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How Does Debt Consolidation Work?

The Borrowell Team Apr 06, 2020

If you have multiple sources of high-interest debt, you might consider combining them into one monthly loan payment. Debt consolidation is when you get a new loan to pay off a number of smaller (typically) unsecured loans like bills, credit cards and other high-interest debt.

Debt consolidation has many of the same benefits as refinancing but with a different goal. Consolidation looks to make payments easier to manage by streamlining them into one loan. Refinancing, on the other hand, looks to optimize a debt by replacing one with another that has more favourable terms (better interest rates or repayment schedules).

 Like any financial decision, it’s important to take the time to understand both the pros and cons.

What are the Pros?

Lower Interest Rates

Consolidating your debt can also save you thousands of dollars by reducing your overall cost of borrowing. A typical credit card debt has an interest rate of 19.99%. If you get behind on payments, it’s easy to get caught in compounding interest – meaning, you’re essentially paying interest on your interest. If you get behind, the issuer can also increase your interest rate by as much as 29.99%. 

Personal loans and lines of credit often have lower rates, which means more money is going towards principal and less going towards interest- saving you money in the long run.

Get Out of Debt Faster

Let’s say you currently have a $10,000 balance on your credit card with an interest rate of 19.99%. If you make payments of $250 each month, it would take you 5 years and 7 months to pay off your debt, and you’d end up paying $6,547 in interest.

Compare this with a loan that has an interest rate of 10.5% which could help you become debt-free in just three years and pay only $1,734.93 in interest. This means you’re saving an estimated $4,812.

Cash Flow Relief

Depending on your financial situation, consolidating can provide you with some much-needed cash-flow relief. If you’re able to get a longer-term amortization period, you can spread your debt over time and reduce your monthly payments. 

On-Time Payments

Instead of juggling multiple lenders and debts, you can focus on making just one payment. That means you’re less likely to miss a due date or pay late because you’ve lost track (a big deal since 35% of your score is based on payment history.)

An ‘End Date’

Debt can also take a mental and physical toll, especially when you don’t have a plan to get out of it. When you’re only making the minimum payments on your credit card balance, it can sometimes be unclear when you’ll be debt-free. 

Often, a single loan gives you the option of a 3-year or 5-year term, providing you with an ‘end date.’ This provides a goal that can help you build better habits and a more stable financial future. 

What Are The Cons?

Additional Debt

Taking on another loan could have a negative impact if you continue to also use your previous accounts (like credit cards!). The aim of consolidation is to help you tackle debt, not incur more. There are huge advantages as long as you're managing your debt responsibly. 

Difficulty Getting Approval

A debt consolidation loan can sometimes be hard to obtain, particularly if you don’t have collateral like a house or other form of equity. There are still lots of options including getting a co-signer or paying a slightly higher rate.

Types of Debt Consolidation

If You’re a Homeowner

If you’ve built enough equity in your property, you can roll your debts into your mortgage with home equity loans. By doing this, you’ll almost always pay a lower interest rate than if you pay your debts separately. However, in order to do this, you must refinance your mortgage which might incur fees or penalties. 

When it comes to adding debt to your mortgage, there are two main options: you can add it on top of your mortgage by refinancing, or using a Home Equity Line Of Credit (HELOC).

Refinancing Your Mortgage

Adding your debt to your mortgage usually has the highest savings, but you have to make sure you’re ok with the new payments. Since your debts are being added, your mortgage payments might be higher, also you should also be careful as a longer amortization could also mean you pay more interest over time. However, if the goal is to reduce monthly payments, you may decide a longer period is worth the higher overall cost. 

Home Equity Line Of Credit (HELOC)

Using a HELOC to pay off your debts isn’t likely to result in as big a cost savings as adding it to your mortgage since interest rates are usually higher; however, you’re still likely to save vs. paying off the debts individually. 

Personal Loan

Although a personal loan usually comes with a higher interest rate than adding your debt to your mortgage, it’s usually a lot lower than the interest rates charged on credit cards and payday loans. The benefit of a debt consolidation loan is that it comes with a repayment schedule that gets you to pay the debt back. You can learn more about the application process here.

If you’ve fallen behind on bills and your credit score isn’t as good as it once was, you may want to take time to build your score first. You can also look to a credit counsellor who might be able to help you with debt settlement.  

The Bottom Line

Making sure you have a good credit score is the key to helping you get the best interest rate. It can sometimes be worth investigating what you can do to improve it before applying for the loan. If you aren't a member and don't know your score, you can get your free credit score, as well as personalized tips for how to improve it when you become a member. You can also see what products you qualify for and your likelihood of approval. 

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