Is debt consolidation a good idea?

Is debt consolidation a good idea? Learn how to figure out when debt consolidation makes sense and when there may be better alternatives to address debt.

Author: Sarita Harbour

If you're struggling to pay down debt on multiple loans or bills, you probably wish there were a way to bring them all together under one roof. Well, there is. It's called debt consolidation, sometimes called debt restructuring, and it can simplify debt repayment. But how do you consolidate your debt? And is debt consolidation a good idea for you?

The truth is that it depends. Here's how to get a handle on debt consolidation pros and cons and find out if consolidating what you owe could work for you.

What is debt consolidation?

Debt consolidation loans are usually used to pay off debt from credit cards, credit lines, overdraft balances, and higher-interest loans like payday loans. Here's how it works: someone takes out one new loan to pay off the combined total money owed on several smaller loans or bills. The new loan funds go toward each unsecured credit account, and generally the new loan will be at a lower interest rate than all (or most) of the other credit.

What is debt consolidation vs. a settlement?

Debt consolidation is different from debt settlement or a consumer proposal.

When you consolidate, you'll apply for a consolidation loan through a lender such as a bank, credit union, or other financial institution. They'll review your credit application for factors like your credit score, income, and whether the new loan will be secured with some kind of collateral. From there, the lender will decide whether or not they'll approve the loan, as well as the interest rate that you'll pay, based on the information in the application. When you get a consolidation loan and make all your payments in full and on time, it should not have a negative impact on your credit. If anything, it could give your credit a boost.

Debt settlement refers to the process of creating a formal offer known as a consumer proposal. This lets you settle your debt with your lenders by reducing the amount owed and offering partial repayment at no interest through a trustee in bankruptcy. A consumer proposal is an alternative to declaring bankruptcy, although both have a significant negative impact on your credit.

What are the pros and cons of debt consolidation?

Spiraling debt is more common than you might realize.For some Canadians, paying down debt is preventing them from doing what they want to do, including saving for retirement. In the face of overwhelming debt, consolidation might seem like a golden opportunity.

The reality is that consolidating your debt has both pros and cons. Benefits include:

  • One simple monthly bill
  • Smaller payments overall
  • A lower interest rate that ensures more of your payment goes toward the principal

But debt consolidation also has downsides. You might run into trouble if:

  • The lender places your consolidation loan funds directly in your bank account, tempting you to spend the money
  • Your unconsolidated credit is paid off but not closed, encouraging you to incur more debt on top of the consolidation loan
  • You use the consolidated payment as an excuse to continue poor financial habits such as overspending on credit cards and credit lines followed by repeat consolidation loans

Is debt consolidation a good idea for you?

Debt consolidation can be a lifeboat when you feel like you're drowning in an ocean of monthly debt payments. It can help you really simplify your finances, and the smaller total payment might be easier to fit in your monthly budget.

However, you have to get approved and qualify for an interest rate lower than your current unconsolidated debt rates. And it pays to think carefully before using consolidation as a bandage for poor financial habits: even after consolidation, some people get tempted to continually apply for and use additional credit, find their balances creeping up, and then apply for another consolidation loan. Anyone looking into consolidation needs to be committed to keeping future debt under control.

To learn more about whether debt consolidation makes sense for you, talk to an advisor today.