Debt consolidation vs. consolidating credit: What’s the difference?

Financial jargon can be murky at the best of times. Downright frustrating when you’re sinking in the depths of unmanageable debt. You’ll often hear “consolidation” recommended as a top option to simplify payments and reduce costs. But it’s not always clear what that means.

Here, we aim to provide some clarity on your options — including an overview of how each solution works, situations where each may be practical, and their potential drawbacks.

Debt consolidation loan

Debt consolidation is the process of securing a personal loan from a bank or private lender to pay off multiple outstanding debts. This loan would ideally provide a lower interest rate than your existing debts and be sizable enough to combine (or consolidate) all unsecured debts (e.g. credit cards, personal loans, etc.) into a single monthly payment.

What are the benefits of debt consolidation?

A favourable consolidation loan would help you to:

  • save money,
  • simplify your monthly budget, and
  • repay your debt faster without significantly damaging your credit.

Because your loan should have a lower interest rate than the debts you’re consolidating, it would ideally grow much slower than a typical credit card or a payday loan. This means you could put more funds toward the principal value every month, making it easier to pay off.

It may also help you decrease your utilization rate, prevent missed or partial payments, and avoid a Bankruptcy, Consumer Proposal or debt management plan — all of which reduce negative impacts to your credit rating.

What are the drawbacks of debt consolidation?

There are two main concerns to be aware of:

Re-fueling the cycle of debt

The biggest risk is your debt may actually increase over time. Most lenders will not require you to cancel credit cards or lines of credit as a prerequisite to receiving a consolidation loan. Once you’ve paid off your revolving credit, your own self discipline is the only thing stopping you from using it again.

Increasing the cost of certain debts

Another common pitfall is not factoring all interest rates into your consolidation plan. Lenders can often make some extra money at your expense by giving you precisely what you think you’re looking for.

For example, imagine you want a $15,000 consolidation loan to pay off your two credit cards ($6,300 and $3,500, at 19.99% APR), a line of credit ($4,100 at 4.5% APR), and a personal loan ($1,100 at 6.4% APR). Your bank offers you the full value at 10.5 percent over five years — two and a half percent less than the average of all your existing debts.

At 2.5 percent less than the average of your existing debts, it certainly looks like a good deal. But is it really?

Of course, it would make sense to pay off your credit card balances because the annual interest rate is nearly half what you’re paying right now. This could save you $83 per month or up to $4,980 over five years. However, you would not want to consolidate your line of credit balance or your personal loan. It would nearly double your interest payments and could cost you close to $1,000 more over the same period. 

You could decide to accept only the $9,800 need to pay off your credit cards and continue making payments on the lower interest debts as usual. However, depending on your financial situation, you may benefit more from a different credit consolidation option discussed below.

Who would benefit from debt consolidation?

Consolidation loans can be a highly effective option, but they’re not right for everyone. Those who benefit most from debt consolidation typically have:

  • A relatively good credit history to qualify for a reasonable loan value and fair interest rate.
  • Rigorous self discipline to either cancel revolving credit accounts or at least stop using these accounts until you’ve repaid your loan.
  • Strong budgeting skills.
  • Financial means to make a single large monthly payment.

Other options to consolidate credit

Debt consolidation is not the only tool available to consolidate your credit — nor is it always the best. Depending on your situation, one of the following options may provide the simplicity, financial relief, and structure you require to eliminate your debt.

Credit Card Balance of Account Transfer

Credit card providers will sometimes offer you the opportunity to transfer a prequalified balance from third-party credit cards at an extremely low rate (e.g. zero to five percent). These balance of account transfers are usually valid for a limited time (usually six months to a year) and may also include a one-time transaction fee of one to three percent on any funds transferred. 

This option can be helping in reducing the amount and cost of your credit card debt. However, approach these offers with extreme caution and be sure to read the fine print. The bank or card issuer will often charge the full interest rate on the entire balance transferred if you fail to pay it off within the specified offer period — which can create serious difficulties if you’re not prepared.

