Debt Consolidation 101

Okay, you have some debt you want to get rid of… Join the club. In a recent Nielsen poll, the number one financial priority goal for Canadians is “paying down debt” – for the 5th year in a row. And the average debt owed by Canadians for each of those 5 years? Each year is higher than the last.

Not surprisingly, there are a lot of ‘debt solutions’ available to help Canadians tackle their debt. As someone who discusses debt every day, I get this question a lot: “When it comes to paying down debt, is it better to consolidate our debts into a line of credit, or just leave them on the credit cards and pay them down one at a time?”

My answer is fairly straight-forward. Debt consolidation is not the answer to solving financial indebtedness. It seems to be the solution touted by many in the industry (you see them on TV, online and hear them on radio ads all the time), but when it comes to identifying and dealing with root causes, debt consolidation does not work. If it is going to help you sleep better, it probably isn’t going to do the trick in motivating you to change spending behaviours. And I guarantee it will take you longer to eliminate the debt.

That said, there’s nothing wrong with wanting to pay less interest – as long as it doesn’t change your motivation. If a zero percent 6-month balance transfer takes the pressure off eliminating the principle, I don’t recommend you take advantage of it!

Before making any financial decision it is important to educate yourself. Here is a brief description of the two debt products referenced so far:

Credit cards are very flexible lending vehicles. Even if you intend to pay them off each month, all the credit card companies require is a ‘minimum due’ payment each month. Interest is charged based on the balance being carried, and if you use the card while paying interest, interest will be owing on new purchases from the day they are posted to your account. If you are trying to pay down a credit card, stop using it to avoid additional interest charges. If you might be tempted to change your payment plan should the credit card company increase your credit line or decrease your interest rate, consider a term loan to commit to a pay-back schedule.

Lines of credit are even more dangerous for those wanting to eliminate their debt. Again minimum due payments are small, and sometimes only the interest owing is required to keep lenders happy. Lines of credit often have much larger limits, especially if they are secured to your home (called a Home Equity Line of Credit). They are dangerous because several thousand dollars can be racked up quickly using cheques, a click of a button or plastic – no questions asked.

The least favoured lending product seems to be the Term Loan. A term loan is a fixed rate/fixed payment/fixed term product. Once the term loan is set-up you are contractually obligated to make your fixed monthly payments until the debt is retired (in the time frame you decide on up-front). Amortization tables dictate how much of each payment is interest vs. principle and this changes over the course of the loan (like a mortgage). Interest charges are front-loaded, meaning a greater proportion of the fixed payments are considered interest early in the term. The interest rate is fixed from the date you sign, so unless you break the contract you are guaranteed to have paid off the debt by the end of the term.

So, if you want to consolidate your debts to help lower the total interest paid, consider the term loan. It can help you become debt-free because of its lack of flexibility, and that’s a good thing.

Finally, try to get into the habit of paying off your credit cards in full. Even if you have 4 outstanding balances, pay them down one at a time while using a 5th credit card for new purchases (and paying it off in full each month). This will ‘stop the bleeding’ and limit the damage done going forward as you work out a plan to eliminate your debt.

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