Having a large debt can negatively affect your life in a number of ways.

First and foremost, what is debt consolidation and how does it work? Simply put, it affects your pocketbook. A huge debt load hanging over your head means that you will have to use some of your income just to pay the interest, which reduces your available cash for other needs and requirements.

Having a high level of personal debt can also be an emotionally taxing situation. It can lead to feelings of shame, depression, embarrassment, anger and/or anxiety. Indeed, some studies have shown it to be associated with higher blood pressure, along with poorer self-reported general and mental health.

Although scientists have yet to fully explore the connection between debt and health, it is no surprise that this situation is becoming more and more common, as American household debt has more than tripled since the 1980s.

This kind of toxic debt is not something anyone would want to experience if they had the choice. Unfortunately, an unsustainable debt load is the reality for millions of people around the world.

Because of high interest rates, people struggle to pay their debt off for years, sometimes taking on extra jobs and spending less time with their friends and family in the process. Perhaps lulled into a false sense of security, they pay the minimum payments, believing they are making inroads towards solving the problem. They are mistaken.

The fact is, without a serious change in income (upwards) or standard of living (downwards), these people may find themselves deeper in debt than when they started. If you are one of these people, you’re familiar with these concerns.

However, it’s not all bad news. Certain tools and strategies do exist, and it is possible to escape your debt. One of the strategies that may help you is debt consolidation.

What is debt consolidation?

When a person is in debt, they owe money to a creditor (or multiple creditors) for goods received or services performed. Not only is the principal amount owed, so is interest. Many people use credit cards, and most credit cards have annual interest rates up around 20%, with some interest rates being even higher.

In most cases, owing multiple creditors high interest rates without an infusion of cash is simply unsustainable.

Debt consolidation is a strategy designed to address the undesirable situation of having multiple loans owed to different creditors.  When debt is consolidated, a new loan is created to address the repayment of the smaller debts.

Debt consolidation brings all these debts together into one loan with one monthly payment. Since it’s effectively combining several smaller loans into one larger one, this process is referred to as “consolidation.” It’s a form of debt relief.

How does debt relief work?

While most people talk about debt consolidation as “bringing together” multiple smaller loans, that’s not what’s actually happening. It is impossible to merge loans together, financially speaking. Each loan has different terms, interest rates, and so on.

In the case of a traditional debt consolidation loan, the lender will either use the funds to pay out the debts you jointly agree will be paid off, or they will deposit the funds in your bank account, making it your responsibility to pay out the debts or bills you wish to consolidate.

Effectively, the smaller loans are paid for you and the one larger one remains for you to pay off. This is what people really mean when they refer to debt consolidation. It is technically debt refinancing, but in the end it’s a way to help people manage their debt.

Debt consolidation loans are generally issued by banks, credit unions, and finance companies. Debt repayment programs also exist for people who are having difficulty paying their multiple debts, effectively consolidating all debt payments into one payment. This can also be seen as a form of debt consolidation.

What is debt management / consolidation and what forms does it take?

Debt consolidation loans can take many forms, but usually they are either personal loans or home equity loans. In many cases, debt consolidation loans offered by lending institutions take the form of a second mortgage or home equity line of credit.

Here are a few of the most common (and best) ways people are doing debt consolidation in Canada:

1. Home equity loan – Often referred to as “taking out a second mortgage,” a home equity loan is a good way to consolidate debts if you have a decent amount of equity in your home (home equity is the amount you own after you subtract your mortgage from the value of the home). A home equity loan generally offers the lowest interest rates when done through a regular bank or credit union.

2. Line of credit – If you can obtain a line of credit from your bank or credit union, you could use it to consolidate your debts. Lines of credit can be secured by your home or unsecured if you have good credit and a good income. Using a line of credit to consolidate debt comes with the downside of having to pay a set amount each month that is much higher than your minimum monthly payment (only paying the minimum would take decades to pay off the loan).

3. Loan from a bank or credit union – This straightforward option works well if you have a good credit score and good collateral (security for the loan) to offer. After mortgages and lines of credit, this option will generally offer the next best interest rates.

4. Low interest rate credit cards – If you’re unable to get a loan from a bank or credit union but you have a good credit score, you could consolidate your debt through a low interest rate credit card. You’ll have to ensure you pay a lot more than the minimum payment in order to get the balance paid off in a reasonable amount of time.

5. Debt repayment program – If you don’t qualify for a debt consolidation loan and you’re struggling to make minimum payments, a debt repayment program might be an option for you. These plans eliminate interest, consolidate debt payments into one affordable monthly payment, and ensure you are debt free within 5 years.

