How debt consolidation works

Debt consolidation allows you to combine your debts into one single monthly repayment.

It can be the perfect solution to your financial worries, especially if you’re juggling creditors or looking to lower your monthly outgoings.

You can choose to consolidate debt in three ways: through a debt consolidation loan, debt management plan or a consumer proposal.

In this in-depth guide, you’ll learn about each debt consolidation method and its advantages and disadvantages, so you can decide which is the right option for you.

1. Debt consolidation loan

What are debt consolidation loans?

With a debt consolidation loan, you can pay off your other debts, allowing you to make one fixed monthly payment towards the loan amount.

Many debt consolidation loans are available, with some requiring collateral, such as your home and car, to secure funds.

What types of debts can be consolidated with a loan?

You can put many types of unsecured debt into a consolidation loan, such as:

  • Credit card debts
  • Unsecured lines of credit
  • Personal loans
  • Payday loans
  • Outstanding bills
  • Income tax debts.

Advantages of a debt consolidation loan

A debt consolidation loan is the most common method because it’s relatively simple.

You make one lower monthly payment with a loan instead of the many payments you made before, reducing your total monthly payments and freeing up money each month.

Typically, your loan will likely have a lower interest rate than the combined rates you’re paying on your debts, meaning more of your money is going towards paying off your debt rather than the interest.

Very simply, a debt consolidation loan allows you to reduce your interest and your total monthly payments by combining your debts into one loan.

As a result, you can pay off your debts sooner, with the loan term typically lasting 1-5 years.

Disadvantages of a debt consolidation loan

The main disadvantage of a debt consolidation loan is that you will still have the same total debt as before. If you’re looking to reduce your overall debt amount, a consolidation loan won’t help you.

A consolidation loan is essentially the process of replacing your existing debt for another. So, you must be careful to avoid racking up debt on your previous lines of credit.

Interest rates can be higher than other debt relief solutions, and some require collateral to secure the loan.

It’s worth noting that if your accounts are in collections, you will likely struggle to be approved for a consolidation loan. Even if you qualify, you’ll pay a much higher interest rate.

If you are taking out a second mortgage to consolidate debt, you could owe more than the value of your home if housing prices drop.

How to qualify for a consolidation loan

To qualify for a debt consolidation loan, you must have a regular income and ensure you can afford your monthly loan payments.

Your total debt, credit score and credit history are also considered. In most cases, you’ll require a credit score of at least 650. You might need a co-signer or use an asset as collateral if you have a low score.

If you have poor credit, there are other ways to consolidate your debt. Speak to a Licensed Insolvency Trustee today for a free consultation.

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Debt consolidation loan interest rates in Canada

Traditional lenders such as banks and credit unions will offer the best interest rates for debt consolidation loans, typically 7% – 12%.

Finance companies will charge at least 14% for secured loans and over 30% for unsecured loans. They may also charge some additional setup fees.

Your credit score and whether you can offer an asset as collateral are significant factors affecting the interest rate on a consolidation loan.

More often than not, if you have a good credit score, your interest rate will be lower.

Likewise, if you can provide collateral for a secured loan such as a Home Equity Line of Credit, your interest rate is likely to be lower. But the lender can sell the asset if you don’t make your payments.

Depending on your lender, interest rates can be fixed-rate or variable-rate. Fixed-rate loans mean that the interest rate will stay the same during your loan. Variable rates can change at any time, resulting in an increase or decrease in your loan payments.

Types of debt consolidation loans

There are several different types of Canadian debt consolidation loans to choose from:

Debt consolidation loan

An unsecured debt consolidation loan isn’t guaranteed by an asset, which is a higher risk for the lender and requires a good credit score. An unsecured loan can result in a higher interest rate.

Typically, you will require a secured consolidation loan by using one of your assets as collateral. For example, you could offer your vehicle, savings or investments as collateral for the new loan. This may result in a lower interest rate.

Your credit score and income are considered when applying for a debt consolidation loan, among other factors. You repay the loan and clear your debt by making fixed monthly payments.

