5 factors in choosing a debt consolidation plan

If you have various debts -- a car payment, credit cards and a line of credit, for instance -- and are struggling to keep up with themconsolidation-options all, debt consolidation might sound tempting. But there are so many options: secured and unsecured loans, lines of credit, balance transfer credit cards or debt settlement and debt repayment plans. How do you choose the one for you? 

"Do your homework before you commit to a debt consolidation plan," says Tom Feigs, a Calgary-based financial coach with Money
Coaches Canada. 

The important thing is to pick what will help you maintain a reasonable standard of living and resolve financial difficulties within a reasonable period, says Scott Hannah, president of the national Credit
Counselling Society. But there are a few other things to consider, too. 

1. Cost.
Your first question should be, "How much will this cost me?" Consider interest rates, fees and upfront costs. Each option comes with its own cost pros and cons. 

For instance, a balance transfer credit card could lure you in

Quick reference glossary
  • A secured loan is one in which the borrower pledges property as collateral. If the borrower defaults, the lender may sieze the property.
  • An unsecured loan is not backed by collateral. Unsecured debt can be wiped out by bankruptcy.
  • A debt settlement plan allows you to pay a lump sum to settle a debt for less than the original amount.
  • A debt repayment or management plan is an agreement between a debtor, a credit counselling agency and creditors in which the debtor makes regular monthly payments at a lower interest rate and monthly payment than the original debt.
  • A balance transfer credit card allows you to transfer the balance of one or more credit cards to another credit card, usually at a lower interest rate.
  • A line of credit is an open-ended, revolving loan in which the borrower may access money up to a certain limit, pay it back and borrow it again.
with a low interest rate, but be sure you know how long you're locked in for that rate -- if it's a short promotional period, interest will spike when it's over. Additionally, a balance transfer typically comes with a 3 to 5 per cent cost to move your debts onto the new card, according to Feigs and Hannah. 

A debt repayment or management plan is a more long-term solution because a non-profit credit counselling agency negotiates with your creditors for a lower interest rate and lower monthly payments, then cobbles together a single lump sum for you to pay off. You make monthly payments to the agency, which doles the money out to your creditors. However, you'll have to pay a fee, generally about $50-$75. 

With a debt settlement plan, a financial institution helps find a middle ground between you and the creditor, and you will likely end up paying less than you owe. However, the expert brokering this
deal on your behalf will charge you a fee, usually a percentage of
the amount of the debt they removed from your balance.

Lay out all of your debts, including interest and fees, then crunch the numbers to see which option is the most cost-efficient. 

2. Self-discipline.
Debt consolidation isn't the end of your debt problems, it's simply a tool to help you get on track. If you consolidate and then go right back to spending on your freed-up accounts, you'll end up in worse shape than before, so you have to know your own self-discipline.

If you can keep yourself accountable, a line of credit or credit card balance transfer might be suitable options for you. But if not, you're likely better off working with someone who can keep you in line, such as a credit counsellor, financial planner or your bank and creditors. 

"In some cases, people have debt but they also have good control," says Feigs. "They got into debt because of school or a home renovation for a growing family. But people who are using credit cards to bump up their lifestyles may not be paying attention and they're going to need the services of a money coach to teach them to live within their means."

Be honest with yourself and be cognizant of your habits. If you know you have triggers and weaknesses that brought you to this point, you're better off seeking professional help to walk you through the process. If a one-off situation, such as health issues or job loss, led you to your predicament and you're certain you have the know-how to get back on track, you could be able to pull off your debt repayments without any coaching.

3. Repayment timeframe.
A debt repayment plan pulled together by a credit counselling agency comes with a timeframe of about three to five years to pay it off. On the other hand, a line of credit or a credit card with a low  introductory rate may force you to aggressively tackle your debt before the low rate expires.

But that's only if you're disciplined. There is no concrete deadline to paying off debt with revolving lines of credit. If you're not careful, you could continue to keep adding to your balance even while you're trying to whittle it down -- meaning, it could take years to pay off and at a higher interest rate once the intro rate expires.

Consider all the factors in your life that could be affected by your debt. Are you already in a home, with most financial milestones out of the way, and able to take some time to pay it down? Or are you considering marriage or a family soon and need to clear that debt so you can be ready for the next big step? Your life stage could determine how quickly you need to pay it off.

4. Payment flexibility.
Some options are more flexible than others when it comes to making payments. For instance, a line of credit could keep incurring interest while payments go untouched during times when your savings are redirected to other budget categories, such as holidays or summers. Contrast that to a secured loan, using your home, car or other assets as collateral if you can't repay, which makes on-time payments a bit more urgent, lest you lose those assets.

The amount of payments will vary among options, too. For instance, a longer debt consolidation plan of five years might be easier on your wallet than a rigid three-year plan, which could cause your budget to hurt in other areas.

"It's hard to resist spreading out payments to reduce current monthly payments," Feigs says. But the longer you pay, the more susceptible you are to debt fatigue. If you're just paying off interest on your debt consolidation or barely putting a dent into your lump sum, you'll grow tired of the burden.

It's your job to strike a fine balance between feasible monthly payments and a spartan lifestyle you can't maintain.

5. Effect on credit report.
The experts note that the most conventional plans, such as a secured loan, won't tamper with your credit score at all. A balance transfer credit card won't hurt your credit score, either, as long as you make your monthly payments.

A debt settlement plan will mar your score significantly, though, because it usually involves holding off on paying your creditors in an effort to force them to write off some of the debt. Under a debt settlement program, the creditors will reflect the credit rating as a "9" and the information about the debt settlement will remain on your credit report for a maximum of 6 years.

Even a debt repayment plan will dent your score, though not as significantly -- it'll result in a "7" rating on your accounts. Once the accounts have been paid in full, the information about the debt repayment plan will drop off your credit report after 2 years.

"There's a more severe impact because you're asking to write off a portion of your balance," says Hannah. "It'll reflect on your credit report for up to six years."

But it could be worth the temporary ding to your score: Hannah has seen clients try to settle their consolidated debt on their own, only to turn up at his organisation with the lump sum and additional credit they racked up when they couldn't reel in their spending.

See related: 4 common debt consolidation mistakes, How to find a good credit counselling agency
Published July 15, 2015

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