Are Consolidation Loans for Bad Credit? The Answer May Surprise You

Are consolidation loans for bad credit borrowers? Debt consolidation loans are on the rise, but those with bad credit aren’t the only ones using them. But what is a debt consolidation, and does it hurt your credit score? The average Canadian household debt load is 177% of their income. That means for every $1 they bring in, they owe $1.77 to their creditors. Many Canadians are struggling to get by. Between the increased cost of living and the proliferation of credit cards, it’s easy to fall into a debt trap you can’t get out of.  As a financial industry insider, I am here to tell you the truth about debt consolidation loans: what they are, how they work and when you should get one.

Why are debt consolidation loans so common?

Debt consolidation loans are common because life in Canada can be expensive and a lot of spending has moved away from physical cash. Cryptocurrencies have taken money completely online and the credit card industry has been talking about the death of cash for years. During the pandemic, stores even encouraged consumers to use plastic cards instead of cash. More than that, most Canadians have been lulled into a sense of wealth fueled by easy credit and a housing boom. Often, one type of debt influences the other.

What is housing debt?

The cost of housing has exploded. More Canadians are house-poor now than ever before. That means after they pay their mortgage and the related costs of homeownership, they can’t afford much else. So they turn to credit to fill the gap. 

What is credit card debt?

Credit card debt is the total outstanding balance you owe on each of your credit cards. There are over 76 million active credit cards in circulation right now. The average Canadian has about two. What’s more, Canada ranks #2 in the world for the highest rate of cashless transactions. It didn’t use to be that way. Credit cards only came to Canada in the late 1960s but today, they are accepted everywhere and especially online.

Aren’t consolidation loans for bad credit?

Contrary to popular belief, it’s not an extra special loan for people with bad credit. A debt consolidation loan is a regular personal loan, usually secured. Why do we call it a consolidation loan? Because of how you’re using it. 

A car loan is a personal loan you use to buy a car. A consolidation loan is a personal loan you use to combine your other debts into one easy payment. Simply put, “consolidation” is just a fancy bank word for “bring together” or “combine into one.”Sure, consolidation loans for bad credit are common, but they’re also a great option for those with good credit scores too.

How does a debt consolidation loan work?

All you need to do to get a debt consolidation loan is meet the basic credit and income requirements for a personal loan. How much you’ll be approved for depends on your income, credit score, and how much you need to pay off your high-interest debt

You then take the funds from the personal loan and use them to pay off your high-interest debt like credit cards and payday loans.  Most banks are able to pay your other creditors directly on your behalf. 

Now, instead of juggling several debt payments to many different creditors, you make one payment to your new creditor, ideally your own bank. There are two different kinds of loans you can use to consolidate your debt, but most of the time your bank will ask you to secure the loan with collateral.

Now, if the big 6 banks say no, you can still get a consolidation loan for bad credit. There are several private lenders who offer personal loans for those with risky credit files, like Fairstone Financial or Easy Financial to name a few. Full disclosure, expect much higher interest rates. So make sure you have an aggressive debt pay-down plan in place before you go this route.

An unsecured debt consolidation loan

An unsecured debt consolidation loan means the bank gave you money based solely on your creditworthiness and ability to pay. That means they did not ask you to offer them any collateral in exchange for the loan. 

Collateral are items of value that you agree to let the bank take away from you in the event you cannot repay the loan. If you default, they would take those items and resell them in order to recuperate some of their loss. Credit cards, lines of credit and student loans are examples of unsecured loans. 

Unsecured loans have higher interest rates because the bank has no immediate recourse to mitigate loss. Consolidation loans for bad credit are more likely to ask for collateral, but those with good credit can secure the loan to access a lower rate.

A secured debt consolidation loan

A secured debt consolidation loan means there is some sort of collateral or item of value attached to the loan, more common with consolidation loans for bad credit. It means you have given the bank the right to take that thing away from you if you cannot repay the loan as agreed. When you get a car loan, the bank registers themselves on the title of the car. If you default, they repossess your car and resell it to recuperate some, or all, of their loss. 

The same is true with a mortgage. If you default on your mortgage payments, the bank will foreclose on the property and resell it. You can also secure personal loans with miscellaneous items like household goods, electronics, or with a savings or trust account. 

Secured debt consolidation loans have lower interest rates because the bank has the security of knowing they can use the collateral to mitigate loss. Borrowers are also far less likely to default on loans that have something of value attached to them. Like I said before, collateral isn’t just for consolidation loans for bad debt. Those with great credit may choose to secure their consolidation just for a better interest rate.

If you are a homeowner, your bank may ask you to secure your debt consolidation loan with the equity in your home using a Home Equity Line of Credit (HELOC).

