What Is Debt Consolidation and How Does It Work?

Dealing with debt can be an intimidating prospect for anyone. Even if you have a great salary, it can be surprisingly easy to start amassing uncontrollable debt that seems impossible to deal with.

The average level of debt held by Canadians is on the rise—though different age groups are seeing different levels of debt and growth rates. For example, the average debt of an 18-25 year-old in Q2 2024 was $8,042 (a 3.23% increase from the previous year). In addition, every age group in Canada saw increases in average debt year over year:

• 26-35 year-olds had an average debt of $17,381 (up 1.51%)
• 36-45 year-olds had an average debt of $26,835 (up 2.67%)
• 46-55 year-olds had an average debt of $34,030 (up 2.67%)
• 56-65 year-olds had an average debt of $28,054 (up 4.51%)
• 65+ year-olds had an average debt of $14,434 (up 0.84%)

Debt consolidation is one option for dealing with rising debt, but it can be confusing to understand all of your options. Read on to learn all about debt consolidation—what it is, how it works, and whether it is right for you (and if so, what kind of debt consolidation would be best).

What Is Debt Consolidation?

Debt consolidation is the practice of taking multiple sources of debt and combining them into a single account. This offers several advantages for borrowers. First, it makes it easier to keep track of payment due dates. Having to remember many bill payments instead of only one can be a huge load off your mind.

It also makes it easier to keep track of your creditors. With one bill to pay, you don’t have to worry as much about whether you lost track of one of your debts in any given month. The peace of mind this provides alone can be a good reason to seek out debt consolidation.

Debt Consolidation vs. Bankruptcy 

Debt consolidation and bankruptcy are two distinct strategies for dealing with debt. 

Debt consolidation is a method of combining multiple debts into a single loan or payment. This can simplify debt management and potentially reduce interest rates or monthly payments. Bankruptcy is a legal process designed to help individuals eliminate their debts. Individuals work with a Licensed Insolvency Trustee (LIT) to help them assess their financial situation, file necessary paperwork, and liquidate assets.

Debt Consolidation vs. Consumer Proposal 

Debt consolidation and consumer proposal are two different strategies to reduce debt. 

Debt consolidation rearranges all debts into one easy-to-manage monthly loan or payment. It potentially reduces interest rates but not the overall debt amount. Consumer proposal, on the other hand, is a legal process in which a Licensed Insolvency Trustee (LIT) helps individuals settle their debt with creditors for less than the full amount owed. It’s an alternative to bankruptcy and is designed to make debt repayment more manageable.

How Does Debt Consolidation Work?

Debt consolidation can work in different ways depending on who you work with. There are two major types of debt consolidation that you can pursue: debt consolidation loans and debt consolidation programs (DCPs).

It’s important to know the differences between DCPs and loans and how they work so you don’t fall for any of the myths about debt consolidation that occasionally get shared online.

Below, we outline each, which can help you evaluate which debt consolidation method is right for you.

Debt Consolidation Loans

A debt consolidation loan is a service offered by a bank or other lending institution where they consolidate (i.e., “merge”) several debts into one by providing a loan to cover the balance of the existing debts.

To qualify for debt consolidation loan services, it’s important to have sufficiently good credit. A high credit score can help you qualify for a loan with better terms such as having a lower monthly payment or having a lower overall interest rate. However, if you have a low credit score, lenders may choose not to provide you with a consolidation loan.

Debt consolidation loans can be a great way to simplify debt repayment while minimizing the impact on your credit score.

How does a debt consolidation loan affect your credit?

A debt consolidation loan can impact your credit both negatively and positively; however, if you make consistent, on-time payments and avoid accumulating new debt, your credit will be positively impacted over time. 

Some ways a debt consolidation loan can negatively impact your credit include:

• A new hard inquiry: The lender will run your credit, dropping your score slightly in the short term.
• A new credit line: Your report will contain a new line item, which may temporarily lower your score. Other debts on your credit report paid off by the debt consolidation loan will be up to date, however, and this can slowly improve your credit rating.
• More debt: Your credit cards will be paid off, but that could create a temptation to use them and drive balances right back up.