What are the advantages of debt consolidation?

Consolidating your debt is a generally positive measure. It takes some of the pressure off by:

Simplifying the process

When you consolidate debt, you go from having many debt payments to only one. It’s a lot easier to keep track of.

Lowering your monthly payments

Consolidating debt typically results in a smaller monthly payment compared to the original multiple debt payments.

This happens if you consolidate your debt at a lower interest rate or have a longer period of time to repay the loan (also known as the amortization period). Of course, this depends on if you can get approved for a low interest rate debt consolidation loan.

Helping you create a repayment timeline

Having only one monthly payment makes it easier to plan out a repayment timeline, which means you can potentially pay off your debt faster.

This depends on if you manage to get a lower interest rate and keep your current monthly debt payment the same. In this case, more of your monthly payment can go to paying down the principal of your debt since less will be put towards interest.

Boosting your credit score over time

If you’re able to successfully consolidate and repay your debt in a timely manner, your credit score should improve over time. It’s a great way to boost your credit score and take care of your multiple debts all at once.

Giving you a sense of control in a difficult situation

Having multiple debts to worry about involves a lot of mental stress. Consolidating your debts and having one clear, easy-to-follow repayment schedule can give you a sense of control and progress, which will ultimately bring you peace of mind.

What are the disadvantages of debt consolidation?

There are some possible negative outcomes that can arise, so it is important that you also consider the disadvantages involved in debt consolidation.

For example, if you were to take out a new loan to pay off the consolidated debt, you might choose a loan with a variable interest rate. This is an inferior choice than a fixed-rate loan, because it’s possible that your rate could go up.

Another consideration is that you might end up losing some of your assets, particularly if you put your home on the line as collateral with a home equity loan. In these cases, creditors might be able to take your assets if you don’t stick to the repayment plan.

A quick reality check on debt consolidation loans

According to some statistics reported by major banks, the majority of people (up to 78%) were in fact not financially better off once they had repaid their debt consolidation loans. In these cases, they had simply re-accumulated their debt.

One shouldn’t let this statistic be a reason not to get a debt consolidation loan, however. It just means that a consolidation loan has to be used properly if it’s going to be of any benefit to you.

Debt consolidation isn’t a “get-out-of-jail-free” card. It only helps you address your current debts. Once you’ve repaid your debt consolidation loan, you should keep following a budget and maintain controlled spending habits so you don’t find yourself overwhelmed with debts once again.                                           

A false sense of security

One of the negative aspects of a debt consolidation loan is actually related to one of its positive aspects – giving you peace of mind. After repaying the consolidation loan, there is always a danger that you’ll be fooled into thinking your debt problems are over and go back to unwise financial decisions.

A lower interest rate and one monthly payment will give some people a sense that they have more breathing room financially, so they might start spending more even before their consolidation debt is paid off.

Feeling good about yourself and your financial situation when you have a debt consolidation loan is great, but make sure you don’t let that feeling lead you to accumulate more debts.

Simply put, many people get debt consolidation loans because they have found themselves in a situation where they spend more than they earn. Getting the most out of debt consolidation means you have to re-think your spending habits. Again, once the loan is repaid, you don’t want to go back to the way things were before.

If these issues aren’t addressed getting a debt consolidation loan could actually make your financial situation worse since it might push you to overspend even more in the long run. This will cause serious damage to your credit score – and your ability to receive future debt consolidation loans.

Don’t fall into a vicious cycle of debt. Use debt consolidation as a way to reassess your finances and make the right choices going forward.

Know what you’re getting yourself into

Some lenders might offer you a debt consolidation loan that has up-front fees. This is a red flag, and you should avoid it altogether. There are many people out there trying to make money off people in difficult situations. Avoid falling for this sort of thing.

If you don’t have many options, a non-profit credit counselling agency could help. A qualified credit counselor will be able to point you in the right direction when it comes to debt consolidation and getting your finances under control.

Is debt consolidation a good idea?

Before you figure out if debt consolidation is right for you, work out a budget and financial plan and see if it will help you achieve your goals. If you can stay on top of the one monthly payment without derailing your spending, a debt consolidation loan will work for you.

When it comes down to brass tacks, consolidating your debt is almost always a good idea. As long as you are able to secure a lower interest rate than your current situation, you’re moving in the right direction.

Remember, qualifying for a consolidated loan requires you to meet certain conditions. Qualification can depend on factors such as your existing credit score, your current level of income, and more.

To find out more about qualifying for a loan in the context of consolidating your debt, make sure to contact the experts at Lend For All.