The basics of debt consolidation in Canada
We hear a lot of talk about "debt" in the news today. We hear about the national debt, mortgage debt, student loan debt, auto loans, personal loans, financing agreements, and myriad other forms of debt. And the unique and creative ways that companies develop to keep consumers in debt seems to grow by the minute. Indeed, it seems almost as though being in debt is just the way things are, and that there's no way around it.
At the start of 2020, Canadian consumers owed nearly $100 billion in credit card debt. Canadians also owed an average of $20,160 per automobile, an average of $180,000 in mortgage debt per family, and a staggering $28 billion in total student loan debt.
Now of course, these last two categories of debt-mortgages and student loans-are different from other classes of consumer debt in that they are an investment in one's future. After all, taking out student loans to further your education will likely result ultimately in higher career earnings. And taking out a loan to buy a house is an investment because real property is statistically likely to appreciate in value over the long run.
But the first two classes-auto loans and credit card debt-represent a large portion of consumer debt that is less likely to pay a return sometime in the future. These classes of debt are also quite easy to rack up, and to rack up quickly. What is more, steep interest rates and enticing minimum payment structures operate to keep consumers in debt, not help them get out. In this vein, debt consolidation can be an extremely useful tool to retake control of your finances and put you on track to reach your financial goals.
In this article, we're going to take a look at debt consolidation programs. Our goal is to explain what these programs are, how they operate, and the benefits and drawbacks of using a debt consolidation program. We hope you can use this information to make an informed decision as to exactly whether using a debt consolidation program is right for you.
Debt consolidation overview
So what exactly is debt consolidation? Well, in a sense it's exactly what it sounds like! It's a way to consolidate your existing debt. To consolidate, of course, means to unite; to combine; or to bring together into a solid, unified whole. So debt consolidation, by extension, means to combine all the debts you owe into one, single debt. In other words, it means bringing together all the debts you owe to all your various creditors into one easy-to-manage package.
Now, debt consolidation does not, as a general rule, reduce the amount of debt you owe to various creditors. Rather, debt consolidation is a financial tool designed to make it easier to manage your debt.
Debt consolidation vs. debt management
You may be wondering, "What's the difference between debt consolidation and debt management?" That's a great question, and we hinted at the answer a bit earlier, but so it's perfectly clear: debt consolidation is simply one method of debt management.
Debt management can take a variety of forms. It can be as simple as identifying all your various debts and making a plan to pay them off, to budgeting a little extra money each month to go toward debt payments, to more extreme measures like saving as much as you can in order to pay off your debts in a large lump sum. In other words, debt management is nothing more than you making a financial plan that ensures you're able to repay all the money you owe on time. Debt consolidation is just one component of a larger debt management plan.
How does a debt consolidation program work?
We mentioned earlier how debt consolidation is a financial tool intended to help you manage your debt. In this section, we're going to take a look at exactly how these plans work.
Remember that debt consolidation simply means bringing all your debts together under one roof. Of course, in all likelihood if you have multiple debts, you likely owe money to more than one entity. For example, you could owe $10,000 to credit card company A, $5,000 to credit card company B, $8,000 to Bank A on an auto loan, and $2,000 to Hospital for medical bills.
Owing money to these four different entities, of course, means you'll have to make four separate monthly payments, and each payment will probably be due on a different date. You'll also likely be paying four different interest rates. Keeping track of multiple payments, all of which are likely due on different days, and subject to different interest rates can be demanding and exhausting. Having all these moving parts up in the air also dramatically increases the risk of missing a payment! And even if you diligently track all your payments and due dates, it sometimes just stops making sense to create so much extra work for yourself. This is where debt consolidation programs come into play.
Continuing with the example set out above, let's just assume, for the sake of making our calculations easier, each of the above loans has 10 equal payments left. Let's also assume your interest rate with credit card company A is 21%, your rate with credit card company B is 18%, the rate on your auto loan is 6%, and the rate on your medical bill is 4%.