Some ways a debt consolidation loan can positively impact your credit include:

• Improved credit utilization rate. By using a debt consolidation loan to pay off your existing credit card debts, you reduce the balances on those cards to zero, lowering your credit utilization rate.
• Potential for improved payment history. With only a single monthly loan payment (usually lower than pre-consolidated payments combined), you’ll be more likely to stick to your payments.
• Simplified debt management. You’ll only need to focus on one goal (paying off your loan) with a single payment and unified interest rate.

Debt Consolidation Programs

For those who don’t have the credit history or credit score required to get approved for a consolidation loan from a bank or other lender, a DCP is an effective way to eliminate debt without taking more on.  Because this is a negotiation and not an immediate payoff, your debt doesn’t just “go away.” It still exists, just in a more manageable form. 

Why a Debt Consolidation Program Works

One of the biggest differences is that you aren’t applying for a loan—so you don’t need a good credit score and will be able to receive help regardless of your credit history. Instead, you work with an experienced Credit Counsellor to negotiate with your creditors to have them reduce your debt, minimize or eliminate the interest on it (sometimes to as low as 0%), and combine it into a single, easy-to-track monthly payment. This means you’ll know exactly when your debt will be paid off without any surprises. 

Should I Consider a Debt Consolidation Program (DCP)?

A DCP is not a one-size-fits-all solution. Carefully evaluate your financial situation and consider the potential benefits and risks before making a decision. 

Pros of a DCP:

• One monthly payment instead of several payments.
• Lower interest rates negotiated by a Credit Counsellor.
• Quicker repayment of debt with a consistent payment schedule.
• Adjustable debt repayment period to suit your current budget.
• Reduced collections calls (as some debts can be recalled from third-party collections).

Cons of a DCP:

• Temporary negative impact on credit scores.

How to Ensure a Successful Debt Consolidation Program

Once you’ve decided to go with a DCP, it’s important to set yourself up for success. Keep in touch with your credit counselling team and inform them of any changes to your financial situation or additional financial hardships while on the program. Here are some additional tips to help you achieve success:

• Be honest and upfront with your Credit Counsellor.
• Stay committed to paying off your debt.
• Fully read and understand all the terms you are agreeing to. 
• Make your monthly payments on time.
• Don’t accumulate more debt while on a DCP.

Learn more about how to ensure a successful debt consolidation program.

When Should You Consider Debt Consolidation?

You should consider debt consolidation if you find yourself overwhelmed by multiple debts from various sources, such as credit cards, loans, or utility bills—especially if high-interest rates are making it difficult to pay them off. Debt consolidation simplifies your payments into one manageable monthly payment, which can help you regain control of your finances. If your debt is taking over your life in a negative way, it’s time to consider debt consolidation. 

Which Type of Debt Consolidation Is Right for You?

So, which type of debt consolidation is the best for your needs? That depends on your specific situation. It’s important to consider the differences between a DCP and a consolidation loan before choosing one or the other. Your Credit Counsellor will guide you through your options; however, here are some general guidelines:

Choose a DCP if you have a low credit score and are willing to give up access to new credit. Signing up for a debt consolidation program means forgoing your credit cards. At first, this sounds like a negative since we’re all used to the convenience of credit. However, it is often a blessing in disguise for those who are struggling with overwhelming debt.

Under a DCP, you can still use prepaid cards or debit cards with credit logos (the ones that draw from your bank account but can be processed like credit cards, like Visa Debits). By cutting up your credit cards and closing the accounts, you can eliminate the temptation to keep spending on your cards after you’ve paid them off—helping you avoid adding more debt just as you start paying it off!

Choose a debt consolidation loan if you have a high credit score and stable income to pay off your loan. If you have a high credit score and can secure a loan with great terms, then a debt consolidation loan might be your best choice. It not only helps you eliminate your other sources of debt immediately (transferring them all to the loan), but it allows you to keep building your positive credit history if you keep making your monthly payments on time.

Other Debt Consolidation Options to Consider

In addition to a DCP and debt consolidation loan, there are other options to eliminate your debt. 

You can consolidate debt into your mortgage, which would mean breaking your current mortgage agreement and getting a new one, which includes your high-interest debts. In this case, you could significantly reduce your overall interest rate and make repayments easier, without having to give up your credit cards. 

Another option is to open a Home Equity Line of Credit (HELOC), which allows you to borrow money against the equity you have built up on your home. This would give you a revolving line of credit with variable interest rates, which means you might pay more in interest over time compared to other options. 

