It’s no secret that rising interest rates and ballooning inflation are deepening financial anxieties for Canadians. Earlier this year, the Canada Mortgage & Housing Corporation reported that Canadian household debt is now highest among the G7.
With growing numbers of Canadians feeling the pinch, borrowers are facing particularly hard circumstances as the cost of debt continues to rise. As a result, extreme debt solutions like consumer proposals and bankruptcy are more readily considered as a way out of unmanageable burdens of debt.
What is a consumer proposal?
A consumer proposal is a legal agreement made between a lender and a creditor to repay at least part of the debt that is owed. It is debt management option for consumers who:
- have more debts than assets,
- are unable to keep up with their debt payments, and
- have debts that amount to less than $250,000.
Consumer proposals are intended as an alternative to bankruptcy. In Canada they are administered by a Licensed Insolvency Trustee (LIT), or a Bankruptcy Trustee. During the consumer proposal process, your LIT will take the balance of your unsecured debts (including credit card debt, line of credit, student debt and more), and draws up a settlement offer to your creditors. You will still have to pay back your debt, but it may be negotiated down to a fraction of what you previously owed, paid out at regular intervals.
The benefit to your creditors is that the negotiated settlement offered will likely be more than they would have recovered by seizing your assets.
“Consumer proposals are a step to take if you want to avoid bankruptcy”, writes Rebecca Awram, Mortgage Advisor at Seniors Lending Centre. “However, borrowers are required to offer creditors more than they would receive if you filed for bankruptcy.”
How does filing a consumer proposal work in Canada?
When a consumer proposal is accepted for the creditor, payments are made directly to the trustee, who pays the creditors on behalf of the debtor. The trustee will also take 20% of future payments for their administration fees, excluding the $1,500 required to propose and proceed with the agreement. Most consumer agreements last for four to five years.
Consumer proposals can handle most types of unsecured debt, like credit card debt or student loans. If you’ve got a mortgage and decide to file for consumer proposal, you shouldn’t have a problem renewing, provided that you can still make your payments.
But while a consumer proposal could save you from having to declare bankruptcy, it could also cost you more, since creditors will be looking to recoup more money than they would with a bankruptcy.
However, you’ll have much longer to pay off the agreed debt with a consumer proposal, which can soften the blow.
What do you lose by filing for consumer proposal?
Consumer proposals can significantly reduce your debt load and may be an effective way to consolidate if you can make repayments. It’s also a good alternative if you can’t qualify for a debt consolidation loan, but still have the resources available to negotiate repayment.
And, unlike with filing bankruptcy, you won’t be forced to relinquish any assets, such as your house or your car. However, consumer proposals can get expensive, and there’s no guarantee that your proposal will be accepted by your creditors, even though it costs $750 to file one.
It can get even more expensive if you’ve got valuable assets such as a new car or significant home equity that lenders might otherwise expect to claim in bankruptcy.
In some cases, consumer proposals will require you to include the cost of assets above a certain threshold, as the proposal must be greater than the value of the equity in your home and car (minus the provincial exemption limit, which is the basic amount of items and assets you get to keep in the event of insolvency).
This can lead to you to essentially buy back certain assets as part of their consumer proposal, significantly increasing the total cost of your payments.
Lastly, if accepted, a consumer proposal will damage your credit score to about the same degree as bankruptcy, so you’ll still have a huge credit building task ahead of you once it's all over.
What does it mean to file for bankruptcy in Canada?
Bankruptcy is the final option for insolvency, intended to allow someone financially under water to be discharged from most of their debts.
Like a consumer proposal, a bankruptcy is managed through a licensed trustee, who files the bankruptcy on your behalf and manages your assets held in trust. The trustee will then liquidate your qualifying assets (including tax refunds, stock investments, vehicles or home equity) and distribute the agreed amounts to your creditors.
Once you have been declared bankrupt, payments to any unsecured creditors will cease. If you’re under threat of legal action over debt, or having your wages garnished, those activities will also stop.
What are the main drawbacks to filing for bankruptcy?
The biggest drawback to bankruptcy, and the reason why people generally want to avoid filing for bankruptcy at all costs, is that there is a risk that you could be forced to sell your home.