This renders the following monthly payments on each debt:
- Credit card company A: $1,210
- Credit card company B: $590
- Auto loan: $848
- Medical bill: $208
So, added together, your total monthly debt obligation would be $2,856, all due to different entities at different times. But if you enter a debt consolidation program, you'd make just one monthly payment to a single entity, at a single interest rate!
Debt consolidation companies do this by essentially "buying" the debt from your creditors. In other words, the debt consolidation company will pay your creditor a portion of what you owe them, in exchange for the creditor transferring ownership of the debt to the debt consolidation company. The creditors benefit by receiving immediate payment on the debt, the debt consolidation companies make money by collecting the entire debt from you (so they profit the total amount of the debt less the amount they paid to the creditor to buy it), and the consumer benefits by having just a single monthly payment to a single creditor instead of having to make multiple payments to multiple entities!
When debt consolidation can be right for you
As you can see, debt consolidation is a useful tool that can go a long way in streamlining your finances. But debt consolidation is particularly useful in a couple of situations.
The example that we set out above identifies the first situation in which debt consolidation makes sense. If you owe multiple debts to multiple entities, requiring you to make multiple payments on different due dates, debt consolidation can make your life much easier.
Student loans are another prime example. Over the course of my higher education, I took out 6 or 7 federal student loans. Although all my loans were from the government, meaning I technically owed money to just one entity, each loan came with its own due date. So, before I consolidated my student loans, I was making 6 or 7 small student loan payments each month. But after I consolidated, I now make a single payment on the same day each month. I also have just one interest rate, which brings us to our next point.
The second situation in which debt consolidation can help consumers is if you owe money on multiple high-interest accounts, such as credit cards.
The average interest rate on a consumer credit card is just over 19%. Paying 19% interest on multiple credit card balances can add up very quickly, and it can make it very difficult to ever pay off the card. For this reason, many debt consolidation companies will offer you a lower interest rate than credit card companies if you consolidate multiple accounts with them. This can help you get out from under credit card debt and get your finances back on track.
Benefits of a debt consolidation programs
We've covered a lot of this already, but to summarize: the main benefits of debt consolidation are (1) that consolidation makes it easier to manage your monthly debt obligations by making it so that you only need to make one payment to cover all your debts for the month; and (2) consolidation can help you lower the interest rate on high-interest accounts.
Drawbacks of debt consolidation programs
Debt consolidation is a great tool that can help consumers truly achieve financial freedom. But, like every good thing, it isn't without its drawbacks. While debt consolidation often results in the consumer paying less interest overall, it can cause you to pay more interest on some accounts that you would have otherwise paid.
For example, let's return once more to the example we set out earlier with the two credit card companies, the auto loan, and the medical bill. Let's say you consolidate all those debts and the consolidation company offers to average all four interest rates and charge you the average of those rates.
Those interest rates were 21%, 18%, 6%, and 4%. That means the average rate comes out to 12.25%. So, as you can see, you'd be paying a lower interest rate on your credit cards, but a higher rate on your auto loan and your medical bill. Still, with a total principal balance of $2,500 each month and an interest rate of 12.25%, we arrive at a total payment of $2,806. As you can see, this is $50 less per month than the $2,856 that you would have been paying if you didn't consolidate!
Another drawback worth mentioning is that debt consolidation prevents you from paying off any individual debt early. Because consolidation wipes out all your individual debts and replaces them with one new debt, you're stuck paying on the one new debt until it's gone. Once again, this isn't necessarily a bad thing, especially if you benefit from a lower overall interest rate or had no plans to pay off any debts early. But you could end up paying a bit more interest over the life of the debt if you could have paid off a high-interest debt earlier without consolidation.
Whether debt consolidation is right for you is a very personal decision that is entirely dependent on each consumer's unique financial situation. Still, debt consolidation is an extremely useful tool that can go a long way in helping you not only regain control of your finances, but also to achieve financial freedom.