steps:

Step 1: Compare lenders

Before choosing a lender, make sure you get pre-approved so you can compare offers. Use an online loan comparison platform like Loans Canada to quickly compare lenders and their financing offers.

Step 2: Complete the application

Once you have found a good offer, work with the lender to finalize the application. You will also need to provide certain documents, which may include the following:

• Photo ID: A driver's license or passport may be required to verify your identity and age.
• Proof of residency: You must be a Canadian citizen or permanent resident to be eligible for a debt consolidation loan in Canada.
• Proof of income: Bank statements and pay stubs may be requested to demonstrate to the lender that you earn enough to make your payments. You may also need to provide information about your debt level so the lender can calculate your debt-to-income ratio and confirm that you have sufficient funds, after paying your bills, to cover the loan payments.

Step 3: Receive the funds

If your application is approved, you will receive the funds via Interac e-Transfer or direct deposit. Depending on the lender, the money may be released within 24 hours to a few days of approval.

Types of Loans That Can Be Used to Consolidate Debt

There are several ways to consolidate your debts. Depending on the product chosen, each option has its advantages and disadvantages.

Consolidating Your Debts with a Personal Loan

A personal loan from a bank, credit union, or alternative lender is a common way to consolidate debt. However, to obtain a large amount at a low interest rate, you generally need a high income and a good credit score. It is therefore recommended that you check your credit score before applying for a loan.

You can also increase your chances of approval by adding a co-signer or offering collateral.

Advantages:

• Consolidate multiple debts: You can combine several debts to simplify tracking your payments.
• Get a lower rate to save money: you can reduce the cost of interest by obtaining a more advantageous interest rate.
• Extending the term to reduce payments: choosing a longer loan term allows you to reduce the amount of payments.
• Improve your credit score: every payment made on time helps build your credit history.

Disadvantages:

• Co-signer sometimes required: a co-signer is often necessary if your credit score is low.
• Good credit score required: a good credit score is generally required to be eligible.
• It can increase your debt: a personal loan is still additional debt. If the funds are not used to pay off your existing debts, you could end up in even more debt.

Consolidate your debts using your home equity

If you have equity in your home, you can consolidate your debts using a home equity loan or a line of credit.

• Home equity loan: A home equity loan works similarly to a personal loan, except that it is secured by your property.
• Home equity line of credit (HELOC): A HELOC works similarly to a credit card, except you only pay the interest during the drawdown period. Repayment of the principal is only required at the end of this period, which can last from 10 to 15 years. The HELOC is also secured against your property.

Advantages:

• Simplified payment management: you can consolidate multiple debts, making it easier to track your payments.
• Possibility of obtaining lower rates: the presence of a guarantee may allow you to obtain a lower interest rate than that of an unsecured debt consolidation loan.
• Higher amounts and more advantageous rates: thanks to the guarantee offered, eligibility is generally easier, approved amounts can be higher and interest rates lower.
• Opportunity to build your credit: every payment made on time helps improve your credit score.

Disadvantages:

• Risk to your assets: You could lose your property if you miss payments on your loan.
• Risk of re-indebtedness: Consolidation does not address spending habits. Even after repaying your debts using your home equity, you could accumulate new balances and end up with an even higher level of debt.

What is your home equity?

Home equity is the portion of your property that you actually own. For example, if your house is worth $250,000 and you have already paid $100,000 off your mortgage, you currently have $100,000 of your home equity.

How much can you save by consolidating your debts?

To illustrate the potential savings with a debt consolidation loan, let's look at an example.

Suppose you have two credit cards: one with a balance of $3,000 and the other with a balance of $2,000. Assuming you make monthly payments of $200 on each card, how long will it take to pay them off and how much interest will you pay?

We will then calculate the time required and the total cost if these two credit cards are combined into a personal loan. For this example, let's assume you obtain a 2-year personal loan with an interest rate of 7.5%.

As you can see in the table above, debt consolidation would save you $286.95 in total interest, while reducing your monthly payments by $175. The only downside is that the repayment period is longer.

