Debt consolidation vs consumer proposals

Imagine you're juggling a $40,000 load of debt from credit cards and lines of credit, on top of a car loan and a mortgage. Your paycheck just about covers your living expenses, leaving little room to tackle this mountain of debt, while interest continues to escalate. Adding to the strain, it's time to renew your fixed-rate mortgage.

This scenario is increasingly common among Canadians as evidenced by the noticeable uptick in online searches for debt consolidation and bankruptcy solutions.

So, what options do you have in such a stressful financial situation? This article zeroes in on two key strategies to mitigate financial strain: debt consolidation and Consumer Proposals. We go deep, analyzing the pros and cons of each option and in which scenario is one likelier to opt for a consumer proposal vs debt consolidation and vice versa. Our objective is to equip you with the necessary insights to help make an informed decision and clean up your financial situation.

What is debt consolidation?

Debt consolidation is a financial strategy used to simplify debt management and potentially reduce the overall interest rate on outstanding debts. Here's how it generally works:

• Combining debts: Debt consolidation involves taking out a new loan to pay off multiple debts. This could include credit card balances, loans, back taxes and other unsecured debts. The idea is to combine these debts into one single loan.

• Lower interest rates: Ideally, the new loan will have a lower interest rate than the average of the existing debts, reducing the total amount of interest paid overtime. This isn't always guaranteed, so it's important to shop around for the best terms.

• Simplified payments: Consolidating debt means you only have one monthly payment to keep track of, instead of multiple payments with different due dates and amounts, making it easier to manage your finances and avoid late payments.

• Types of debt consolidation Loans: There are several ways to consolidate debt, including personal loans, home equity loans, and balance transfer credit cards. The best choice depends on your financial situation. If you're a homeowner with accumulated equity in your property but poor credit, a home equity loan from PADS can be the ideal solution for consolidating your debt.

• Impact on credit score: Initially, applying for a debt consolidation loan may impact your credit score because lenders will perform a hard inquiry into your credit report. However, in the long term, consolidating debt can improve your credit score by lowering your credit utilization ratio and making it easier to make on-time payments.  

• Considerations and risks: It's important to consider the fees involved with debt consolidation, such as origination fees for a new loan or balance transfer fees for a credit card. Also, using a secured loan (like a home equity loan) to consolidate unsecured debt puts the collateral at risk if you fail to make payments.

What is a consumer proposal?

A consumer proposal is a legal process designed as an alternative to bankruptcy in Canada, allowing individuals to settle their debts with creditors for less than the amount owed. It's administered by a Licensed Insolvency Trustee (LIT), who works with you to formulate a proposal—a plan to pay creditors a portion of what is owed to them over a specific period or to extend the time you must time you to pay off the debts or both. Here’s how it works:

• Assessment: You meet with a Licensed Insolvency Trustee (LIT) to discuss your financial situation. The LIT assesses your income, debts, and assets to determine if a consumer proposal is the best option for debt relief.

• Developing the proposal: If a consumer proposal is considered the best path forward, the LIT will help you develop a proposal for your creditors. This proposal will outline how much you can afford to pay back, how long the repayment period will be (not to exceed five years), and how frequently you will make payments.  

• Filing the proposal: Once the proposal is prepared, the LIT files it with the Office of the Superintendent of Bankruptcy (OSB). Filing the proposal activates a "stay of proceedings," which immediately stops most creditors from pursuing legal action against you, such as garnishing your wages.  

• Creditor voting: After the proposal is filed, your creditors have 45 days to accept or reject the proposal. Acceptance is based on a majority vote (in dollar value) of the creditors who decide to vote. If most creditors accept the proposal, then all are bound by its terms.

• Making payments: Once accepted, you must adhere strictly to the terms of the proposal and make regular payments to the LIT, who then distributes these funds to your creditors as outlined in the proposal.

• Credit counselling: Completing two credit counselling sessions is a mandatory part of the process. These sessions aim to help you manage your finances better in the future, understand the factors that contributed to your financial difficulties, and rebuild your credit.  

• Completion: Once you have fulfilled all the terms of your consumer proposal, including making all the payments and attending the counselling sessions, you will be legally released from the debts included in the proposal.   

• Impact on credit score: A consumer proposal does affect your credit rating, recording an R7 rating on your credit report for the debts included in the proposal. This rating remains for three years after you complete the proposal payments, marking that you have made a settlement with your creditors.

A consumer proposal can be a viable option for individuals looking to avoid bankruptcy and get a fresh start on their finances, while still repaying a portion of their debts. It's less severe than bankruptcy in terms of impact on your assets and credit report, but it's still a significant financial decision that should be made with careful consideration and guidance from a Licensed Insolvency Trustee.