Debt Consolidation for Specific Cases

Debt Consolidation for Buying a Home

A Debt Consolidation Program (DCP) can affect your ability to buy a home, as you may not qualify for a new mortgage or may only qualify for one with  less favourable terms. 

When you enter a DCP, creditors may apply an R7 rating to your credit report, which indicates that you have made an alternative arrangement to repay your creditors. Lenders may see this on your credit history and decide not to give you a mortgage or may offer higher interest rates, making it difficult to purchase a home.

Consolidating your debt into your mortgage can be a good idea depending on a few factors. You will need to ask the following questions to your mortgage broker:

• Can you qualify for a new mortgage based on the current rules around mortgages?
• Will your new mortgage rate be less or more than your current rate?  
• Does the decrease in interest you will pay on non-mortgage debts outweigh the increase in mortgage interest you will pay?
• How much will it cost to break your current mortgage? Are there any legal fees involved?
• Will your property need to be re-assessed? Will there be fees involved with that?

Before deciding to consolidate your debt into your mortgage, speak with your bank and a mortgage broker to understand the full picture of what this might look like. 

Debt Consolidation for Student Loans

Before considering debt consolidation for student loans, graduates should carefully consider all options, including government repayment assistance programs, or simply improving budgeting skills. Transferring government loans to a private lender can result in losing access to government repayment assistance programs and tax deductions, and could lead to higher interest rates. Additionally, extending the repayment period might lower monthly payments but increase the total interest paid over time.

If you go down this path, you can either use a debt consolidation loan or a DCP to pay off your student loans. Debt consolidation can help with student loans and Student Lines of Credit by combining two or more government-issued student loan debts into one payment. With a debt consolidation loan, you would obtain a loan from a bank or credit union and use it to pay off your student loans. Then, you would only be making payments on the new loan. With a DCP,  a credit counsellor would negotiate with creditors on your behalf to rearrange all your debt into one payment and reduce or stop interest rates. Student loans can be included in this program only if they have already gone to collections. 

Debt Consolidation with Bad Credit

Consolidating debt with bad credit can be challenging, but there are several options to explore. You might consider borrowing from a loved one, securing a co-signer, or transferring balances to a 0% interest credit card if you have already qualified for one. Home equity loans are another option, though they carry the risk of losing your home if you fall behind on payments. If these aren't viable, a consumer proposal or a DCP  through a non-profit credit counseling agency like Credit Canada might be worth considering. These don’t require good credit and can help you manage your debts with lower monthly payments and reduced or no interest. 

Learn 7 ways to consolidate debt with bad credit.

Balancing the Benefits of Debt Elimination Strategies

It can help to run a check of your current outstanding debts and compare the cost of paying them off using a loan vs the cost of negotiating the payment down with reduced interest in a DCP. This is something that a debt calculator tool could help you with. Simply plug in the value of the debts, their interest rates, and how much the monthly payment would be, and get an estimate of how long you’d be paying it off using five different repayment strategies (and how much you would pay in interest over that time).

For example, if you had a debt of $20,000 with an annual interest rate of 20%, here are some approximate payoff times and interest amounts:

• Minimum Payment Method (2.5% of Balance). This would take over 25 years and amass over $36,750 of interest over that time.
• Paying $500 a Month. This would clear the debt in about 5.6 years and add about $13,233 of interest over that time.
• Consolidation Loan at 8%APR (Paying $500/Month). This would clear the debt in 3.9 years and reduce the interest paid to about $3,339 (assuming an 8% APR).
• Debt Consolidation Program. Under a DCP, the monthly payment would be about $462.92 and take about 4 years to pay off—and may very well eliminate interest payments.

Of course, there’s always some room for variability depending on the creditor or the bank you deal with. For example, a bank might offer an even lower APR rate on a consolidation loan—allowing you to pay off your debt faster and with less lost to interest than stated here. Or, a creditor might not be willing to negotiate away your interest when you enter a DCP.

This is why it’s important to investigate all of your options before choosing a method for consolidating your debt. In some cases, you may even want to consider filing for insolvency with a licensed insolvency trustee (LIT) if you are drowning in debt that you cannot conceivably recover from.

Need help finding the best way out of debt? Credit Canada is here to help you. Our experienced and compassionate credit counsellors are here to give you the non-judgmental support you need to get out of debt and get back to your life. Reach out today to get started!