Q: My bank sent me an email with some new services they offer. The timing was kind of funny because I was going to contact them as soon as I had time. Some big expenses that I had last year got me behind. I’m still not back making as much as before COVID and can barely make the minimum payments on my credit cards. Last month I had to get a payday loan to cover my rent. I did manage to pay that loan back, but I’ve already signed up for an online loan in case I need it. The email from my bank had a short self-assessment for my money and then suggested that I look into getting a debt consolidation loan. Do you think taking out a loan like that can help me? ~Darren
A: Many Canadians are finding themselves in a tight spot these days. Inflation and living costs are high and many people haven’t recovered from income disruptions or fluctuations that occurred over the past two years. The financial institutions recognize this and are trying to help their customers. However, when you have business in more than one bank or credit union, or you’ve turned to high-interest loans to get buy, exploring all of your options before settling on a decision is usually the better way to go.
How does a consolidation loan work?
The first thing most people think of when they hear “debt consolidation” is a loan. A debt consolidation loan shifts what you owe right now on your debts over to a new debt. If the new loan is at a lower interest rate than what you are currently paying on your debts, it could be a smart financial move. A consolidation loan means only making one payment going forward, which can simplify your finances and potentially save you some money. However, it takes more than just a better interest rate on a new loan and streamlined finances to actually get you out of debt in the long run.
What are the risks with consolidating debt?
There are two significant risks when it comes to debt consolidation. The first is not addressing the underlying problem that got you into debt in the first place. It could be job loss, reduced income, a family illness, or overspending. When you skip the step to identify why you got to the point you did, you’re potentially setting yourself up with a lot of additional debt down the line, and more limited options to deal with it.
The second big risk is that your credit will be affected. Whether the effect is positive or negative depends on your current credit rating and how you go about getting back on track. Using a loan to pay off older debts with an inconsistent payment history can help your rating increase. Making consistent, on-time payments on a new loan and/or other debts can also help improve a credit rating.
Applying for your first consolidation loan might not cause a big drop to your credit rating, but subsequent applications will. If you consolidate through an option that allows you to repay less than what you owe, your creditors could report the amount that was written-off on your report. There is no such thing as a quick fix when it comes to credit, but time will be on your side as you work to re-establish your credit score.
There are two key types of consolidation
Many Canadians don’t realize that there are several ways to consolidate debt and it’s never a one-size-fits-all situation. Consolidation options fall into one of two categories — those that require borrowing more money to pay off what you owe, and those that use existing money in your monthly budget to consolidate your payments.
When you borrow money to pay off what you owe, either you or your lender use the new money you borrowed to pay off the debts you already had. Going forward, you make payments to the one new loan rather than to each of the other creditors. If this sounds easy enough, it can be — if you qualify, if the interest rate on the loan is less than what you’re currently paying, and if you close the accounts you pay off.
Those who don’t want to, or who aren’t able to borrow money to consolidate their debts, can consider consolidating their payments instead. There are several options available to do this, ranging from debt repayment programs through non-profit and for-profit credit counselling agencies, as well as legal options administered by insolvency trustees. If not borrowing more money sounds like a good option, you’re not alone. With help to create a realistic budget, support to stay on track, and assistance to deal with creditors, they are worthwhile options to explore.
One of the most positive outcomes of payment consolidation, especially with a non-profit agency, is that you learn new money skills and develop new money management habits that set you up for success in the years to come.
Overcome the limitations of debt consolidation
It’s important to keep in mind that the ability to consolidate our debts is simply one tool we have to get out from under the weight of debt. And while some consolidation options can take care of troublesome debt quickly, they can also trap us in a cycle of using unhealthy financial habits to get by from day to day. Be aware of the limitations of debt consolidation as you consider how best to handle your own situation.
Not all debts are suited for consolidation
Whether or not it makes sense to consolidate your debts depends not only on your situation and goals, but also on the types of debt you have. Some debts are better suited for a specific type of consolidation, while consolidating other types either isn’t possible or not in your best interest.
For example, as tempting as it might be to consolidate government student loans with your credit card debt, you lose the ability to claim the interest as a tax credit when you file our income taxes if you include the student loans in a new loan from your financial institution.
Consolidating joint debts can be problematic if both borrowers aren’t applying for the consolidation loan together. Secured debts like a mortgage or home equity line of credit (HELOC) can be options to consolidate debt, but including them in a debt consolidation loan might prove costly. Professional guidance and advice will help you determine what will work best for you.
Debt consolidation won’t change your spending habits
Consolidating your debts and finding a more efficient way to pay back what you owe isn’t enough to change your spending habits; we develop our money management habits over many years. Restructuring your debt could even make your spending worse because debt consolidation takes the pressure off. It can stop late payment notices and collection calls, high interest charges, or even free up some money in your budget. With the pressure off and a little money to spend it can be easy to get carried away.
To change your habits after you consolidate debt, take concrete steps to change how you spend your money. If you still have credit cards, take them out of your wallet. Set up automatic bill payments through your online banking so that you don’t miss any due dates. Establish and stick to your budget, even if that means shopping with cash. Once you feel confident that you can stay on track, carefully reintroduce any conveniences you miss, such as shopping with a debit card versus cash.
Debt consolidation won’t change your savings habits
Most people will show off their new car before they brag about their savings account balance. It’s easy to agree that we should save money, whether for our retirement, an emergency fund or a down payment. But the feeling we get from setting money aside to spend later pales in comparison to thinking about everything we could spend the money on now. Savings isn’t flashy or fun, and just because the pressure is off with your debt payments, that won’t suddenly make you a saver.
Getting into the habit of saving is the single most important thing you can do if you want to avoid facing debt problems again in a few years. Saving is easier if you set meaningful financial goals. Make them SMART and incorporate saving for them into your budget. Learn how to pay yourself first on paydays. Start small if that’s all you can afford and work your way up. Seeing your savings account balance grow will motivate you to stick to your goals because success simply feels good.
Debt consolidation won’t make you budget better
While there might be some truth to the reasons why we don’t budget — too many payments, too much debt, not enough money, a bad credit rating or a stressful situation — when it comes right down to it, the math behind outlining a budget isn’t hard. But the problem for most people isn’t with the math.
We didn’t need to consolidate our debt because we couldn’t calculate our budget accurately. Financial problems are seldom that simple and the decision-making processes behind managing our money are complex. It is also as much psychological and emotional as it is mathematical.
If you want to become better at budgeting, take steps to increase your money skills and level of financial literacy. Read books and blogs, attend free personal finance webinars, become curious about your own habits, try different ways to manage your money, and celebrate your small wins.
The bottom line on consolidating your debts to get back on track
Debt consolidation can be the right option to successfully deal with your debts, and it exists in several forms. Some protect your credit rating while others do not. Some mean borrowing more money while others help you manage better with what you’ve already got. Consider your longer-term goals as you think about which course of action is best for you. Then take steps to improve your money skills so that you can look forward to a more stable financial future.
Scott Hannah is president of the Credit Counselling Society, a non-profit organization. For more information about managing your money or debt, contact Scott by email, check nomoredebts.org or call 1-888-527-8999.