The Truth About Debt Consolidation

Refinancing and consolidating your debt under a new, lower rate sounds like a no-brainer, but it’s not always the best move. Many folks these days have no choice but to refinance because they’re in a loan that was fixed for a period of years, but is now going to an adjustable rate that could make payments go way up. Or maybe you have a loan with a balloon payment due at the end of its term and you either need to refinance or sell the house and move.

There are definitely good reasons to refinance, but should you really be rolling all your debt over into a mortgage loan with a much longer term? Are you sure you want to consolidate that car note at 10.9%, your student loan payments at 7.5%, that credit card balance at 17.9%, and your current first mortgage at 6.8%? What if you’re offered a rate of 6.25% that allows you to consolidate all this debt under the new lower rate, with lower overall monthly payments? It’s a no brainer, right?

No way!

Although there are some cases where you may decide it’s beneficial for you to consolidate debt in this manner, I can’t think of a situation where wouldn’t cost you lot more in the end with typical rates and terms. Mortgage brokers will also try to convince you that it’s a good move tax-wise because you’re taking debt from something like a car loan, which is not tax deductible, and putting that into a mortgage loan, which is tax deductible. This doesn’t always work out as well as you might think, which I’ll explain in a minute. Bottom line is that consolidating debt is fine if that’s what you want to do, but before making that decision, you need all the facts.

There are two major factors that make debt consolidation ultimately more expensive:

1. Paying interest on money for which you have already paid interest
2. Paying interest at a low rate for a lot of years can be more expensive than paying at a higher rate for only a few years

In my opinion, what matters most in determining whether things like this are a good deal is how much it costs in the end. As the character, Wimpy, used to say in the Popeye cartoons, “I’ll gladly pay you Tuesday for a hamburger today.” Only you can decide if it’s worth the extra money down the road to lower your monthly payments today.

Paying interest on money for which you have already paid interest

I hate to pay for things twice. When you have a car loan, for example, for a term of 60 months (5 years) and you’re on year 4 and you want to consolidate that remaining debt under a new mortgage, you’re going to end up paying all that interest over again. Why? Because if you look at an amortization schedule of the car loan, you’ll see that the vast majority of the interest gets paid up front. This means if that car note at 10.9% is for a 5-year term and you’re on year number 4, you’ve already paid the majority of the interest on that loan. Adding the remaining debt to a new consolidation loan or mortgage would mean that you’ll be paying the interest all over again!

In order to see an example, we need to use a loan amortization calculator. If we take the car note as an example, we’ll make the following assumptions:

- original loan amount: $25,000
- term of loan: 5 years (60 months)
- interest rate: 10.9%
- down payment: $0

If you put that information into the amortization calculator, you’ll see that on your very first payment, you’re paying $227.08 in interest and $315.23 on the principal and the amount of interest you pay each month goes down. By the time you’re on your 48th payment (end of year 4), you’re paying $60.14 in interest and $482.17 on the principal and your remaining balance is $6139.29.

What would happen if we were to consolidate this remaining balance under a new mortgage loan at 6.25%? To make sure we’re comparing apples to apples, let’s isolate the money from the car loan and see what would happen to just that money, without the new 1st mortgage and all that stuff added to it. If we used the amortization calculator again with a loan amount of $6139.39 (the amount remaining after the 4th year of the car loan), an interest rate of 6.25% (the interest rate of the new mortgage), and a term of 30 years (360 months), we would get some alarmingly different numbers.

Doesn’t that make you think a little differently about consolidating debt under a mortgage with a much longer term? It’s pretty clear that consolidating the car note under a new 30-year mortgage makes no sense whatsoever if your goal is to pay out the smallest amount of interest possible.

Paying interest at a low rate for a lot of years can be more expensive than paying at a higher rate for only a few years

I give the above example because I hate so much to pay interest twice, but in a more general sense, paying back a loan over a long period of time is expensive. But is it always? Let’s just take some easy numbers and compare payback amounts:

It’s interesting to see that a loan with a term of 5 years at 10% costs dramatically less than a loan 30 years at 5%. But if we look in the middle, there seems to be a break even point. The loan at 10 years and 5% interest is actually the best deal because you’re paying the least interest with a low payment. You get a payment of about half that amount if you go 30 years, as is the case with many mortgage loans, but you’re going to pay back more than 3 times as much in interest.

Oh, and let’s consider that tax deduction issue I mentioned earlier. I have a friend with a construction business who thinks that just because you can write off expenses, it practically makes everything free. Uh…you still have a net payout even if you are getting a significant tax deduction. Don’t make the mistake of justifying a high cost by saying that some portion of it is tax deductible. Let’s look at an example:

Say you’re comparing the 5-year loan above against the 30-year loan and the 5-year loan is not tax deductible, but the 30-year loan is. With a very rough assumption of an ordinary income rate of almost 30% and a deduction of $9324.80, you’re still going to have a net payout of $6527.36 compared to a net payout of $2748.20 with the non-tax deductible loan. Tax deductible does not mean free!

If all this stuff seems obvious to you, then give yourself a pat on the back, because you wouldn’t believe how many people think it’ll cost them less in the end to refinance with a lower interest rate under any circumstances. There are probably more elegant formulas to show these relationships, but for those of use who just need to pound it out and see the different scenarios to determine what the best deal is, this is the method:

1. Take each installment loan you have and look at the amortization schedule for the total loan. Enter the amount you originally borrowed and the original start date of that loan.

2. See where you are currently in that schedule of payments and note the remaining balance and the total interest paid to date.

3. Look at the total interest that will be paid by the end of the loan, and subtract from that the interest paid to date from Step 2. The result is the amount of interest you will pay if you stay in that loan until the end of its term.

4. Now enter the remaining balance from Step 2 into the amortization calculator, as well as the term and interest rate of your new mortgage (ex. 360 months @ 6.25%). The result is the amount of interest you will pay on this money if you consolidate under your new mortgage.

5. Repeat this process for each installment loan you have.

Written by Jim on August 25th, 2007 with 1 comment.
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