Mortgage refinance loan

If you have home equity, you can use it to refinance your existing mortgage to access a loan to pay off your debts.

Home equity is the difference between the value of your home and the remaining balance on your mortgage. Your equity increases as you pay off your mortgage or as the value of your home increases.

For example, if you owe $250,000 on a mortgage and your house is valued at $200,000, your home equity is $50,000.

With a mortgage refinance loan, you access this home equity by renegotiating your existing mortgage loan agreement.

Second mortgage

A second mortgage is an additional loan that you can take out if you have equity in your existing mortgage.

Interest rates are generally low because you secure the loan with your home, and payments are flexible.

There may be fees and interest rates depending on your circumstances, so always speak to your bank or financial institution to learn more.

What’s important to note here is that your loan uses your home as collateral, so if you fail to pay back the loan, it could lead to foreclosure.

Home Equity Line of Credit (HELOC)

A Home Equity Line of Credit is a revolving line of credit secured by your home’s equity.

Typically, it has lower interest rates than other loans, and there are no fixed repayment amounts. Instead, you pay interest on the money you use.

In Canada, you can borrow up to 65% of your home’s appraised value as a line of credit.

To qualify with an existing mortgage, you’ll require equity of 20%, along with a good credit score. You’ll also need a regular income and a debt load that’s not too high.

If your lender is a bank, you need to pass a stress test to prove that you can afford the repayments.

Source: Government of Canada: Getting a home equity line of credit

Auto equity loan

If you own a vehicle or have equity in your car, you can use it as collateral to secure an auto equity loan. These types of loans are popular with individuals with poor credit, which can be expensive.

These are risky loans: the lender can repossess your car if you don’t make your payments.

Line of credit (LOC) or overdraft

line of credit (LOC) is an open-ended revolving loan, similar to a credit card.

It has a maximum limit but no set expiration date, meaning you can pay it off at your own pace. However, if you don’t make regular payments, you can end up owing more than you did before.

An unsecured line of credit is not guaranteed by an asset, so it can be harder to qualify. Typically, there are high-interest rates and a monthly fee.

Debt consolidation for credit cards

You can use a credit card to consolidate debts if this new interest rate saves you money in the long run.

How to consolidate credit card debt

If you’re looking to consolidate your credit card debt, one common tactic is to arrange for a balance transfer, where you transfer the balance of a card with a high-interest rate to one that has a lower rate.

By paying a set amount each month, you can eradicate your debts quickly.

If you decide to use a credit card with a lower interest rate to consolidate your debts, establish whether it’s just a promotional offer for a limited period or if it’s a fixed rate.

This will affect how long you have to make payments to reduce the debt.

Credit cards with a lower interest rate are difficult to obtain if you have a poor credit score.

Will a consolidation loan affect my credit score?

To successfully qualify for a debt consolidation loan, most lenders look for a credit score of at least 650. If your credit score is lower, you should consider alternatives like a debt management plan or a consumer proposal.

And if by chance you are you’re approved for a loan, your poor credit score results in a higher interest rate. As a result, your debt consolidation won’t help improve your situation.

While a debt consolidation loan can help your finances in the long term, it may lower your credit score temporarily for two reasons:

  • A lender will perform a credit check recorded on your credit report.
  • Opening a new credit account lowers your average account age.

Will a debt consolidation loan improve my credit score?

Reducing your debt load and making payments on time are crucial components of a good credit score, and a debt consolidation loan can help you do so.

It’s simple: your credit score will rise when you have less debt and establish a good payment history.

While there’s an initial dip after taking out a debt consolidation loan, you’ll increase your credit utilization ratio, which should boost your credit score after a while.

Additionally, if it’s your first loan, your score will benefit from using a mixture of credit.

But a word of caution. If you default on your consolidation loan payments, you will damage your credit score.

See also: How to improve your credit score in Canada

Debt consolidation loan with co-signer

If you cannot qualify independently, you could ask someone to co-sign your consolidation loan. A co-signer can be anyone who has good credit and is willing to guarantee your loan.