Consolidation loans: a case study

Remember, while consolidation loans for bad credit are common, they’re also a great option for this with good credit too. A debt consolidation loan makes perfect sense if you are carrying a lot of high-interest debt like credit cards, payday loans, or high-interest personal loans from subprime lenders.  Even some car loans can be quite expensive despite being a secured loan. 

Let’s take a look at the total cost of credit, which is the amount of pure interest you’ll pay if all you do is just the minimum monthly payment, and how long it will take you to pay off the debt in full:

According to this chart, you have a total outstanding debt load of $23,800 in high-interest credit. You’re paying a total of $616 a month in total minimum monthly payments. 

Your credit cards will cost you over $12,500 in just interest alone. By the time you pay off your car, it will have cost you another $3,654.54 of pure interest. 

Your current debt load will cost you a total of $16,158 in just interest and take you over 20 years to pay it all off in full. Now let’s consider an unsecured personal loan to consolidate all of this high-interest debt. At the time of writing, the average interest rate on an unsecured loan in Canada was about 8%. 

Your new loan will pay off all your outstanding high-interest loans to your other 4 creditors. Now, instead of making several monthly payments to several lenders, you’re only going to make 1 monthly payment to your new lender (preferably your own bank).

Your new consolidation loan will be paid in full in just 5 short years and save you over $11,000 in interest. In this case, your monthly payment is actually less than the combined payments you were previously making to all your other creditors. So, in addition to saving a ton of interest, you’re also saving $133 a month in your budget. Clearly, consolidation loans for bad credit aren’t really a thing anymore. Consolidation loans are for anyone trying to get out of debt faster and save on interest.

Pro tip: Put that $133 in a savings account each month. In a year you would have about $1,600 in savings. That cushion would help you avoid going into debt again should an emergency pop up.  Better yet, invest it and let market returns and compound interest work their magic.

When does a debt consolidation loan make sense

Sure, a consolidation loan for bad credit makes sense when the banks say no. But a debt consolidation loan also makes sense if you are carrying a lot of high-interest debt, namely credit cards and payday loans. But there’s a trick to using a consolidation loan the right way. It starts with recognizing the warning signs before they turn into major problems. 

If you’re carrying credit card balances over 30% of their available limit or more, you’ll want to consolidate sooner rather than later. What do I mean by that? Let’s say you have a credit card with a $4,000 limit. If you’re consistently carrying a balance over $1,200 month over month, and you’re only making the minimum monthly payment, that’s a red flag. 

Once you make another purchase and increase your balance beyond that 50% threshold, you start to damage your credit score. If you max out your card completely, you’re hurting your credit almost as much as missing a payment. Also, you’re paying an insane amount of interest. If you go over your limit, you’ll be charged an over-limit fee and, in some cases, your interest rate will increase too. Your minimum monthly payment just got higher and 0 of it will go to your balance. 

You want to consider a consolidation loan before you cause some serious harm to your credit by maxing out your credit utilization ratio. You still need to be creditworthy to qualify for a debt consolidation loan. Protecting your credit score will help you get the best possible interest rate once you decide to consolidate. If you wait too long and need a consolidation loan for bad credit, you’ll get nailed with high-interest rates.

You also want to consolidate your debt while the monthly payments are still relatively manageable. If you max out all your available high-interest credit, you may find yourself in a situation where you’re missing payments and collection companies are calling. You also need to have room in your budget for the monthly payment on a consolidation loan. If your debt load becomes so unmanageable that you start missing payments, you’ll cause serious damage to your score. Your bank may refuse to consolidate your debt. If that happens, then you’re in some really hot water. 

While your debt consolidation loan will eliminate the payments you’re making to your other creditors, in some cases, your monthly payment may be higher if you are consolidating a lot of debt into a short repayment term. That’s not a bad thing if you can afford it. You’ll still be saving a ton of interest and paying off your debt in a fraction of the time, so long as you are able to pay. But if your current debt load is causing you to live paycheque to paycheque, a higher payment on a consolidation loan is going to be disastrous.

When does a debt consolidation loan not make sense?

It does not make sense to consolidate if you’re already to the point where you cannot afford all your monthly payments. Like I said a moment ago if you’re not keeping up with your payments, a couple of things are probably happening: 

You’re likely spending almost half, if not more, of your monthly income on just your debt repayments. In this case, you are likely carrying so much debt that the payment on a consolidation loan may be higher, which will not help you. It will actually make things worse. Sometimes a debt consolidation loan will lower your payment and relieve your budget, but sometimes it doesn’t. It’s important to compare lenders and their offers to ensure a consolidation loan is right for you.

At this point, you are also causing considerable damage to your credit score. Between maxed-out credit cards killing your credit utilization ratio and missed payments, your credit score is taking a one-two punch right to the gut. You’ll be charged a higher interest rate on consolidation loans for bad credit, or you run the risk of not qualifying at all. 

