Debt Consolidation – How does it work?

What is a debt consolidation?

Debt consolidation is what it appears to mean: a method of putting individual debts together into one payment.

Debt consolidation is usually accomplished with a debt consolidation loan (“DCL”). Such a loan is used to pay off several individual debts to enable the debtor to make one easy payment.

At least that’s what many lenders would lead you to believe. The fact of the matter is that in many situations, a DCL may not make any financial sense.

To illustrate this, let’s look at a couple of examples.

Debt Consolidation – Example 1: Anatomy of a Good Decision

Here is Samantha’s debt profile:

Credit cardAnnual Interest RateBalance
Mastercard21%$10,000
Visa21%$10,000
American Express21%$10,000
Total$30,000

Now suppose that Samantha wants to consolidate her debt so she can make one easy payment. She meets with her bank and they see that Samantha has a high paying job and a great credit history.

As a result, she’s considered a low default risk and is offered a $30,000.00 consolidation loan, to be repaid over 5 years at at the bank’s best rate: 7% per year.

Will taking this loan improve Samantha’s financial situation?

Absolutely it will! She’s currently paying 21% on her credit card debt but her bank is offering her a $30,000.00 DCL that will allow her to pay off that high-interest debt.

If she takes the loan, she’ll be repaying the bank $30,000.00 over 5 years at 7% per annum, which is only one-third of the interest she’d be paying if she continued paying her credit cards at 21% per annum.

She’ll be saving a lot of money in interest, but how much?

If she was to pay back the bank $30,000.00 over 5 years at 7% per annum, she’d be paying the bank a total of $35,642.16 – the original loan of $30,000.00 plus $5,642.16 in interest.

On the other hand, if she declined the loan offer and continued paying down her credit cards over 5 years at 21% per annum, she’d be paying the credit card companies a total of $48,696.05 – the original $30,000 in credit card debt plus $18,696.05 in interest.

Therefore, she would be saving $13,053.89 in interest charges if she took the bank’s DCL (i.e., $18,696.05 – $5,642.16).

This is an example of debt consolidation that makes sense.

Debt Consolidation – Example 2: Anatomy of a (Really) Bad Decision

Now let’s suppose Samantha has the same debt profile as in Example 1, but:

  • She lost her high-paying job and managed to find new employment, but at significantly lower pay
  • After losing her previous job, she started falling behind on her credit card payments. This has negatively impacted her credit score.

Like in Example 1, Samantha wants a $30,000.00 DCL to pay off her 21% per annum credit card debt, but her bank won’t give her the loan because of her lower pay and bad credit history.

So Samantha ends up going to a “high-risk” lender – a lender that will lend money to a borrower who is at high risk of defaulting.

These lenders will provide loans to individuals with lower income and a spotty credit history but at a price: they will charge significantly higher interest than what a bank will charge.

Let’s call this high-risk lender “EZ Simple Loans”  (not an actual company) or “EZ” for short. EZ will provide Samantha with a $30,000.00 DCL at 36% per annum. Naively, Samantha agrees to take the loan and uses the $30,000.00 to pay off her credit card debt.

As you can probably already guess, Samantha’s decision to take this loan has made her financial situation much worse.

As in Example 1, if she declined the loan offer and continued paying down her credit cards over 5 years at 21% per annum, she’d be paying the credit card companies a total of $48,696.05 – the original $30,000 in credit card debt plus $18,696.05 in interest.

However, by taking out the EZ DCL and agreeing to pay back the $30,000.00 loan over 5 years at 36% per annum, she will be paying $65,039.33, comprised of the original $30,000.00 loan plus $35,039.33 in interest!

So in this second example, Samantha made a really bad decision.

Debt Consolidation – A Rule of Thumb

The rule of thumb to use when deciding whether a DCL makes sense is to compare the loan’s interest rate to the Weighted Average Interest Rate (“WAIR”) of your current debt.

How is WAIR calculated? Use this formula for each individual debt and add up the result:

Individual Debt Balance/Sum of Total Debts x Interest Rate of Individual Debt

So for example, here is how to derive the WAIR of 19.30% per annum in the table below:

Credit CardBalanceAnnual Interest RateWeighted Average Interest Rate
Visa$20,00029%5.80%
Mastercard$50,00018%9.00%
American Express$30,00015%4.5%
Total:$100,00019.30%

 

Visa:                  $20,000 / $100,000 x 29% = 5.80%

Mastercard:   $50,000 / $100,000 x 18% = 9.00%

Amex:               $30,000 / $100,000 x 15% = 4.50%

Therefore, WAIR is equal to:  5.80% + 9.00% + 4.50% = 19.30%

In this case, a $100,000 debt consolidation loan would only make financial sense if the offered interest rate was less than 19.30% per annum. You can use this method to analyze any debt consolidation loan offer.

Consumer Proposal – an Alternative to Debt Consolidation

In Example 2, rather than taking out a high interest debt consolidation loan from EZ Simple Loans, Samantha could have filed a consumer proposal with a Licensed Insolvency Trustee. A consumer proposal would have allowed Samantha to settle her credit card debt rather than paying back the $30,000.00. Moreover, upon filing a consumer proposal, the credit card companies wouldn’t have been able to charge any additional interest.

Want to discuss YOUR situation? Contact us!

If you find yourself in a similar situation like Samantha’s, we’d be more than happy to hear from you. We can sit down with you and review your legal options to help manage your debt.

If you have any questions about consumer proposals or you are thinking about it as an option to resolve your financial difficulties, please contact us at:

Phone: (416) 260-3264

Email: help@startingovertoronto.com

We can meet with you for a FREE, no obligation consultation at one our offices in Toronto, Scarborough, Etobicoke, Don Mills, Mississauga or Brampton.