Debt consolidation 101: How does it work in Canada?

I’ve helped thousands of Canadian families understand how to deal with large amounts of unsecured debt.

I’m going to break down debt consolidation today. This is a debt consolidation 101 post. It’s a long article—but if you stick with me, you’ll know more about this highly effective method for reducing debt than 99% of Canadians.

Debt consolidation is one of those terms that Canadians have a lot of confusion about. Is it a good idea? Does it wreck your credit? Is it a scam?

By the end of this short guide, you’ll know more about debt consolidation than most Canadians. I’ll answer the questions I hear all the time from 4 Pillars clients including:

What is debt consolidation?
Is debt consolidation a good idea?
What are the advantages and disadvantages of debt consolidation?
What is the difference between debt consolidation versus debt settlement?
Should I use debt consolidation or file a consumer proposal?
Is debt consolidation a good option for paying down credit card debt?

Also, if you’re more of an audio learner, you can listen to my podcast episode on debt consolidation here. Tune in with myself, David Moffatt, and Ryan Brown as we break down the pros and cons of debt consolidation and how it can impact your financial situation.

The basics: what is debt consolidation?

Debt consolidation means taking out one big loan to pay off many small loans.

As the Government of Canada’s Office of Consumer Affairs (OCA) explains, “debt consolidation loan is a loan (usually from a bank) that lets you repay your debts to all your creditors at once.

This means that you only have one monthly payment, often at a lower interest rate than you are paying now. This saves you money on interest fees and lets you pay off your loan faster.”

How debt consolidation works

With debt consolidation, you essentially ask a creditor to loan you one big lump sum of money to pay off all those small debts.

Your new big loan will be a much lower interest rate—saving you thousands of dollars over the next few years.

Is debt consolidation a good idea?

Generally speaking, more Canadians are using tactics like debt consolidation and consumer proposals to get out of serious trouble, rather than declaring bankruptcy. I offer data and analysis of this trend in the section below.

Long story made very short, every year thousands of Canadians have used debt consolidation to reduce their debt.

For those that can’t qualify for a consolidation loan as the debt load is simply unmanageable debt restructuring may be a better option.

Debt consolidation is a legal and ethical way to get out of your overwhelming debt situation.

According to the Government of Canada, “this option [debt consolidation] may be suitable for debts such as those relating to credit cards, public utilities or other consumer loans. However, not all debts can be combined into a consolidation loan — a mortgage cannot be included, for example.”

As I explained, debt consolidation combines your smaller loans into a larger loan with the goal of getting a lower interest rate.

However, you can also use your existing assets (such as your home) to have even more leverage with creditors. So debt consolidation can also involve a secured loan against an asset that serves as collateral, most commonly a house.

Using your house as collateral in debt consolidation can help you negotiate a lower interest rate. With an asset on the table, banks will see you as a less risky investment which means you increase your bargaining power with lenders.

For example, the worst-case scenario for the creditors is they force the sale (foreclosure) of the asset to pay back the loan if payments aren’t met.

The banks never want to be in this position but with an asset, banks feel more comfortable about lending more money to you and earns you an even lower interest rate.

The pros of debt consolidation

Debt consolidation is about increasing your leverage with the primary goal of lowering your interest rate.

The interest rate charged by a financial institution for a personal loan is usually lower than the rate charged for a credit card. As a result, you will save money on interest payments.

This has many benefits:

You can use your assets (such as a home) to secure a lower interest rate.
You protect your credit rating.
Your creditors will be promptly paid in full by the bank.
You will only have to make one monthly payment to your financial institution, instead of a bunch of different payments to different lenders.
You will pay less of your money to interest, getting you out of debt faster.
As long as you follow the terms of your consolidation loan and make your payments on time, your credit rating should not be negatively affected.

The biggest benefit to you is paying less interest though. You work hard for your money and it really is a shame for you to pay high-interest rates if it can be avoided. Paying high-interest rates can turn small loans into large debts over time.

The cons of debt consolidation

Debt consolidation does have a few disadvantages You may save on interest charges, but will still have your debt. So, you will still have to work hard to repay the money you borrowed.

You may still have access to your credit cards — don’t be tempted to use them and go further in debt.

Financial institutions will expect prompt payments and if you found the debt hard to pay before it may still be a challenge to repay the new consolidation loan.

Also, some people use a co-signer to get a consolidation loan. If you can’t make your payments, your co-signer will be left with your debt.

People often use their houses as collateral. If you can’t make the payments, you’ll risk losing your home.

Over the past five years, there are fewer and fewer unsecured consolidation loans given. This is because the bank that gives you the loan takes on all the risk of losing it if you cannot pay it.

