by Scott Hannah
Q: I have two credit cards with outstanding balances of approximately $5,000 and $8,000. I also owe about $15,000 on my car loan. I know it’s crazy to be carrying a balance on your credit cards which is why I spoke with a loans officer at my credit union where I have my mortgage about consolidating my debt at a lower rate of interest. Because I have a good credit rating and equity in my condo, they have approved a line of credit for me with a limit of $50,000. They would have given me $100,000 but they would have had to put a lien on the title of my condo and I didn’t want that. The line of credit will allow me to consolidate my debt at a much lower rate of interest and with a minimum payment that is less than half of what my payments are today. Before I go ahead and consolidate debt on a line of credit, I wanted to know if there are any hidden dangers that I should be aware of. Thanks! ~Geoff
A: First off, it’s great that you are taking the time to find out the potential downsides of using a line of credit for debt consolidation before going ahead and asking questions afterwards. I wish more people would carefully evaluate the pros and cons of taking out credit and the implications to their financial well-being over the long term.
There are risks and benefits with all credit products and one of the best ways to protect yourself is to fully understand the terms and responsibilities associated with the type of credit you are looking for. In addition, you need to understand that while your financial institution has approved a credit limit of $50,000, it doesn’t mean that fully utilizing this limit is in your best interest.
Here are four things for you to consider and carefully evaluate before using your credit line to consolidate debt:
1. Look to the future before taking on debt today
Financial institutions will typically look at your past history of repayment, financial ability to repay the credit requested, along with any security they may require to support the credit application. In your situation, because of your good credit rating and the equity in your home, your financial institution (FI) is comfortable lending you up to $50,000 on an unsecured basis. However, while creditors are very good at managing how much credit they will extend to their customers, they do not consider how extending this credit may impact their customers. It’s up to the consumer who is looking to take on debt to carefully weigh the pros and cons of incurring debt to ensure they can manage it.
For instance, what happens if your circumstances change, how will you manage? Would you use your line of credit when you’re dealing with a financial crisis? What if you lost your job, does it make good financial sense to take on debt when you have no income or reduced income? You could find yourself in worse shape if you don’t resolve your situation in a timely manner. Your credit rating could suffer a lot of damage and take years to repair if you are not careful. It’s easy to have a false sense of financial security with a line of credit.
2. A line of credit can make it hard to say No to impulse spending
Many consumers take out a line of credit (LOC) with the intent of consolidating and paying down their debt. Unfortunately, having access to additional credit that doesn’t cost them anything until they use it can be a hard temptation to resist, especially when the interest charges on lines of credit are still low. It becomes easy to justify that the great prices you got on your purchases will more or less offset the interest charges. While this may be true if you paid off the charges in a short period of time, a lot of people carry active balances on a LOC, and the ongoing monthly interest charges can and do erase the savings on the items they bought.
3. Budgeting is a four-letter word
Alright, I’m being a little cheeky, but budgeting really is a four-letter word from my perspective and that word is "plan." I’m not going to go into the ins and outs of making a spending plan as I’ve written on this many times before. The point I want to address here is that if you don’t have a good understanding of your actual monthly expenses and aren’t living within your means, a line of credit can become your worst financial enemy. When you have a line of credit, if you find yourself short between paydays it’s a relatively easy and painless process to tap into and borrow from your credit line; shortfall solved just like that. If you haven’t managed to save up funds to cover annual/seasonal expenses, it’s not a problem if you can once again tap into your LOC.
By living beyond your means with the help of a LOC, your dream of getting out of debt may turn out to be nothing more than a dream, or in this case a nightmare. Even with low interest rates, the amount of interest you’ll pay each year will be in the thousands of dollars once your balance starts climbing closer to your credit limit. It’s difficult to get ahead and save for retirement if you stay in debt. This is a serious problem in Canada right now; Canadians are carrying record levels of debt and finding it near impossible to save sufficiently for retirement.
4. The impact of rising interest rates
We’ve had two interest rate increases over the last year and the Governor of the Bank of Canada is promising more in the future. With an increase in interest rates, two things will happen; your interest rate on your LOC will be increased and your monthly payment will go up to offset the higher interest charges. Depending on your financial situation at the time, your financial institution could reduce your credit limit as a means of reducing the potential increase in the number of customers who may struggle with higher interest costs. This isn’t likely in the short term but it’s something to be aware of.
The bottom line on lines of credit and debt consolidation
Credit can help you drive forward towards a solid financial future; use it carelessly and you may be headed for a financial crash that can take years to resolve. A line of credit is just a tool to help you manage your finances; it can be good or bad depending on how you use it. However, due to its revolving nature, it can keep you in debt longer than a pay-down loan. So play it smart; use a credit line carefully and responsibly and never let it get in the way of your long term financial goals.
- What to Do If You’ve Been Declined for a Consolidation Loan
- What is Debt Consolidation and How Does It Work?
- 7 Steps to Get a Great Credit Score in Canada