Equity is worked out to by taking the market value of your home, minus the cost of your remaining mortgage, taxes, and other closing costs. In many provinces including Ontario, the exemption limit on the equity on your home is around $10, 000 — so if the equity in your home is less than $10,000, you can keep your house and your trustee will work with you on continuing your mortgage payments.
However, if you have over your province’s exemption limit in equity, you may have to find a way to pay back the surplus equity or forfeit your home.
“Get the right advice about what level of equity in your home will be considered for bankruptcy filing,” says Awram. “It may be added to your asset list if it's over a certain threshold, perhaps making the consumper proposal a better choice.”
Another drawback is that people who are in bankruptcy are also subject to strict income guidelines, with any “surplus income” going to creditors for up to two years.
You may also be forced to relinquish your registered accounts. Your TFSA contributions will not be protected from bankruptcy, nor will RRSP contributions made in the previous 12 months. Each province has its own guidelines regarding RRSP savings.
Lastly, declaring bankruptcy has its own price: The minimum cost to declare bankruptcy in Canada is typically around $1,800 to cover the trustee’s administration fees and time.
How do consumer proposals and bankruptcy compare?
Because consumer proposals involve offering creditors more money than you would in bankruptcy, they can be more expensive. However, the overall cost of either ultimately depends on your level of debt and the value of your assets.
Consumer proposals don’t necessarily require you to relinquish assets. However, if you do have assets which would likely be sold in bankruptcy, creditors may deny a consumer proposal with that in mind and encourage you to file for bankruptcy instead. And with bankruptcy, you may be allowed to keep assets such as a car only if it isn’t worth very much, as well as your house, if you’ve not got much equity in it.
Bankruptcy is also a much faster process than consumer proposals, especially if you’re declaring bankruptcy for the first time. While bankruptcy can last from nine to 21 months, consumer proposals usually involve making payments for up to five years.
One way they are similar is that both will cause your credit score to drop to the lowest rating. However, while bankruptcy will remain on your credit report for six years, a consumer proposal can be removed as soon as three years after being paid off.
How to choose between consumer proposal and bankruptcy
Knowing how to navigate severe debt can be a challenge, and will require the help of a Bankruptcy Trustee or credit counsellor.
“Consumer proposals are not necessarily a better option for your finances in the long run, as the effect on your credit score is really the same over time,” says Awram. “Lenders, unfortunately, tend to view the two outcomes about the same.”
Consumer proposals may seem less severe than bankruptcy, but both are still legally binding agreements that will significantly reduce your ability to borrow in the future. Keep in mind that it will usually take much longer to be discharged from a consumer proposal, meaning it will be longer still before you’re able to rebuild your credit score. This could be vital if you hope to land a future mortgage or any kind of loan.
Awram also suggests that the state of your assets should be an important factor in your decision. “If you have no assets, declaring bankruptcy might be the superior option.”
Alternative debt solutions in Canada
Both bankruptcy and consumer proposals are severe debt solutions, but there are alternatives that could prevent lenders from having to face those extremes at all.
Mortgage default numbers in Canada remain at a record low of 0.15%, indicating that Canadians are nonetheless finding ways to consolidate their debts and afford their increasing mortgage payments.
Debt consolidation, selling assets, informal proposals and guidance from credit counsellors are all on the table.
But is it a good idea to consolidate debt into your mortgage? According to Awram, that’s becoming less of a viable solution today. “Of course, mortgage rates have been high and rising for a while now, making qualification for this type of lending harder than ever.
For borrowers who are carrying large loads of credit card debt, one solution may be to apply for a balance transfer credit card and roll over all your outstanding credit card debt onto the new credit card. Often, these types of credit cards come with a low interest or an interest-free grace period ranging from one month to a year, giving you some time to pay off your debt without incurring more in interest. However, it’s crucial to commit to making payments during this grace period, as any missed payments can incur even higher interest rates.
Filing for consumer proposal or bankruptcy can be challenging and emotionally taxing. When considering either, always get advice from a licensed expert throughout the process – you never want to end up losing more than is necessary.