Debt Consolidation versus Debt Settlement

So what is the difference between these two methods of dealing with debt? Simply put:

  • A debt consolidation requires you to repay all of your debts, albeit on favourable terms.
  • A debt settlement allows you to repay some of your debt on favourable terms. The balance of what you owe is legally discharged.

Debt Consolidation Option 1: Getting a loan

The most effective way to perform a debt consolidation is to get a loan at a lower interest rate than the interest you’re currently paying on your debts. For example:

  • Cindy has 10 credit cards totalling $10,000. The average interest rate she’s paying is about 18%. If she were to pay off this debt in one year making equal payments of $916.80 each month, she’d be paying $1,001.61 in interest:
Begin End
Month Balance Payment Principal Interest Balance
January 10,000.00 916.80 766.80 150.00 9,233.20
February 9,233.20 916.80 778.30 138.50 8,454.90
March 8,454.90 916.80 789.98 126.82 7,664.92
April 7,664.92 916.80 801.83 114.97 6,863.09
May 6,863.10 916.80 813.85 102.95 6,049.25
June 6,049.24 916.80 826.06 90.74 5,223.18
July 5,223.18 916.80 838.45 78.35 4,384.73
August 4,384.73 916.80 851.03 65.77 3,533.70
September 3,533.70 916.80 863.79 53.01 2,669.91
October 2,669.91 916.80 876.75 40.05 1,793.16
November 1,793.15 916.80 889.90 26.90 903.25
December 903.25 903.25 889.70 13.55
10,988.05 1,001.61
  • She’s able to get a $10,000 consolidation loan from TD Canada Trust. The loan has an interest rate of 9%.She uses the $10,000 to pay off all her credit card debt and starts repaying her TD loan over one year on a monthly basis. Because of the lower interest rate, she’d be paying only $494.14 in interest and her monthly payments ($874.51) are also lower:
Begin End
Month Balance Payment Principal Interest Balance
January 10,000.00 874.51 799.51 75.00 9,200.49
February 9,200.49 874.51 805.51 69.00 8,394.98
March 8,394.97 874.51 811.55 62.96 7,583.42
April 7,583.42 874.51 817.64 56.87 6,765.78
May 6,765.78 874.51 823.77 50.74 5,942.01
June 5,942.01 874.51 829.95 44.56 5,112.06
July 5,112.06 874.51 836.17 38.34 4,275.89
August 4,275.89 874.51 842.45 32.06 3,433.44
September 3,433.44 874.51 848.76 25.75 2,584.68
October 2,584.68 874.51 855.13 19.38 1,729.55
November 1,729.55 874.51 861.54 12.97 868.01
December 868.00 868.00 861.49 6.51
10,487.61 494.14

As the 9% interest she’s paying on the TD loan is significantly lower than the 18% she was paying on her credit card debt, she’ll be able to pay off her debt much more easily. This is the ideal way to get out of high interest debt.

Debt Consolidation Option 2: Debt Management Plan

If Cindy was unable to get a debt consolidation loan, she could attempt to facilitate a Debt Management Plan through a reputable credit counselling agency.

The agency negotiates with the creditors to work out a repayment plan. Cindy would be required to repay all of her debts, but the agency may negotiate a reduction in the interest and monthly payments paid by her. The maximum repayment period is usually 60 months.

The clear disadvantage of a DMP is that it affects Cindy’s credit in a way similar to a bankruptcy filing. Also, she’d be required to repay all of her debts, albeit on more favourable terms, despite the negative impact on her credit rating.

Debt Settlement – Filing a Consumer Proposal

A consumer proposal is a legal settlement under the Bankruptcy and Insolvency Act facilitated through a bankruptcy trustee. It allows a debtor to pay less than the total amount she owes to her creditors. The balance of her debts are discharged upon completing payment of her proposal.

To use Cindy as an example again, she owes $10,000 in credit card debt and is unable to get a loan or afford to pay a Debt Management Plan. She works with a bankruptcy trustee to put together a proposal where she’ll pay $200 per month for 36 months ($7,200) as full and final settlement of the $10,000 she owes. The payments are made to the trustee who holds the money in trust for Cindy’s creditors.

Cindy’s creditors accept the proposal and three years later, she finishes paying the $7,200 to the trustee, who then pays himself his fees (based on a government tariff) from the trust account with the balance paid to Cindy’s creditors on a pro rata basis:

Payment under proposal $7,200.00
($200/month x 36 months)
Trustee fees per gov’t tariff (3,165.21)
Distributed to creditors: $4,034.79
Owed to Cindy’s creditors: $10,000.00
Return to Cindy’s creditors: 40%

So to summarize Cindy’s situation, here are the advantages of a settlement through a consumer proposal:

  • Cindy wasn’t required to pay all of her debts
  • Upon filing the proposal, Cindy’s creditors were legally prohibited from initiating or continuing collection proceedings against her. The legal term for this is called a “stay of proceedings”
  • The impact on her credit is no worse than if she attempted a debt management plan through a credit counselling agency
  • Cindy wasn’t required to pay a fee to the trustee. The trustee’s fees are paid by her creditors out of the trust funds he holds in trust.

This blog post is an overview rather than a complete analysis. Before applying any of these suggestions, please contact us to discuss your situation with us. We’ll be more than happy to speak with you.

© Copyright Fong and Partners Inc 2010.

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