Debt Consolidation Loans

Debt Consolidation Loans

In today’s environment, there are many forms of debt available to the average person. These debts can be short-term such as credit card bills, medium term such as car loans or long-term such as mortgages on residential properties. Given this range of debt that can be taken out – often simultaneously – it can sometimes get overwhelming to monitor and track the payment dates and amounts due of each debt component. To this end, one major option used by a significant number of Canadians looking to reduce their periodic payments and/or number of creditors is a debt consolidation loan.

What is a debt consolidation loan?

In a nutshell, a debt consolidation loan involves a customer taking out one large loan to pay off multiple small debts at once. These loans are typically extended by financial institutions as personal loans that cover all outstanding debts of a person. Once the borrower has used the immediate funds to pay off his/her creditors, they then pay back the financial institution in periodic principal and interest payments just like a regular loan. In essence, the smaller debt components get accumulated into one large debt piece that is typically offered at a lower rate of interest, thus providing both financial and efficiency benefits.

Who and what can qualify for a debt consolidation?

It is important to remember that there are two types of debt consolidation loans: secured and unsecured. Secured loans require the borrower to put up some personal asset as collateral, which can be claimed by the bank in the event of default. Unsecured loans, on the other hand, are not secured on any personal asset, implying a higher risk for the financial institution. This higher risk translates into a higher rate of interest as well to compensate the lender for the additional risk undertaken.

Thus, when lenders evaluate potential borrowers who are looking to take out a debt consolidation loan, there are four main criteria that they would use to make their decision:

In terms of what type of debt can be classified as eligible to be consolidated, there are certain parameters set out that vary by financial institution. As a general rule of thumb, the following types of credit are generally able to be merged together as part of the debt consolidation loan:

Credit Card Debt: In Canada alone, there are 3 billion credit card transactions made every year. An Equifax report stated that these originated from 31 million individual accounts, of which 30% didn’t pay back the credit card balance at the end of each month. Annually, this is approximately $7 billion just in interest for late payments.

Public Utility Debt: Public utilities include water (hydro), electricity, natural gas, telephone services and other essentials provided by a specialist provider. Typically, these companies charge the consumer at the end of each month with payments due within ~2 weeks. The debt from these can be bundled into a debt consolidation loan.

Other Consumer Loans: Broadly speaking, consumer loans are debts taken out for a multitude of purposes including auto loans, student loans, and other personal loans.

Mathematically Sound:

There are several advantages to obtaining a debt consolidation loan. However, most borrowers that consolidate their debt are primarily looking to decrease the interest payments they make per month. To do this, they rely on the simple fact that debt from credit cards and other consumer loans as mentioned above typically has a higher interest rate tag attached to it. For example, credit cards charge 8-12% on the low end and 23% on the upper end for payments that are made past the due date.

This means that if the borrower is able to receive the debt consolidation loan at a reasonable rate provided by retail banks, he/she can stand to save up to 5% or more on each payment. In other words, on every $1000 of debt owed, the borrower is now in a position to save $50 by way of lower interest payments – even though the principal has remained exactly the same!

Other Key Advantages:

There are several pros of debt consolidation loans when compared to alternative forms of debt reduction. While the main attraction remains the lower interest rate as explained above, some of the secondary advantages are presented below:

Factors to Consider:

While debt consolidation loans offer a host of advantages, there are some caveats that need to be kept in mind:

1. Principally the Same: Only the interest amount is liable to change post-debt consolidation. The principal amount remains exactly the same.

2. Keep the Bad Habits at Bay: Often, borrowers fall into a false sense of security after debt consolidation when they see the additional capacity under the credit card. This could lead to overspending again, which brings them back to square one.

3. Security Troubles: A secured loan where the borrower puts up collateral and fails to pay may lead to reclamation of the asset by the lending institution, which tends to be much less forgiving of such instances than credit card or utility companies, who can earn money off of the late payments.

Main Differences:

A comparable debt reduction technique is debt restructuring wherein creditors agree to forgive a portion of debts in exchange for prompt payments of the remainder. The main differences between debt consolidation and a debt restructuring is explained below:

What the Numbers Say:

The debt to income ratio is one of the primary indicators used by economists to evaluate the level and sustainability of household debt within an economy. Essentially, it shows the level of debt payable for each dollar of income earned i.e. a ratio of 150% would imply that for every $1 that a borrower earns, he/she has to pay back $1.50. In Canada, this number is amongst the highest in the world of all developed economies, currently standing at 176.2% as of January 2019. Of this debt, a report released by the CMHC in 2017 stated that non-mortgage debt (comprised of auto loans, credit cards, and all other credit) accounted for 19% of total debt outstanding.

In such an environment, debt consolidation loans can often be one of the main tools available to consumers looking for debt relief, but hesitant to impact their credit score.

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