The Lure and the Trap of Debt Consolidation - and the Possible Benefits

A while ago I did an article entitled Debt Consolidation Refinance - Pros and Cons. It's a good article, if I do say so myself. Nonetheless, I think there's more to say on the subject, not just from a point of view of cranking some numbers, but on a meta level as well.

The most concrete lure of debt consolidation refinance is cash flow. Specifically, lower payments. The trap is that you are spreading principal payments over a much longer time. You refinance your home to pay off your car loan. Instead of paying the car off over three or five years, now you're paying it off over thirty. Instead of having it paid off when you go to buy another car, you still owe most of what you borrowed, and unless you saved the cash in the meantime, now you're layering more debt on top of what you already owe. So instead of having a paid off $25,000 automobile that's still worth $10,000 and no debt, you now have the forgoing plus $20,000 of debt that you still owe, and you are still paying interest on, on a car that you aren't going to get any more use out of. The fact that the security is your home rather than the vehicle changes nothing except the exact terms of the loan. You added $25,000 to your balance and $20,000 of it is still there, you're still making payments on it, and you are still paying interest on it.

Low payment is one of the best ways to sucker people into doing stupid things that I know of. Maybe that explains why I'm not rich; I want to figure out whether I'm actually helping the situation, and by the time I've worked it through, the folks are off calling the guy who's selling them the Option ARM who doesn't mention downsides or what is really important. As far as I can tell, low payment is the entire advantage of renting, for crying out loud. People think in terms of cash flow while flushing their financial future down the toilet in the name of lower payments.

There is a reason why that Statement of Cash Flow is the least important of the financial statements corporations are required to file, and Wall Street only discusses cash flow when there's something wrong. Unless they've got a large proportion of clients that don't pay their bills, the Income Statement is a lot more important. Corporations don't think of their facilities only in terms of the payments on their loans. Neither should you.

When you pay off a loan, of whatever nature, you are essentially transferring money from one pocket to another. Furthermore, once you have paid it off, you are no longer paying interest - the real cost of the money - on the balance. It's only the interest charge that you are really paying and that is costing you money. Paying off principal is paying yourself. Stretching the loan term from three years to thirty does not alter the amount of principal you pay, but it does greatly increase the amount of interest you pay. Even if you cut the interest rate from 10% to 6% and get a tax deduction to boot. Paying attention to payments is for suckers. You have to be able to make your payment, as I've said before, but so long as the payment is one you can make, concentrate on the real cost of the money - interest rate - and the cost of the loan, or how much you have to spend in order to get the loan funded. Weigh this against the benefits and how long those benefits last.

If all you are paying attention to is cash flow, and you consolidate your debt because it lowers your payment so that you can spend more money, don't be surprised if you find yourself in the same situation a little while down the line. This is a real world illustration of the law of diminishing returns. Each time you do it, you dig yourself in deeper, and there is less additional spending needed to get you to the point where you have to consolidate again. You consolidate your $1500 house payment and $40,000 in debt, and your new payment is $1800. Then you consolidate that and $30,000 in debt, and your new payment is $2100. Then you consolidate that and $20,000, and your new payment is $2400. What do you do when you can't consolidate any more, and you can't afford the payments, either?

If, on the other hand, you consolidate because it lowers your cost of interest and gets you a tax break and you still keep making the same payments as before, then you're miles ahead. If you're using debt consolidation to lower your payment, you are doing it wrong. If your choices are bankruptcy or debt consolidation, well, if you've got a nice stable home loan that you're not going to need to refinance for a couple of years, I might actually consider bankruptcy, particularly if I only need to shed one or two lines of credit. Obviously, talk to bankruptcy attorney first, but once you've rolled it into your home loan, those higher costs are a part of your life for as long as you own the property and haven't paid the loan off. If you can't afford them and you're a serial consolidator, eventually you're going to get to point where you lose the property.

If you consolidate in order to cut your interest costs, and you don't roll excessive loan fees in to your balance, and you keep making the same payment as before and don't take on any more debt until the balance on your home loan is at least as low as it was before you consolidated, then you come out ahead. Way ahead. You're a little bit ahead due to the lowered costs of interest, and you're a little bit further ahead due to the tax break from interest on home loans, and after you get to the point where you were before, every payment you make without adding new debt pays off much more of your balance. In my original Debt Consolidation Refinance article, I used the example of rolling $75,000 debt into a preexisting $300,000 mortgage. It raised the minimum payment by about $400 and cut the overall minimum payment by $1100. If that minimum payment is the reason you did it, you just hosed yourself. But if you cut your overall cost of interest, and kept making the same payments, you've accelerated your payoff schedule. Make the same payments as before, and you're even in less time than it would have taken to pay the consumer credit down. Keep making those same payments after you've brought yourself even, and it can pay the entire debt load off in half the time or less that your home loan would have taken. Even if you don't make it all the way to zero before you need another car, debt consolidation can set you years ahead in just a few short months - but only after you've paid your balance down to where it was before.

In short, debt consolidation refinance is not some magic wand to get out of debt free. There are pitfalls into which the overwhelming majority of people fall, because they do it for the wrong reasons, and afterwards, they keep doing it again and again until some disaster happens and they lose the property. However, correctly handled, it can significantly enhance your financial situation.

Caveat Emptor