If your income is so low that you use your credit cards to supplement the cost of living, you really don’t want to get a consolidation loan. That’s because your income isn’t sufficient enough to meet your basic needs, so you were left reaching for your credit cards to fill the gap. That’s not a discipline problem, that’s survival. You can’t budget or “personal finance” your way out of systemic failures. 

If you take on a debt consolidation loan to pay off your credit cards, and then turn around and max them out again because groceries, hydro and rent are all equally important, now you’re in even more debt. Instead of getting out of trouble, you’re headed straight for it on the road to bankruptcy. 

Or, maybe you make great money but you have some self-control issues. I’m married to a recovering shopaholic with a heart of gold but you have to make some serious lifestyle changes for the debt consolidation loan to work properly. You need to understand how you got into so much debt in the first place. Then you need to make the appropriate changes to your behaviour and your budget. If your debt consolidation loan is going to serve its intended purpose you need to have a real, actionable plan to pay it off and not end up in the same situation again.

Will a debt consolidation loan hurt my credit score?

Yes. But not in the way you think. I dealt with many customers who were overly concerned about how the credit check for their loan application would hurt their credit score. Yes, credit checks will affect your score, but minimally. You might drop a few points, but it will likely pop back up after you make your next few debt payments on time. 

The more serious issue at hand is how your credit card balances are impacting your score and the amount of interest you’re paying. Your credit utilization ratio is the second most important influence on your credit score, it makes up 30%. Your credit score will start to be negatively affected as soon as your credit card balance climbs over 30% of your credit limit. 

A debt consolidation loan pays off your credit cards in full, bringing their balances down to 0. This knocks your credit utilization ratio down to 0 which has an immediate positive impact on your credit score. Any points you lost with a credit check will be more than made up for when those credit cards get paid off.

A debt consolidation loan myth debunked

A lot of my clients believed a debt consolidation loan for bad credit would show up on their credit files and hurt their scores. They believed the banks frown upon consolidation loans, would see it on the report, and then refuse to lend to them. That’s just not true. And this myth is holding people back from seeking the help they need. 

A consolidation loan is just a regular personal loan. On your credit file tradelines, there is nothing to distinguish it from any other installment loan. Creditors raise their eyebrows when they see a couple of unsecured personal loans in addition to a lot of credit card debt and lines of credit. It’s normal and expected for your lender to ask you about each tradeline, what kind of loan it is, and why you have it. It’s literally their job to ask about your debt in order to process your application. 

Lender: “Mr. Customer, I see you have a $25,000 personal loan, can you tell me what that’s for?” 

You: “ Oh, that’s my consolidation loan. We had a couple of emergencies pop up and needed to use our credit cards. We decided to consolidate because it lowered our payments and saved us a ton of interest.” 

If your credit cards are carrying minimal balances or no balances at all, your lender will move right along. In fact, they may take a mental note that you are more financially literate than the average bear because you know how credit card interest works. This very well could make you much more creditworthy in their eyes. As a creditor myself, I was quicker to lend to people who understood how different credit products worked and the impact on their wallets. 

But,  if you responded that it was a consolidation loan, meanwhile all your credit cards are maxed out, your lender will not be impressed. You either haven’t learned anything or your financial situation is quite precarious. They may choose not to lend to you if they suspect you have a money management problem, regardless of your income and credit score. 

Lenders do not actually have to lend to you even if you pass the basic qualification requirements. They often used the 5 C’s of credit in addition to your income and credit score.

Can you avoid a debt consolidation loan and still pay off your debt?

The short answer is yes. But it depends entirely on how much debt you have and how much money you make. You need to have disposable income left over after you cover your basic living expenses and make all your monthly debt payment obligations. If you want to pay down your debt without a consolidation loan, you two have options:

The snowball method

With the snowball method, you make all your minimum monthly payments to each of your credit products. Then, you put as much extra money as possible onto your debt with the lowest balance owing. As you pay off that debt, repeat the process with the next lowest debt balance owing. Keep doing this until all your debt is paid off.

The avalanche method

With the avalanche method, you make all your minimum monthly payments to each of your credit products. Then, you put as much extra money onto your debt with the highest interest rate. Once that is paid off, do the same thing with the debt with the second-highest interest rate. Keep doing this until all your debt is paid off.

Final thoughts about debt consolidation

“But Heidi, isn’t a debt consolidation loan bad for my credit score?” I heard that question a thousand times a day during my tenure as a private lender. If I’ve learned anything during my time in credit and lending, it’s how very little people understand about credit and lending (or personal finance for that matter).

The truth is, debt consolidation loans for bad credit are common, yes, but that’s not the whole truth. Debt consolidation loans are common, in fact, they made up the bulk of my lending portfolio. And most of my clients were borrowers with good credit scores. Still, most people don’t understand what they are, how they work or how to use them properly. That ends today! If you’ve been trying to pay down your high-interest debt but the balances just aren’t moving in the right direction, a debt consolidation loan might be right for you.