You have undoubtedly seen or heard slogans like this:

Combine all your debts into one low payment! 

Get the loan you need to get back on your feet!  

These are generally consolidation loans, and the basis for their appeal is quite straightforward.  You are lowering and combining your monthly payments and, hopefully, lowering the interest rate you are paying as well.  Depending on your circumstances, this can provide some much-needed financial relief; however, it is important to understand what exactly is going on when you take on a consolidation loan.

Consolidation loans in general.

When you take out a consolidation loan, the financing company is essentially loaning you money to pay off your debts.  The amount of the loan, interest rate, and approval can vary on a case-by-case basis; however, there are some things that apply in all cases:

  • This is a loan, there is interest being charged.  When you borrow $40,000 in a consolidation loan, you are going to be paying back more than that.  Even at a relatively low interest rate of 5%, paying off that loan in 5 years will cost you approximately $5,000 in interest.  Most consolidation loan interest rates are higher (sometimes significantly) than 5%.
  • If most of your debt is with credit cards, this can still provide a significant reduction in monthly payments.  Credit card interest is generally in excess of 18%.
  • A consolidation loan, unlike a credit card debt, is structured to have an end date. So there is, in theory, light at the end of the tunnel.
  • You get to keep your credit cards, and in some cases a consolidation loan can have a negligible effect on your credit score.
  • Approval, and interest rate, depend on you as the borrower.  The lower your credit score the higher the likely interest rate.  A lender may advertise rates as low as 3%, but you may only qualify for a rate in excess of 15%.

Sounds great, is there a downside?

Consolidation loans can be a good option, depending on your circumstances, but there are important things to consider.

  • The interest. Yes, this was mentioned before, but the fact is if are borrowing $40,000 then you are repaying more (probably no less than an extra 15% to 20%).  Knowing the true cost of a consolidation loan is important.  You may be shocked to find out how much interest you will end up paying.
  • You get to keep your credit cards! Yay? This can be a risk.  Unless the consolidation loan is done in conjunction with a financial management strategy there is a chance for debt levels to spiral out of control once again.  If you experience financial stress while paying of the loan you may be tempted to turn to your credit cards to make ends meet.  Then you must repay not only the loan plus interest, but also the credit card debt and its interest too.
  • Managing your finances. A consolidation loan addresses some of the stresses that occur when carrying excessive debt but does not address the underlying causes of financial challenges.  If managing credit has caused you problems, simply having access to more credit is not likely to solve those problems.

What about a Consumer Proposal?

It is not uncommon for people to confuse a consumer proposal with a consolidation loan.  With a consumer proposal, you address all your unsecured debts and end up with one low(er) payment.  The processes, though, does have substantial differences.

  • What’s the same?
    • A single monthly payment.
    • You pay less than what you would if you continued servicing your existing debt.
  • What’s different?
    • A consumer proposal is an insolvency filing and will adversely affect your credit rating.
    • Depending on your circumstances, a consumer proposal may result in you repaying less than your total outstanding debt load.  This will never be the case with a consolidation loan.
    • There is no interest charged in a consumer proposal.
    • You do have to surrender your credit cards in a consumer proposal, and lines of credit, etc., will be closed.
    • Credit counselling and financial management courses are a requirement of your consumer proposal, with the goal of helping establish your long-term financial health.

How about an example?

Jane owes $30,000 on two credit cards, both with an interest rate of 19%.  She is offered a consolidation loan from the bank at an interest rate of 9%.  Jane is single and earns about $3,000 per month from her job.  Let’s see how the numbers work out for Jane:

 Credit CardsConsolidation LoanConsumer Proposal
Opening Debt$30,000$30,000$30,000*
Monthly Payment$780$622.75$300**
Interest Rate19%9%NA
Payment Duration60 Months60 Months60 Months
Interest Paid$16,623$7,365NA
Total Paid$46,623$37,365$18,000

*This is the total for the debts included in the consumer proposal, not the total proposal payment. **Based on her income, Jane’s monthly proposal payment would likely fall between $200/month and $400/month – this varies based on each individual’s circumstances.

When addressing your financial future, it is important to evaluate all your options.  A consolidation loan can be beneficial; however, it may not be the best approach to move forward to your debt free future. For more information on how a consumer proposal can benefit you, please contact us for a free phone or video consultation.

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