Debt Consolidation Pros and Cons
Comparing three options for consolidation, so you can find the best fit.
Every debt solution has its benefits and its drawbacks. It’s important to understand the pros and cons of each solution you may be considering, so you can choose the best option for your needs.
This guide can help you weigh the pros and cons of three options that allow consumers to consolidate debt in a single monthly payment. If you have any questions or would like assistance identifying the best solution to use in your situation, call 1-888-294-3130 for a free consultation with a trained credit counsellor.
The primary benefits of debt consolidation
Although there are different ways to consolidate debt, all of them provide three key benefits:
The primary purpose of debt consolidation is to pay back everything you borrowed and charged in a more efficient way. Meeting your obligations helps you avoid the severe credit damage caused by options that only repay a portion of what you owe.
Juggling multiple credit cards and unsecured personal loans and Lines of Credit (LOCs) can be a challenge. Debt consolidation combines all your unsecured debts into a single monthly payment. This simplifies your repayment plan, so it’s easier to manage within your budget.
One of the main goals of any debt consolidation option is to reduce or eliminate the interest rate applied to your debt. Minimizing accrued monthly interest charges allows you to save money and focus on repaying the principal – the actual debt you owe. As a result, you can often get out of debt faster, even though you may pay less each month.
Comparing the pros and cons of each consolidation option
There are three ways to consolidate debt that all offer the benefits described above:
- Debt consolidation loans are the most common way to consolidate debt. You use an unsecured personal loan to pay off credit card balances and other unsecured debts.
- Credit card balance transfers are good for consolidating lower amounts of credit card debt. You open a balance transfer credit card with low APR and move your existing balances to the new card.
- Debt management plans help consumers with poor credit or high debt amounts to consolidate. If you can’t consolidate on your own with the two options above, you can enroll in this solution through a credit counselling agency.
Each option consolidates debt in a unique way, and as a result, each comes with slightly different pros and cons. This table can help you compare the pros and cons of each:
|Debt consolidation loan||Balance transfer||Debt management plan|
|Credit score required to qualify||Good (650+)||Very good (720+)||Any|
|Recommended debt amount||Less than $5,000||Less than $25,000-$35,000, depending on your budget||Any|
|Cost||Loan origination fees (0.5-8% of the amount borrowed)||Balance transfer fee (3-5% of each balance transferred); some cards have annual fees||Setup and monthly administration fee, based on budget, total debt and where you live|
|Interest Rate||Based on credit score – can be as low as 0% APR for up to 18 months||Based on credit score – recommended 10% APR or less||Creditors agree to reduce or eliminate APR on each account; average reduction between 0-11%|
|Closes your accounts||No||Not typically, although some lenders may require it||Yes|
|Credit impact (if executed correctly)||Positive||Positive||Two-year negative remark on your credit report|
The hidden risk of do-it-yourself debt consolidation
Let’s be honest. Most people would prefer to solve their debt problems on their own. That’s why the most popular and well-known method of debt consolidation is to use a personal loan.
However, many Canadians are ultimately not successful with this method, or with balance transfers. When you consolidate debt on your own with a loan or transfer, your existing accounts typically remain open.
While this may seem like a positive, it can quickly become a negative if you’re not careful with your budget. You will pay off or transfer your balances, which will zero out the balances on your existing accounts. That leaves you open to running up new debt.
If you start making new charges before you pay off the consolidated debt, you can end up with more debt instead of less. What was meant to be a solution has the potential to make your situation worse.
If you decide to consolidate your debts on your own, make sure to set a strict budget. You need to avoid making new charges until the consolidated debt is paid off.
Choosing the best solution for your needs, credit, and budget
If your unsecured debts are still manageable, you have good credit, and you’re able to balance your budget to avoid new debt, then a balance transfer or consolidation loan may be an option. Do-it-yourself options are also preferable if you’re concerned about damage to your credit score.
On the other hand, if you’re having trouble making ends meet and your credit score has already taken some hits from being in debt, then you may be better off with a debt management program. Professional support can be immensely beneficial for getting out of debt when you’re overwhelmed.
If you need help deciding, a trained credit counsellor can help you identify the best solution. Credit counselling agencies like Consolidated Credit are nonprofit charitable organizations, which means our counsellors only recommendations based on your best interest. They won’t try to “sell” you on a debt management plan if another solution is a better fit for your situation.
Comparing the pros and cons of consolidation to other solutions
Consolidation loans vs home equity loans
Debt consolidation loans aren’t the only lending option that you can use to pay off existing debt. Home equity loans are a popular option available to homeowners, where you use the equity in your home for paying off debt.
The advantage of using a home equity loan is that you may be able to qualify for a lower interest rate than with an unsecured loan. However, you assume a measure of risk for using this option. If you can’t keep up with the payments on the loan, you could be at risk of losing your home.
In general, using an unsecured loan is preferable to a secured loan because it doesn’t risk your collateral. If you can’t qualify for an unsecured consolidation loan at a good interest rate (10% or less), then you may want to consider credit counselling before cashing in on your equity.
Debt consolidation vs debt settlement
Consolidation is often confused with debt settlement, where you settle a debt for less than the full amount owed. That confusion is not accidental. Many debt settlement companies intentionally advertise their services like debt consolidation to lure in consumers.
However, these solutions are vastly different. Debt consolidation pays back everything you owe, while settlement only pays back a percentage. As a result, debt settlement will cause significant damage to your credit score. The credit report notation for settlement lasts for six years from the date of discharge.
Debt settlement should also not be confused with a debt management plan. With debt management, you make monthly payments that the credit counselling agency that they distribute to your creditors each month on your behalf.
By contrast, with a debt settlement program, you still make monthly payments. However, the money is held in an escrow account until you have the funds necessary to make a settlement offer. Your creditors do not get paid each month. This can lead to missed payments and additional credit damage.
Confusing debt settlement with consolidation can lead to significant credit damage and make a bad situation worse. In fact, the Canadian government has issued a consumer alert regarding debt settlement services, including the fact that they use misleading terminology such as debt consolidation to describe their services.