However, if you reduce the loan term to one year and increase your payments to $434 per month, you could repay the loan in 12 months and pay only $208 in interest.

Points to Consider When Choosing a Debt Consolidation Loan

Ultimately, when considering applying for a debt consolidation loan, you'll find there are many options available. Therefore, it's important to consider the following three factors to determine the best solution for your needs.

• Loan amount offered: Debt consolidation loans are most effective when you can pay off all of your eligible high-interest debts. Therefore, it is essential to find a lender who can approve the appropriate amount.
• Annual Percentage Rate (APR): One of the most important elements to consider is the APR, which represents the total cost of borrowing over a one-year period. Will the rate offered to you actually save you money in the long run?
• Loan-related fees: Consider all fees associated with your loan. Even with a low interest rate, excessive fees can negate any anticipated savings. Also, be sure to check for any prepayment penalties that apply to the debts you plan to consolidate.

When should you consolidate your debts?

Debt consolidation is generally more advantageous in the following situations:

• If you have difficulty keeping track of your payments: if you have several debts with different due dates, a debt consolidation loan can simplify management by combining all your payments into one.
• You have several high-interest debts: a loan can reduce the amount of your current payments and save you on interest.
• If you wish to reduce your monthly payments: debt consolidation allows you to spread the repayment over a longer period, making the payments more affordable.
• You are eligible: it can be difficult to obtain a debt consolidation loan without a good credit score.

Alternatives to a Debt Consolidation Loan

There are other debt relief options in Canada. Here are some alternative solutions:

Credit Card Balance Transfer

If you're experiencing significant financial difficulties due to a large credit card balance, you can opt for a balance transfer. This form of debt consolidation allows you to combine your credit card balances into a single new card with a very low interest rate.

Balance transfers typically offer rates starting at 0% for a period of 3 to 12 months, which can result in substantial interest savings.

A Debt Management Program

A debt management program (DMP) is an excellent option for people who want to reduce their monthly payments by extending the repayment period. With a DMP, a credit counselor will work with your creditors to consolidate your debts and give you up to 5 years to repay them. They will also try to suspend interest and penalties during this period.

That said, it is important to note that a debt management program will be recorded on your credit report, which may negatively impact your credit score.

Consumer Proposal

If your debt situation has become unmanageable, a consumer proposal might be a more appropriate option. In this case, a Licensed Insolvency Trustee will work with your creditors to develop a repayment plan that is fair to all parties. A consumer proposal can last up to 5 years and may negatively impact your credit score.

Common Mistakes to Avoid When Consolidating Debts

If you choose to consolidate your debts, be sure to avoid the following mistakes:

Failing to address the root cause of debt

Consolidation simplifies payments, but it doesn't correct overspending or poor budgeting habits. Without changing the behaviors that led you to your current situation, you risk accumulating new debt on top of the consolidation loan.

Don't neglect the calculations regarding interest rates.

Some consolidation loans don't actually reduce your overall interest rate. Take the time to calculate and compare your current rates with those offered by the new loan.

Neglecting Fees and Costs

Application fees, balance transfer fees, and closing fees can significantly reduce your anticipated savings. Ensure the total cost of the loan is lower than your current debt structure.

Don't consider all options

Debt consolidation isn't the only solution. Depending on your situation, options like balance transfer credit cards, debt management programs, or negotiating directly with your creditors might be more advantageous.

Missing Payments

A single missed payment can negatively impact your credit score and increase your costs. Consider setting up automatic payments or reminders to help you meet your deadlines.

Extending the loan term excessively

A longer repayment period reduces monthly payments but increases the total amount of interest paid. It is important to find a balance between affordable payments and reducing long-term costs.

Key Takeaways

A debt consolidation loan can be an effective way to simplify your finances by combining multiple payments into one. It often comes with lower interest rates, allowing you to save money while maintaining control of your finances. With the right lender and a solid repayment plan, debt consolidation can be a significant step toward greater financial freedom.