If your debts are becoming overwhelming, there are solutions to regain control. Two options you may have encountered are debt consolidation and a consumer proposal. Both lead to the same destination: debt freedom. However, they take you down completely different paths to get there. Therefore, choosing the right one for your journey is crucial. In this article, we’ll discuss the major differences between debt consolidation vs consumer proposal, providing a crash course in these debt relief options. We’ll break down the pros and cons of each and guide you on how to choose the one best suited to your unique circumstances. Let’s get started!
What’s the difference between debt consolidation and a consumer proposal?
The primary difference is that debt consolidation combines your existing debts under a single loan, preferably at a lower interest rate than the one you’re currently paying. A consumer proposal also allows you to consolidate several debts into one lump sum. But it also reduces your total debt balance and eliminates interest charges.
Debt consolidation entails taking out a new loan from a bank, credit union, or other financial institution. On the other hand, a consumer proposal isn’t a loan but rather a way to negotiate a debt settlement with your creditors. The result is that you end up paying less than you owe. Lenders don’t offer consumer proposals. Instead, you work with a Licensed Insolvency Trustee, who’ll guide you through the process from start to finish.
How does debt consolidation work?
Debt consolidation is one of the most practical ways to alleviate financial stress from overwhelming debts. There are several ways to consolidate debts, but the most popular and practical method is to get a debt consolidation loan. This is a type of personal loan designed to combine multiple debts into one.
A debt consolidation loan takes all your unsecured debts, such as credit cards, payday loans, and lines of credit, and wraps them under a single loan. Once your lender, usually a bank or credit unit, approves you for the loan, you use the funds to pay off your high-interest debts in one go. From there, you make fixed monthly payments over a set period to pay off your debt consolidation loan.
Pros of debt consolidation
Lower interest charges. Debt consolidation loans generally offer lower interest rates than credit cards and other unsecured debts. As a result, you’ll incur fewer interest charges, meaning you can chip away at your balance faster (more of each payment will go toward your principal). Reduced interest charges are the primary advantage of debt consolidation loans.
Lower monthly payments. A lower interest rate also means your monthly payments will shrink, which makes repaying debt more manageable. You’ll have an easier time handling your debt obligations while covering other day-to-day expenses. More room in your budget means less financial stress for your household.
Simplified repayment schedule. By consolidating your debts, you’ll be responsible for only one monthly payment. Managing your bills and staying organized will become much easier.
Fixed monthly payments. A debt consolidation loan is straightforward: you pay the same amount each month until you pay it off. Unlike a line of credit, the interest rate assigned by your lender stays locked for the entire term, so you never have to worry about payment fluctuations.
No damage to your credit. Consolidating high-interest debts under a single loan doesn’t equate to a default; you still agree to pay the entire balance. As a result, your credit score won’t suffer any real damage the way it would if a lender were to write off your debt or send it to a collection agency.
Cons of debt consolidation
Strict eligibility requirements. You’ll need a decent credit score to snag a debt consolidation loan at a favourable rate. Most financial institutions prefer to lend to individuals with a credit score of 650 or higher. In addition, you’ll need a stable income and low income-to-debt ratios to demonstrate you can repay the loan. Lenders won’t be willing to approve your debt consolidation loan application if you’re in rough shape financially.
A low-interest rate isn’t guaranteed. If the big banks turn you down for a debt consolidation loan, you can seek out alternative lenders with more relaxed qualification standards. However, this class of lenders will assign you a higher interest rate. Depending on your credit standing, it may be so high that getting a debt consolidation loan no longer makes financial sense.
Collateral or a co-signer may be required. Some lenders will ask that you put up an asset as collateral for a debt consolidation loan, such as your car, especially if you have bad credit. Alternatively, a lender may require another individual to co-sign the loan contract as extra security.
No option to reduce your balance. There’s no room to negotiate a reduced balance when you take out a debt consolidation loan. Your lender expects you to pay the entire principal plus all interest charges. While lowering your interest is beneficial, it may not be enough to provide you with any meaningful financial relief.
Demanding payment schedule. Debt consolidation loans typically come with short terms, which means you can expect steep monthly payments. There are also strict payment deadlines to meet. Adjusting to this payment routine can be challenging if you’re accustomed to making minimum payments on credit cards or interest-only payments on lines of credit.
How does a consumer proposal work?
A consumer proposal is a federally regulated debt relief program. It allows you to combine your unsecured debts and strike a deal with your creditors to pay a smaller percentage of what you owe. As mentioned earlier, it doesn’t involve taking on a new loan. Instead, your Licensed Insolvency Trustee will help you negotiate a debt settlement with your creditors.
Under a consumer proposal, you’ll make one monthly payment to your Licensed Insolvency Trustee, who’ll distribute the funds to your creditors. Your payment size will always remain the same, and you’ll have up to five years to repay the balance.
In Canada, a consumer proposal is a bankruptcy alternative, another government-sponsored debt relief program. Unlike a consumer proposal, which lowers unsecured debt obligations, bankruptcy eliminates them entirely. While the latter may seem like a better deal, it also has more negative consequences.
