Understanding debt consolidation: what it is, how it works, and how to choose the right option

By Becky Western-Macfadyen, Financial Coaching and Education Manager at Credit Canada

As told to Ian Portsmouth

Here’s the answer to this week’s reader question.

Can you cover all your debt from more than one account and pay monthly payments to only one account?

—Marcio

How consolidating debt works in Canada

Debt consolidation is often misunderstood, so it helps to start with a clear definition. Essentially, it’s the practice of combining multiple debts into a single credit account and making one regular payment, usually monthly. There are benefits to debt consolidation.

One is simplification: instead of managing several due dates, interest rates and balances, there is just one account to track. That alone can take a huge load off your mind.

Another is cost reduction: consolidated debts usually come with a lower interest rate, so more of each payment goes toward the principal (what you borrowed) than to interest charges (the fee for borrowing).

And, when done properly, debt consolidation can create the breathing room you need to reset poor financial habits, build an emergency fund and avoid falling into another debt cycle.

Which debts can be consolidated?

Before we dig in, here are two general types of credit. Secured credit is a loan that is tied to an asset (such as your car or home), so if you default on the loan, the asset is returned. Unsecured credit isn’t tied to an asset, so interest rates tend to be higher than secured. 

Typically, debt consolidation is applied to unsecured debts, such as credit cards, certain lines of credit, payday loans and even government debt—tax arrears, for example. Generally, you wouldn’t consolidate secured debts because they’re tied to an asset. Those already come with relatively low interest rates, and there’s property on the line, so rolling them into a consolidation doesn’t make sense.

Common ways for Canadians to consolidate debt

There are different ways to consolidate debt, and choosing the right one depends on your particular situation. Here’s a quick rundown:

Debt consolidation loan (DCL): You borrow a lump sum from a bank or specialized lender, use that money to pay off multiple debts, and repay the loan over a fixed period at a set interest rate. If you have a decent credit rating, you can get a DCL with a favourable interest rate. But a DCL could cost you more in the long run if the loan term is long, meaning more interest paid over time.

Line of credit (LOC): An LOC can be secured or unsecured, and offers flexibility because you can pay down as much of the loan as you want each month, as long as you cover the accrued interest. However, because an LOC is a revolving type of credit, you can continue to borrow up to your credit limit—which runs against the purpose of debt consolidation. 

Home equity line of credit (HELOC): This is a specialized LOC that uses your home as collateral. A HELOC is inexpensive, but it puts your home at risk if you default on the line of credit.

Credit-card balance transfers: You move debts from one or more credit cards to a single one, often with a very low interest rate—sometimes 0%—for a promotional period that typically lasts six to 12 months. It can give you short-term relief but usually costs 1% to 3% of the transferred balances and leaves you with high-interest credit card debt if you don’t pay off the balance during the promotional period.

Debt consolidation program (DCP): This approach to debt consolidation doesn’t involve any borrowing. Instead, it’s a structured plan offered through a non-profit credit counselling agency like Credit Canada. Instead of taking on new debt, the agency negotiates with creditors on your behalf to reduce or eliminate interest payments on your debts; the principal owed remains the same. In a DCP, you make one monthly payment to the agency, which then distributes the funds to creditors until the various debts are repaid.

Consumer proposal: Similar to a DCP, a consumer proposal consolidates multiple debts into a single payment, often with reduced or no interest charges. But in a consumer proposal, your principal can be negotiated down—sometimes significantly. Other key differences: a consumer proposal is a regulated insolvency process administered by a licensed insolvency trustee, and its terms are legally binding for all parties involved.

How consolidating debt affects your credit 

A consolidation loan may cause a small, temporary dip in your credit score due to a hard credit check, but it tends to help your rating over time by lowering your credit utilization. The caveat is that closing multiple accounts can also drag down your score by reducing your average account age—although that hit is usually temporary if you stay focused on repayment. When you’re paying off debt, your credit score isn’t what matters most. By the time it matters again, you’ll be in a much better position.

Both DCPs and consumer proposals result in an “R7 credit rating,” which tells potential lenders not to give you more credit. This applies for the duration of the plan plus two years in the case of a DCP and three years with a consumer proposal. The trade-off is that most people who need a DCP or consumer proposal already have a poor score from high credit balances, so either approach lets them rebuild from a clean slate.

Who is debt consolidation good for?

If you’re meeting your minimum payments but your balances aren’t declining, or if a debt-free timeline stretches decades into the future, it may be time to consider debt consolidation. You’re a good candidate for consolidation if you have a steady income, want to repay what you owe and are being suffocated by large debt and high interest rates. Critically, you need to be ready to stop borrowing money—especially using credit cards—and commit to a budget. Consolidating your debts and then running up more debt is the biggest mistake people make with debt consolidation.

If your income doesn’t even cover basic living expenses or you’re genuinely unprepared to change your habits, then debt consolidation may not help you. If insufficient income is the root cause of your debt troubles, you need to increase your income, reduce your expenses, or both. If you can’t do that, insolvency may be an option.

Watch out for debt consolidation pitfalls

Be very wary of large upfront fees: a reputable non-profit or licensed insolvency trustee will never ask for thousands of dollars before helping you. And be skeptical of guarantees that sound too good to be true. Debt settlement companies—which are different from both credit counseling agencies and insolvency trustees—operate as fee-for-service businesses with no regulatory backing and no power to enforce creditor agreements. If a creditor says no, a debt settlement company can’t do anything about it. Meanwhile, if you’ve stopped making payments while waiting for a deal that never comes, the consequences can be severe. Similarly, avoid so-called debt repair companies, which claim to help consumers improve their credit ratings rather than manage their existing debt.

Life after consolidating debt

Once your debt is paid off, it’s crucial to create and stick to a realistic budget and build an emergency fund. Even $1,000 in savings means you won’t need to reach for a credit card or line of credit the moment your car breaks down or an unexpected bill arrives. You want to make sure you’re breaking the debt cycle for good.

If you’re unsure where to start your journey out of debt, the first step is simply to get information. Don’t hesitate to talk to a licensed credit counsellor—their advice is free, the conversation is confidential, and there’s no judgment or any obligation to move forward with a plan. 

Understanding the available options and their implications will help you make more informed financial decisions. From there, your focus can shift from managing debt to building long-term financial resilience.

Ian Portsmouth is an award-winning writer and editor specializing in business and personal finance. He is based in Toronto.

Read more from this issue of The Get:

1. Mother Knows Best: The best financial advice from Canadian moms
2. Never bothered to calculate your net worth? It’s real easy math (promise)
3. MVP: Carlene Higgins on starting a beauty brand at 50
4. How to teach kids about money, even if they’d rather spend than save