Considerations and risks of a consumer proposal

• Credit rating impact: A consumer proposal will negatively affect your credit rating. It remains on your credit report for a period after completion (usually three years in Canada), making it more difficult to obtain new credit during that time.

• Not all debts can be included: Certain debts like secured loans (e.g., mortgage), alimony and child support obligations, and student loans (if it's been less than seven years since you were a student) may not be included in a consumer proposal.

• Loss of credit cards: You will likely have to surrender your credit cards and may find it challenging to obtain new ones until your credit score improves.

• Asset consideration: While you generally retain your assets in a consumer proposal, the value of your assets can affect the proposal terms, as you're expected to offer your creditors a deal that is at least as good as what they would receive if you declared bankruptcy.

• Failure to comply: If you miss three months' payments, the proposal can be annulled, reinstating the original debt amounts plus interest, and creditors can resume collection efforts.

• Public record: Your consumer proposal is a matter of public record, which might concern some individuals, though it's less publicized than bankruptcy.

• No Guarantee of acceptance: Creditors might not accept your proposal; in which case you might need to negotiate new terms or consider bankruptcy.

When one might choose a consumer proposal over debt consolidation  

A homeowner, or any individual facing financial difficulties, might opt for a consumer proposal instead of a debt consolidation loan in several specific scenarios. Each choice has its advantages and drawbacks, and the decision often depends on the individual's financial situation, goals, and the nature of their debts. Here are some scenarios where a consumer proposal could make sense as a solution to mounting debt:

• Overwhelming debt levels: If a homeowner’s debt levels are so high that they can’t even afford debt consolidation payments, they may opt for a consumer proposal that can offer a way to reduce the principal amount owed, not just lower the interest rate.

• Low home equity: Homeowners with significant unsecured debt might find a consumer proposal more appealing if consolidating through secured means (e.g., home equity) is not desirable or if they don't have enough equity in their home.  

• Collateral concerns: Homeowners might prefer a consumer proposal if they're concerned about losing their home or other assets. A consumer proposal can protect their home from being seized by creditors.  

• Legal protection from creditors: Once a consumer proposal is filed, creditors are legally forbidden from taking further collection actions against the individual. This includes stopping all lawsuits, wage garnishments, and any other collection efforts that were in progress or planned.

When one might choose debt consolidation over consumer proposal  

On the flip side, there are situations where a homeowner might choose a debt consolidation loan over a consumer proposal, such as the cases below:  

• Leveraging home equity: Homeowners with significant equity in their property might find a home equity loan an attractive option for consolidating debt. These secured loans typically offer lower interest rates compared to unsecured loans and credit cards, making them a cost-effective way to consolidate.  

• A good credit score: Homeowners with a good credit score can access debt consolidation loans with favorable interest rates. If the debt level is high but still manageable and the homeowner has maintained a good credit rating, consolidating at a lower interest rate could significantly reduce monthly payments without the need for a consumer proposal.

• Credit rating concerns: A consumer proposal will negatively impact one's credit score for about 3 years after completion. Homeowners concerned about maintaining their credit score for future financial opportunities could opt for a debt consolidation loan, which can improve credit scores over time through consistent, on-time payments and the elimination of existing debts.  

• Privacy concerns: A consumer proposal is a matter of public record, accessible through the Office of the Superintendent of Bankruptcy (in Canada). Homeowners concerned about the public nature of a consumer proposal might prefer a debt consolidation loan, which is a private agreement between them and their lender.

• Asset retention and control: Homeowners who prefer to maintain control over their assets without involving a trustee might choose a debt consolidation loan. This option allows them to avoid the formal legal process of a consumer proposal and manage their debt repayment directly with their creditors.  

• Less restrictive: When you file a consumer proposal, your ability to obtain new credit is limited and can affect your capacity to secure a mortgage for a new property or qualify for a loan. Debt consolidation does the opposite – it can free up cashflow and simplify your payments.

Debt consolidation and consumer proposals are 2 valid options for those wanting to sort out their finances and find a fresh start. We've unpacked both strategies, highlighting the pros and cons, and laying out the contexts in which one might be more advantageous than the other.

While a consumer proposal can help significantly reduce your debt with 1 fixed payment and no interest payments, the impact to your credit score, loss of credit cards and public record of the filing can handicap you for years to come. A home equity loan for debt consolidation on the other hand, can be a better option, especially for homeowners with considerable equity on their property.

Ultimately, the point of this article is to inform. It’s imperative to understand your own financial situation better and talk to experts before deciding between a consumer proposal and debt consolidation.  

Whichever strategy you decide on, it's imperative to maintain a focus on the long-term goal of financial stability, ensuring that you’re also building the foundations to prevent future financial setbacks. This approach helps achieve immediate financial relief and fosters a sustainable financial future.