Using banks like RBC for debt consolidation

While large banks like RBC offer debt consolidation, often their unsecured interest rates might not be much lower than your current loans and it may be hard to qualify for an unsecured consolidation loan. Large banks are risk-averse—so they will frown on consumers with low income, high debt levels, and blemished credit reports.

If you manage to get a debt consolidation loan from a large bank, you need to be very careful with your payments.

As the Government of Canada warns, “financial institutions may not be as flexible as your creditors. If you run into further problems, financial institutions will generally be less understanding and may refuse to accept a late payment.”

In other words, credit cards will be flexible if you miss a payment. They make money on your missed payments. But a large bank will be less forgiving, especially if you use a secured asset (like your house) with your loan.

When should you apply for debt consolidation?

Debt consolidation is about lowering your interest rate. If you lower your interest rate, a larger percent of your monthly payments will go to paying down your principal, helping you get out of debt faster.

You should use debt consolidation for the following situations.

You are trying to pay down credit card debt. This carries high interest and debt consolidation is a logical tool to use.

You have consumer debt (such as a small collection of debts from retail stores, a high-interest car loan, and other high-interest loans).

Credit card debt is one of the most common reasons why people use debt consolidation. Credit cards can carry a much larger interest rate than even an unsecured loan from a bank.

You aren’t paying down your principle for small loans and are paying high-interest. At this point, your debt might actually be growing every month, so attacking the interest is a good choice.

You have lots of equity in your home. There’s no sense in not using that leverage to save you money.

Debtors with property such as a home or car may get a lower rate through a secured loan using their assets as collateral. Then the total interest and the total cash flow paid towards the debt is lower allowing the debt to be paid off sooner, incurring less interest.

Creditors will also look to see if your income can easily support the monthly debt consolidation payments.

Recognize the warning signs that might lead to debt consolidation

That’s the basics of debt consolidation.

If you’re still with me, I’d like to take a look at some of the bigger financial trends and data from Canadian families in financial distress.

With lock-downs, government programs, and few options for big-ticket purchases (like vacations), COVID-19 pushed Canadians into a new direction: responsible saving.

According to the CHMC, the Canadian debt-to-income ratio declined to levels not seen since 2010.

While this is a promising trend in the short-term, in 2021 as life returns to normal, we’ll see old habits return: buying bigger houses, dreaming about vacations, and returning to confidence (instead of financial conservatism) about our futures.

If we zoom out of 2020, we see dangerous levels of debt and risky financial behaviors.

Since 2009, bankruptcy filings have actually declined in Canada. But the decline in bankruptcy filings does not necessarily mean Canadians have improved their financial security.

New legislation, methods like debt consolidation and consumer proposals, and other factors have opened up avenues for dealing with extreme debt beyond just insolvency.

Most researchers tend to look at bankruptcy to build a picture of Canadians in financial distress. But a family can be in financial distress well before being in a situation of bankruptcy.

For example, one study analyzed the use of payday loans in Canada. It found that the number of payday loan operators has grown, as has the total volume of loans per operator.

Debt: it’s more complex than just income

We often measure financial risk by a metric called the debt-to-income ratio. This metric indicates how much debt is owed for each dollar of household income.

However, the debt-to-income ratio may not be the best indicator of financial distress for Canadian families.

In their study, “Debt and financial distress among Canadian families,” the authors note, “another ratio, the debt-to-asset ratio, measures a family’s resilience to financial shocks. Families with a higher debt-to-asset ratio are more likely to report having experienced a variety of financial problems, like skipping or delaying payments, or using payday loans.”

Debt-to-income ratio is done by dividing total family debt by the total after-tax family income.

Debt-to-asset ratio is obtained by dividing total family debt
by total family assets.

The authors found that debt-to-asset ratio is a better indicator of financial precariousness than the debt-to-income ratio.

As the study shows, debt-to-asset ratio tells a more consistent story than the debt-to-income ratio.

Across all three distress indicators of missing mortgage payments, missing a nonmortgage payment, or taking out a payday loan, people in the highest debt-to-asset groups have a higher probability of reporting distress.

Families in the highest debt-to-asset ratio group were twice as likely to have used a payday loan in the past three years, compared with those in the lowest group (6% versus 3%).

A higher debt-to-asset ratio was associated with a greater probability of missing a non-mortgage payment.

Families with a debt-to-asset ratio above 0.50 had a 13% probability of missing a non-mortgage payment.

In comparison, this probability was 12% for those with a ratio above 0.25 and up to 0.50, and 8% for families with a ratio equal to or below 0.25.

Even further, because people with assets have access to lines of credit or can sell assets to pay off debt when they get in trouble even though they don’t have the income to cover the payments, it’s harder to see the financial distress behind their doors.

