If you’ve done the exercises in the first debt post, congratulations! Hopefully you’ve already been able to reduce your interest rates. We don’t want to be paying any more than is necessary. Interest is money down the toilet and we have much better ways to spend that cash. If making those calls or moving things around didn’t have any big impact, there are more ways to go about it that can take a little more work.
If you’re considering one of these options, great! It means you recognize a problem and are thinking of ways to fix it. My caution is to make sure you have done an analysis of where your money has been going first. If you are still spending more money than you make, no amount of moving things around or lowering interest is going to solve your problem. These are tools to massively reduce interest. No tool will be effective in clearing debt if your income and spending aren’t in line and if you don’t have a solid commitment to stop spending on credit. Far too many people go out and do a big consolidation and then with their newly paid off credit cards go out and start spending on credit again. If you aren’t committed to stopping the over-spend that caused the debt, consolidating is not helping anything you’re just giving yourself more rope to hang yourself with.
It is important that you gauge your commitment to the process of paying down debt before doing these sort of consolidations, especially those that involve your house. Consolidating in these ways can be a life saver in paying down debt and reducing costs significantly while you do. They also can become a way of postponing taking responsibility and making the necessary changes to look after the debt. So take an honest look at where you are in terms of habits and drive to get rid of the debt and make choices here that will work with you instead of against you.
Now that we’ve got that out of the way, lets talk about the different types of consolidation options. Outside of consolidating yourself to one credit card or line of credit with a lower rate via balance transfers, there are three main types of consolidation options.
Consolidation loan
There is a straight up consolidation loan where you take several debts and put them in one place. One great thing about consolidation loans (aside from the better rate) is that it is a loan with a monthly payment that will actually pay off the amount borrowed in a set amount of time. Credit cards and lines of credit don’t have that end date in mind. You could owe an amount on a credit card and make minimum payments for decades before actually paying it off.
Credit cards and lines of credit are also revolving types of credit, meaning that once you make a payment on them that amount becomes available to spend again. This makes it easy to stay in the cycle of debt. Consolidation loans come with a set amount of time to repay and a set repayment amount. This can be hugely advantageous if you aren’t super disciplined in your repayment amounts.
It is very important to keep in mind that the whole purpose of this activity is to lower your rate. If the bank offers you a consolidation loan at 8%, do not consolidate in your student loans that are currently at 6%. If the bank offers you a consolidation loan at 19%, run for the hills. This may seem like an obvious statement, but many a smart person has done this, simply because they didn’t read the fine print or ask the necessary questions. Goal number one in consolidating is to lower interest rates. If you can’t accomplish this there is no real purpose to doing a consolidation loan.
If you haven’t had great repayment history, credit issuers may not be keen on even giving you a consolidation loan. As your debts come down and your consistent payments are registering with your lenders you will be in a better position to apply for this type of loan at a rate that would even make it worthwhile doing.
Home equity line of credit
The most commonly recommended option by many banks if you’re a home-owner is the home equity line of credit (HELOC). Consolidating using the equity in your home to secure a better rate means taking your debt from unsecured to secured. Unsecured debt, like most credit cards for example, means that if you stop making payments the worst that will happen is they will put you in collections. Secured debt, such as a home equity line of credit, on the other hand means that if you fall behind on your payments they can seize the asset, in this case your home. This is why you get a much better rate. This isn’t necessarily a reason not to take this route, it just means that you have to be even more committed to having an emergency fund and having a working plan so that losing your home doesn’t become a reality.
Lines of credit, including the home equity line of credit tend to have interest only minimum payments. So if you are charged $60 in interest during a month, your minimum payment would also be $60. As most people only pay the minimum payments, this can mean this loan will never be paid for. This is just one of many reasons it is so easy to run them up and never really pay them down. Unless you have a solid debt-repayment plan (which we will create in part 3) this option can become just another easy way to owe a pile of money and ignore it forever. We want an end date to this debt. This option requires more discipline in terms of making consistent payments that will have it paid in a set time. On the flip side of that, it gives you the option to lower monthly payments for short term times of financial stress. So depending on your situation that flexibility can be a pro or a con here.
Also bear in mind that if you sell your home, this will be paid out with your mortgage from the proceeds of the sale. This can drastically affect your entire financial picture and your choices so it’s important to consider before signing up.
There’s lots to consider before going for this option. It can have massive rewards in lowering costs of debt and flexibility, but your home is on the line. So be sure to really take into account your entire financial situation and habits before jumping for the great interest rate.
Mortgage re-finance
If your home is up for renewal and you are thinking about rolling the debt into your mortgage I have some words of caution first. While you are lowering your interest rates which is good, you will be significantly increasing the amount of time it takes to pay off the debt by default. So instead of paying a car loan of $20,000 for 3 years at 7% interest for example, you end up adding it on your mortgage which is at 3%. This might seem like a win, especially since you also no longer have a $450 a month payment to make. But if your loan lasts 3 years and your mortgage is for 25 years, mathematically you aren’t winning at all with the interest costs. Plus you’ll be paying for that car long after it’s useful life has passed and you’ll pay significantly more interest over the life of the loan.
The only way that rolling debt into your mortgage is a good idea is if you are diligent enough to set aside your debt repayment amount in a savings account and then make prepayments on your mortgage. Mortgage prepayment options vary significantly so make sure you can even do this before starting. Banks set limits on how much you can prepay and when so make sure you are clear on these rules otherwise it’s all for not.
The biggest problem with consolidating to a mortgage isn’t even the extra time and money it will cost you to get the debt gone if you aren’t pro-active about changing it, It’s that the debt feels like it’s disappeared. While it feels good to have that weight off, it also tends to take out any urgency to actually make the changes in spending and debt repayment amounts to get it gone. I don’t recommend you start out with this as an option. The temptation to ignore the debt and go on using the extra money you’ve freed up is just so high. For this option to be successful in clearing debt with lower interest costs you need to be incredibly committed and diligent in your debt repayments.
So that’s the three main types! A common question when trying to get a handle on the number of places you owe money and the interest rates is whether or not to consolidate student loans elsewhere. The Canada Student Loans program has some features that most loans don’t have. The interest you pay on these loans can be claimed on your income tax return as a tax credit. Basically if you pay $100 in a year in interest on your student loan you will get $15 towards your income tax bill at the end of the year. So effectively the amount of interest you pay isn’t as high as is stated.
Student loans also have some relief programs in times of distress and they have options to increase and decrease (to a limit) the amounts you are required to repay. This can be a huge selling feature if your income is unsteady or if you’re focusing your money on another, higher interest debt first.
I hope this information can help you to make a more informed decision about how to lower interest rates in a way that will actually help you achieve your goals and not set you back further. Each person’s situation, goals and habits are different so there is no universally good or bad option.
I strongly believe it’s necessary to have an understanding of the choices you’re making in finance. While there are lots of great bankers and advisors, they are in the business of sales. Banks are for-profit corporations that have sales targets just like any other business. While they can be great sources of information and advice and I don’t believe they are all out there to make a buck off you, you can’t leave it to someone else to determine what is best for you and your money.
So while reading about finance may not be your favorite thing to do, knowledge really is power. I, for one, would much rather hold that power than to blindly put it in someone else’s hands to decide. Someone who doesn’t know me, my habits or my goals. I am the captain of my ship and I hope I can help empower you to be the captain of yours.
Lots of love
Dawn
Tax Wise 