Check out our article on the ins and outs of consumer proposals for more details about this unique debt relief program.
Pros of a consumer proposal
Significant debt reduction. Depending on your circumstances, you could eliminate up to 80% of what you owe to creditors by enrolling in a consumer proposal. The result is a drastically lower debt burden, so hitting your payment deadline will be much easier. And you’ll have plenty of extra cash left over to cover household expenses.
Legal protection from creditors. Once your proposal is filed with the Office of the Superintendent of Bankruptcy (OSB), you’ll receive a stay of proceedings, giving you the right to stop paying your unsecured creditors. Your creditors can no longer take legal action against you, such as wage garnishments and bank account freezes. Those pesky collection calls will also stop.
No interest or fees. In addition to having a large portion of your debts forgiven, you won’t pay any interest on your remaining balance, nor will you be charged any fees.
No prepayment charges. You’re free to make extra payments toward your proposal when you wish. And you won’t incur a financial penalty when doing so.
No requirement to give up assets. During your proposal, you won’t have to surrender your assets to creditors or pledge them as collateral. Your Licensed Insolvency Trustee will consider the market value of your assets in determining your monthly payments, but they’ll never be in danger of repossession.
Cons of a consumer proposal
Negative impact on credit score. Your credit score will take a hit when you file a consumer proposal. An R7 remark will appear on your credit report, which is one of the lowest credit ratings you can get in Canada. While not as damaging or long-lasting as bankruptcy, you’ll still face more difficulty getting approved for loans while completing your proposal and several years after.
Not all debts are eligible for inclusion. A consumer proposal won’t do you any good if you’re having trouble keeping up with payments on secured debts. A secured debt is any loan backed by an asset, such as a mortgage or car loan. Consumer proposals deal strictly with unsecured debts, like credit cards, payday loans, tax debts, and some types of student loans.
Your proposal can be rejected and you must attend counselling. In some instances, creditors may decline your debt settlement offer, which can stall the process, but you do have the option to appeal and submit a new offer. You must also attend mandatory credit counselling sessions to complete your proposal.
When should you choose debt consolidation?
Consolidating your debt using a loan works best if your finances are still in relatively good shape. Or, to put it another way, creditors aren’t bombarding you with collections calls or threatening to snatch your wages. However, your debt payments are consuming too much of your income, and you want some financial relief to prevent the problem from escalating.
Before scouring the lending market for debt consolidation loans, ask yourself these questions:
- Is your credit score high enough for you to qualify for a low interest rate? Alternatively, are you comfortable pledging an asset as collateral to secure one? Remember: the primary goal of getting a debt consolidation loan is to lower your interest rate to keep more money in your pocket.
- Can you afford the monthly payments? Are you financially equipped to make fixed payments over a long period? Assess the stability of your income—will a lender be willing to give you the financing you need?
- Do you wish to preserve your credit score? Suppose you anticipate applying for a mortgage, auto loan, or other form of financing in the near future. In that case, keeping your credit score intact is vital. A debt consolidation loan won’t hurt your credit, provided you make timely payments.
If you answered “yes” to these questions, consolidating your debt is a wise move. When used in conjunction with proper money management strategies, a debt consolidation loan can contribute positively to your long-term financial health.
When should you consider a consumer proposal?
A consumer proposal works best if your debts are causing your household immense financial stress, to the point where paying back everything isn’t realistic. Maybe your credit score is also in the dumps, preventing you from getting a debt consolidation loan in the first place.
In this scenario, debt consolidation will provide little relief. Your monthly payment will still be too large to manage relative to your income. A consumer proposal would be preferable as it will reduce your outstanding balance instead of only rewarding you with a lower rate. You’ll also save additional money on interest charges, and your unsecured creditors won’t be able to sue you or seize your assets.
A consumer proposal is a sensible debt relief option if the following applies to you:
- You’re legally insolvent, meaning there’s no way you can pay your debts on time.
- You earn a stable income high enough to cover the monthly payment under a consumer proposal.
- Your low credit rating prevents you from obtaining a debt consolidation loan at an interest rate lower than the average rate on your original debt.
- Your debts negatively impact your living standards to the point that you struggle to pay for food, utilities, and other necessities.
- You’re worried creditors will soon pursue legal action against you, such as garnishing your paycheque.
The bottom line on debt consolidation loans and consumer proposals
Both a debt consolidation loan and a consumer proposal are valid solutions for unmanageable debts. The one that’s right for you depends primarily on the severity of your debt problems.
Debt consolidation is ideal if you’re looking to save money on interest and can afford to pay your balance in full. A consumer proposal works best if you’re experiencing extreme financial distress and no loan can give you the relief you need to keep up with your payments.
Whether you use a debt consolidation loan to fix your debt woes or file a consumer proposal, think long-term about how each option affects your wallet, credit score, and stress level. If you need a helping hand in making sense of your debt relief options, contact David Sklar & Associates for a free, no-obligation consultation. As Licensed Insolvency Trustees, we can review your situation, crunch the numbers, and help you choose the right path to get you out of debt for good.
Photo by Karolina Grabowska