Debt Consolidation: What You Need To Know
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- Debt consolidation is when multiple debts are combined into a single monthly payment.
- You can choose from a variety of debt repayment strategies.
- Beware of debt consolidation scams that promise debt relief.
- A debt settlement company is a for-profit business that will negotiate with your creditors for a fee.
What is debt consolidation?
Debt consolidation is when you roll some or all of your debts, or multiple debts, into a single monthly payment. The main appeal of debt consolidation, aside from only paying one bill instead of multiple, is that you can sometimes negotiate a lower interest rate and hopefully pay it off faster. Whether consolidating your debts is the right move for you depends on your unique financial situation, the methods you're considering, and what you feel more comfortable doing.
Methods of debt consolidation
There are a few different methods available when considering how to best consolidate debts. Your options ultimately depend on your type of debt, your available credit, and any real estate assets you could use.
Before we get into the different types of loans, let's look into the difference between secured and unsecured debt because they can affect which types of loans you can take out. Secured debts are tied to a material asset, such as your home or vehicle. Lenders place a lien on the asset, giving them the right to seize it if you're delinquent with payments.
With unsecured debt, lenders don't have any collateral to seize if you're delinquent with payments. However, they can hire a debt collector to persuade you to pay the debt or sue you to garnish your wages (or put a lien on your assets) until the debt is paid off. Examples of unsecured debt include credit card debt, student loans, medical bills, and child support.
Let's look into three distinctly different ways to consolidate your debt depending upon your available assets:
Credit card balance transfer
By consolidating all of your credit card debt onto one new card with a high credit limit and introductory promotional rate that's lower than the average rate on your existing accounts, you can save interest. Preferred balance transfer cards have interest-free promotions that can reduce or even eliminate transfer fees — just bear in mind you can't transfer a balance between credit cards from the same financial institution. And it's important to keep track of what happens when the promotional rate expires and there's still a balance on the account. The annual percentage rate (APR) could be much higher than the promotional rate. And a higher rate does not help to pay off debt.
Home equity loan
If you own property, you can leverage it as an asset to borrow against with a home equity loan. Typically, home equity loans allow you to borrow up to ~80% of your home's equity, allowing you to take out a certain amount of money that you repay in installments over a set amount of time. However, by using your home as collateral, the lender could foreclose upon it if you're delinquent with payments. Plus, if your home's value drops, you could wind up owing more than it's worth. However, interest paid on home equity loans may be tax-deductible while credit card interest is not.
Debt consolidation loan
A debt consolidation loan is where you apply for a personal loan with the intent to pay off your debts, preferably with a lower interest rate than what you're currently paying. Then you use that loan to pay off all your debts at once. Depending on your situation, this may reduce the number of monthly payments you have to keep up with, which will make it easier to help you avoid falling behind.
Debt consolidation scams — what to look out for
Unfortunately, the debt consolidation industry is rife with scammers who may promise debt relief — don't just sign up with one of the many junk mail debt consolidators landing on your doorstep or social media feed. These companies may push you to get a high-interest rate loan that isn't in your best interest and may end up costing you more in the long run. Other companies could pocket the money you send in, instead of distributing it among your respective creditors, leaving you with poorly impacted credit. If something sounds too good to be true, like that they'll be able to possibly reduce your debts by a large percentage, then they may not be the best debt consolidation contender and can lead you even deeper into debt.
Credit counselling agencies
Credit counselling is when you use the services of a credit counsellor or credit counselling agency to set up a budget, learn money management skills, and create a debt management plan. The Government of Canada has a detailed credit counselling page on its web site, with information from the Financial Consumer Agency of Canada. It has links to several associations where you can find a credit counsellor. Starting a conversation with a reputable credit counselling agency won't affect your credit rating. To learn more, check out our guide on credit counselling and how it can help.
A debt settlement company is a for-profit business that will negotiate with your creditors for a fee, offering them a lump sum of money in order to eliminate your debt. If the creditors agree to the suggested number, often lower than your total debt, then you have to provide that amount of money to the settlement company, who will then pay your creditors.
Some elements to watch out for:
In the event that your creditors refuse the offer, you generally still have to pay the fee to the debt settlement company, which could be very high. Debt settlement fees generally vary, and you may be required to pay them upfront or on a monthly basis.
Sometimes, the debt settlement company will offer to handle all communication with your creditors, asking you to give them power of attorney in order to do so. If you feel comfortable doing this, make sure the debt settlement company will inform you of any payments that are being made to creditors, so you know the payments are being received.
Intentionally delayed payments by the settlement company, a common negotiation tactic in order to reduce your debts, can impact you negatively.
Last but certainly not least, consolidating your debt doesn't automatically make it go away. It may feel like less of a burden because you're paying one bill a month instead of several, but debt should still be taken into consideration when reviewing your budget or spending. The good news is, recognizing and crafting a plan to pay off your debt faster is a great step in the right direction.