Remember, if there is any risk that you will be unable to make your repayments (whether due to unemployment or something else), your co-signer will have to make the payments for you.

Debt consolidation loan: joint application

You may qualify for a joint consolidation loan if you are married and your partner has a better credit score than you.

Remember that consolidating your debt in a joint loan does not remove your debt. Instead, you are sharing it legally with your partner.

They will become 100% liable for the debt, and missed repayments may negatively affect their credit score.

How do I apply for a debt consolidation loan?

When you apply for a debt consolidation loan, lenders will review the following:

  • Monthly income.
  • Monthly expenses.
  • Total debt.
  • Credit score.
  • Whether you can provide collateral to secure the loan.
  • Employment status.

You will be required to supply documentation alongside this information.

Debt-to-income ratio

Your debt-to-income ratio is a calculation that compares your monthly debt payments with your income.

Lenders consider this ratio to check if you can truly afford the monthly payments. If you have a ratio of over 40%, it will be harder to obtain a debt consolidation loan because you are carrying a lot of debt.

Interest rates

It’s crucial to find the best interest rate. If the debt consolidation loan rate isn’t lower than the combined rate of your debts, then you are not saving any money.


You should only apply for a loan if you have a high chance of being approved.

Always check your credit score. You’ll want to make sure your score is at least 650 to give you the best chance of approval.

If you are uncertain if you will be approved, wait until your circumstances improve or look at alternatives, such as a consumer proposal.

Check out our guide for tips to improve your credit score.

Check your credit report

Regularly review your credit report to ensure that the individual debts are marked as paid on your credit report. Tell the credit bureaus if you spot an error.

2. Debt management plan

If other debt consolidation options don’t work for you, you might want to consider a debt management plan.

A debt management plan is an informal debt solution that enables you to consolidate debts with assistance from a credit counselling agency.

It allows you to consolidate all of your payments into one monthly payment. This solution is most commonly used for credit card debt.

Unlike other debt consolidation options, you’ll work with a credit counsellor, who will likely attempt to negotiate an interest-free period or interest rate reduction.

See also: Debt management plan

3. Consumer proposal

If a debt consolidation loan or debt management plan isn’t quite right for you, you might want to consider a consumer proposal as a solution to your debts.

A consumer proposal allows you to consolidate your debts into a monthly payment, usually lower than other debt consolidation options.

How does a consumer proposal work?

consumer proposal is a legally binding debt agreement where you repay your creditors a percentage of what you owe in exchange for debt forgiveness.

As the goal of a consumer proposal is to provide debt relief and avoid bankruptcy, your payment terms are based on what you can afford.

Licensed Insolvency Trustee will review your financial situation, determine how much to offer, and then help you negotiate terms with your creditors.

What are the advantages of a consumer proposal?

A consumer proposal has many benefits:

  • Interest-free.
  • One single, lower monthly payment.
  • Only repay a portion of your debt.
  • Payments last no longer than five years.
  • Keep your assets.
  • Stop creditor pressure.
  • You only need a majority of creditors to accept.
  • A trustee will liaise with your creditors.

It’s a straightforward debt relief solution that stops the threat of creditor action, such as collection calls and wage garnishment.

It’s also the only way to deal with tax debts. The Canada Revenue Agency will only accept a formal debt arrangement through a consumer proposal or bankruptcy.

Conclusion: is debt consolidation a good idea?

If you’ve made it this far, you’ve probably learned a thing or two about debt consolidation.

Consolidating your debts is an attractive option because it allows you to combine your debts into one monthly repayment, making it easier to manage.

If you’re still on the fence about the best way to consolidate your debts, a consolidation loan is a good option if you can afford the payments. But whether you’re accepted depends on your income, credit score and whether you can offer collateral.

Debt consolidation won’t fix your problems if you cannot afford the debt, even at a reduced interest rate.

If you owe debts that count for more than half of your income, you might want to consider an alternative debt relief solution.

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