This is important as in 2021 we’ll face a period of low-interest rates and temptation for people with jobs to acquire more and more assets: bigger homes, new boats, deals on new cars.

It’s important to always be cautious with debt, even if you are buying an asset. Financial stability is more important than an inflated sense of security from owning a home or borrowing to secure assets.

With the rising cost of housing in Canada, flat income increases for the working, lower, and middle class, and now an uncertain economic future, it doesn’t take much to take the average Canadian family from relative wealth to financial distress.

Watch out for missed payments. Be careful about using your line of credit. And think twice before taking on new debt, even if it is to purchase an asset. Before debt balloons, it’s a good idea to talk to a professional and look for ways to get things under control.

Debt consolidation: Q&As

We’ve helped thousands of families navigate debt consolidation, so here are some rapid-fire questions and answers.

I have bad credit. Can I still qualify for debt consolidation?

Unfortunately, it’s much harder to get a consolidation loan if you have bad credit. Creditors use your credit scores and payment history to determine risk. If you have not always been able to pay your existing debts most lenders will see this as a red flag.

But if you can offer security or a strong co-signer the lender will be more willing to work with you. Make sure you fully understand the interest rates and fees before agreeing to a consolidation loan as with bad credit these can be substantially higher.

What are the requirements to qualify for a debt consolidation loan?

In my experience, creditors are looking for a few things.

First, they want to see an acceptable credit rating (but your credit rating does not always need to be perfect).

They also want to see regular income so they know you will be able to manage the monthly payment.

You need to show a reasonable level of monthly expenses (might be time to cancel the lease on the Lamborghini).

In short, financial institutions want you to demonstrate that you can make the monthly consolidation payment, in addition to paying for your regular monthly bills and expenses.

A blemished credit rating will likely diminish your ability to secure a consolidation loan, therefore it is best to review all your options to deal with your debt and act as soon as possible.

As mentioned, a debt consolidation loan is only one option available to you.

Debt consolidation vs. debt settlement. What’s the difference?

Most of the debt repayment options that people know about are designed to benefit the company lending you money. Creditors do not always care about you or your struggle to climb out of debt. They only want their investment to pay off.

Lending money is about returning a profit. Be careful about the advice you receive—and who is giving it. For example, a non-profit credit counselor might offer a program to settle with your creditors by paying 100% of the debt.

This is wonderful for your creditors. In fact, creditors often fund the ‘non-profit’ credit counselors as the counselors recommend that you pay back everything you owe in full.

Creditors get their money back in full. But for you, the consumer, it will negatively impact your credit rating, as you did not pay back the debt based on the original terms and conditions and there may be a better option.

With the option to settle, you may be able to actually reduce the amount of money that is owed but the effect on a credit rating is often negative since you are not paying the debt back in full or on the original terms and conditions agreed when the credit was advanced.

This negotiation process requires the creditors to agree to the new payment amount and the new payment terms.

So debt settlement can reduce the amount of money you owe but can harm your credit rating.

Without a good credit rating, it becomes very hard to rebuild your finances. Debt settlement can be a good short-term solution for you, but can also have negative consequences on your future finances and you could end up right back where you started. If you are considering any type of debt settlement you need to make sure the

If you are considering any type of debt settlement you need to make sure the option you chose not only deals with the debt but provides a comprehensive credit rebuilding and financial rehabilitation program otherwise you can be left with bad credit for up to a decade and vulnerable to future financial failure.

Debt settlement when done right is an excellent option, it can bring your long-term financial goals closer and make them achievable but done wrong with no plan for financial rehabilitation it will push your financial goals much further away.

What I recommend for Canadians

Should you use debt consolidation?

There are three basic options available to Canadians in deep financial trouble: debt consolidation, consumer proposals, and bankruptcy. We cover the benefits of each debt reduction approach in the video below.

If you have a manageable amount of debt and a good credit rating (plus equity in an asset like a house and good income), debt consolidation is an excellent choice.

For other situations, consumer proposals and even as a last resort bankruptcy might be a better fit.

It’s critical to understand your options and get your own independent advice, as we always say in the debt advisory business, you either represent the creditors or you represent the debtor. It seems impossible to do both.

About the author:

20-year financial veteran Paul Murphy explains the difference between debt consolidation and consumer proposals. Paul Murphy is the author of Beating the Debt Game and hosts a regular podcast on financial literacy.

More debt consolidation resources

How to deal with large amounts of debt

With over 70 offices across Canada, we offer detailed information about the different options every debtor has.

You can meet in-person at a local 4 Pillars office or just receive more information via email. Get more information about your debt option here.

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And finally, here are real stories about debt from Canadians who survived their financial crisis.