Line of Credit

Credit cards interest rates can range anywhere from 12.99 to 29.99 percent in Canada, while most lines of credit hover between four and eight percent. Paying off your credit cards with a line of credit may therefore be an advisable option to reduce your monthly interest payments. Arguably, this should slow the rate your debt is growing and allow you to pay it off more quickly.

A word of caution, though. Many lines of credit allow for interest only payments. You’ll need to be diligent about paying down the principal value, else you could find yourself paying more in interest — just over a longer timeframe. 

Borrow from family or friends

Depending on your relationship and the amount of debt you owe you may be able to borrow money from a trusted friend or family member to pay off some or all of your existing debts. Ideally they’d be willing to lend this money interest free, with a commitment on your part to pay them back in a timely and fashion.

However, there are three obvious concerns with this option:

  1. The debt will almost certainly stress your relationship, potentially past the breaking point.
  2. Your friend or loved one may (intentionally or inadvertently) put themselves in a difficult financial position to help you out.
  3. You could run into further financial difficulties down the road which may force you to choose between repaying your loved one and paying your bills.

Be sure to discuss these matters candidly and extensively before any money changes hands. It’s also advisable to put any agreements in writing.

Debt Management Plan

A debt management plan is a service provided by credit counselling organizations to pay down many of your unsecured debts via a single monthly payment. The credit counselor will negotiate with your creditors on your behalf both to secure their participation as well as reduce (and ideally eliminate) interest charges. You would make only one monthly payment to the credit counsellor, who distributes these funds to your creditors.

While debt management plans can be effective, there are some concerns to be aware of:

  1. This process is not legally binding on your creditors — Any creditor may walk away from the agreement at anytime. They may also resume your previous interest rate and commence or re-commence collections activity.
  2. Not all debts may be included in a debt management plan — Usually these are limited to credit cards and personal loans. Certain creditors like Canada Revenue agency will not work with credit counsellors at all.
  3. A debt management plan will show up on your credit report — You will have the same R7 rating as you would with a Consumer Proposal.

Consumer Proposal

A Consumer Proposal is a formal debt solution provided by the federal government under the Bankruptcy and Insolvency Act (BIA) and which only a Licensed Insolvency Trustee may administer. This legally binding agreement would consolidate all your debts into a single, interest free monthly payment often at a fraction of their original value.

You may pay your Consumer Proposal either as a one-time lump sum or in monthly installments over a period of up to five years. Because a Consumer Proposal is based on your ability to pay, these payments would be affordable within your budget and provide a clear path for you to become debt free.

As above, there are some potential drawbacks of a Consumer Proposal you need to be aware of:

  1. Acceptance is not guaranteed — A majority of your creditors by dollar value must vote to accept the proposal.
  2. It will damage your credit rating — The debts included will reflect as R7 on your credit report for six years from the date your proposal went into effect.

However, these drawbacks are usually more than offset by the following benefits:

  1. Immediate stay of proceedings — A proposal halts all collections action, wage garnishments, and court judgements as long as you fulfill your statutory requirements.
  2. Legally binding on all creditors — All unsecured creditors must participate in an accepted proposal, and none can back out as long as you fulfill your statutory requirements.
  3. Significant cost savings — Proposal payments are interest free, and the proposal itself can often reduce the amount you owe by 50 percent or more.
  4. Personal and financial growth — Everyone who files a Consumer Proposal must attend two financial counselling sessions to help build budgeting skills and improve their relationship with money.

Choosing the right solution for you

With so many different consolidation options to choose from, it can be difficult to know which one is best for you. Licensed Insolvency Trustees always offer a no-obligation Free Confidential Consultation to review your situation, understand your challenges, and discuss your goals. They will thoroughly explain every solution available to you and offer an unbiased opinion on which one(s) would likely work best for you.

If you’re struggling with significant debt, having trouble keeping up with payments, and worry nothing you do seems to be helping, you don’t have to struggle alone. Reach out to MNP today to discover how you can begin getting a financial fresh start today.