Throughout our lives, some of us take on what seems like an unsurmountable amount of debt whether it’s because life threw curveballs at us or sometimes we made questionable money decisions just because we could. Whatever the reason, justified or not, it is not a good feeling being bogged down in debt. Studies have shown that there is a link between being trapped in debt and a decline in a person’s mental well-being1https://www.moneyandmentalhealth.org/money-and-mental-health-facts/. I am not a mental health professional, so I cannot expand on that much; but I can assist you with understanding your options when it comes to debt management. For this article, I had some assistance from a local banking professional to explain debt consolidation and how you can get started.
What is debt consolidation?
In simple terms, debt consolidation is the process of combining your debt, which may include loans, mortgages, or credit cards, into one loan for a more manageable monthly payment. Essentially your financial institution of choice lends you money and the proceeds go toward paying your existing debt so that you have a single loan to manage. It is important to remember that it does not eliminate debt, it is merely a way to simplify your debt obligations. If you are considering debt consolidation as an option to better manage your debt, you can inquire with a local financial institution, such as a bank or credit union, about your options.
I usually think of debt consolidation as a last resort when it comes to managing your debt. Before you get to the point of needing to consolidate debt, consider the following lifestyle tips to tackle debt management:
- If you can, pay more than the minimum amount on credit card debt;
- If allowed, pay more on your existing loans;
- If you have a lot of high-interest loans, find out if you are able to renegotiate your interest rates;
- Prepare a budget that incorporates paying debt sooner; and
- Track your expenses and determine areas that you can cut back on.
Types of debt consolidation
Generally, there are three main types of debt consolidation, mortgage secured consolidation loan, cash-secured consolidation loan, and unsecured consolidation loan.
Mortgage-Secured Consolidation Loan
This type uses your property, such as a house or land, as collateral. Collateral is something that you use as a guarantee for repayment of the loan. In this case, your property would be used as collateral, meaning if you default on the loan (i.e. you are unable to make the monthly payments), you run the risk of losing your property to the financial institution and they have the right to sell your property to settle the loan. This type of consolidation loan is better suited for someone who wants to manage a large amount of debt.
Your interest rate for this type of loan may depend on your credit-worthiness, which is a term used to describe how a lender (such as a bank) determines whether you will pay your debt obligations. Some things used to determine your creditworthiness include:
- Whether you pay your existing bills and debt on time;
- The amount of debt you have; and
- Your income level.
Cash-Secured Consolidation Loan
This type uses your cash as collateral. Based on your choice of financial institution, you may be required to put your cash in a deposit account for the bank to hold. Sometimes these loans allow for flexibility – if you begin to pay down your debt and there is room for cash withdrawals, the financial institution may allow you to withdraw funds that exceed the loan amount (this is referred to as your equity in the loan). Similar to mortgage-secured consolidation loans, your interest rate may depend on your credit-worthiness.
Unsecured Consolidation Loan
This type of loan is unsecured, meaning that no collateral is needed to obtain it. Due to it being an unsecured loan, there may be a lower cap for the amount of debt you are able to consolidate, so these are usually for smaller amounts. Also, without collateral, you may be subjected to a higher interest rate than the other types of consolidation loans (usually 10-20%). This is because if you are unable to meet your loan payments, the financial institution has nothing to help settle the loan.
Pros of Debt Consolidation
- Debt consolidation allows you to finance all of your debt in one place, with one monthly payment.
- It sometimes allows for a lower interest rate and a longer payment term, meaning you can have a lower monthly payment. This frees up monies to assist you with better financial plans. With the extra disposable income, you can pay extra to the principle, build your savings, and/or treat yourself to something nice every now and then. Remember to avoid taking on extra debt now that you freed up some cash; use the cash wisely.
- Some consolidation loans allow you to pay extra on the principle, which would allow you to pay the loan faster.
- There is a possibility that it will help you to achieve a better credit score; this will be important once the Credit Bureau is fully operational. We plan to write an article on this to explain the credit bureau and the credit scoring process at a later date. For now, it is important to know that a low credit score can (possibly) negatively affect your chances of obtaining more credit, renting prospects, and any other opportunities that may require reviewing your credit score.
Cons of Debt Consolidation
- It is possible that you may pay more in interest over time, even if you have a lower interest rate than before. Sometimes, to assist you with getting a lower interest payment, the bank allows you to pay over a longer period of time, which causes the interest payment to accumulate.
- As stated before, a consolidation loan does not solve your financial issues. It is merely a tool to help you manage your debt.
Getting Started
If you are sure that debt consolidation is for you, some things you may need include:
- A print out of all loans and/or credit card statements, showing the balances and payment history;
- A recent job letter;
- A pay stub that shows your monthly income (if you get paid bi-weekly, print the last two stubs); and
- If you are applying for a mortgage-secured consolidation loan, it may be helpful to have an appraisal of your property;
- If you are applying for a cash-secured consolidation loan, it may be helpful to have a print out of your account showing the amount of money you can use for collateral.
Shopping around
It is always wise to shop around for a financial institution that offers the best package for your situation. While shopping around, some key questions to ask include:
- Am I allowed to pay extra on the principle of the loan? If so, how often and how much can I pay per year?
- Is the interest rate fixed or is it tied to the prime rate? The prime rate is set by the Central Bank and it can fluctuate; therefore, if your loan’s interest rate is tied to the prime rate and prime rate increases, the interest rate on the loan also increases and vice versa.
- Are there any penalties if I pay the loan off early?
- What is the expected term on the loan? (How long will I be paying on this loan?)
- What is the usual time frame to complete the application and approval process for the loan?
- If I am approved for the loan, what are my next steps?
Final Notes
Getting yourself out of debt is not an easy task, but it not impossible. Here are some final notes for trying to manage your debt:
- If you find yourself in a bind, do not be afraid to talk to your bank’s representatives and ask for help.
- It is a frustrating task, but trust the process. These things take time.
- Creating a financial plan to get out of debt takes a lot of discipline and help.
- Try your best to avoid taking on additional debt as you begin to see freed up cash.
