Want to know a secret about debt consolidation loans? They usually don’t work. There’s a lot of money to be made by promoting and arranging these loans, as well as the enormous hope that surrounds them, so you won’t hear too much about how they don’t work. Having worked in the mortgage business for many years, and seeing the process play out again and again, I can say on good authority that it usually doesn’t work. Great idea in theory, but the reality looks radically different.

Nearly any kind of loan can work for debt consolidation — cash-out first mortgages, second mortgages, home equity lines of credit (HELOCs), unsecured loans, and even credit cards. But the problems usually aren’t the loans themselves; it’s the human factor.

An Example Debt Consolidation that Fails

To give an example, the typical debt consolidation profile looks something like this:

Borrower has a $100,000 first mortgage, a $25,000 home equity line of credit, $20,000 in loans on two cars, and $30,000 on various credit cards. Total debt: $175,000.

The monthly payment on the first mortgage is $1,000 (including taxes and insurance), the home equity line is $200, car loans total $700, and credit cards add another $700. Total: a budget-busting $2,600 per month!

The borrower finds he can do a new first mortgage and consolidate all of his debts into one monthly payment of just $1,300 per month on a $175,000 loan. Wow, that was easy, wasn’t it?

But the story isn’t finished.

Two years later our borrower still has his new mortgage — with all of his old debts rolled into it — but he also has:

• a new home equity line of $30,000 (needed a new roof, remodeled master bath)
• a single new car loan of $25,000 (tax credit, zero interest, couldn’t pass it up), and
• $40,000 in credit cards (braces for two kids, “once-in-a-lifetime” trip to Europe last summer, etc).

Do you see the pattern? I saw it all the time — anyone who works in the lending industry sees it all the time! A bullet was dodged with the consolidation and life went back to normal. If house prices were still rising the way they were a few years ago, he’d probably do another consolidation to make the new load of debts go away.

Why Debt Consolidation Doesn’t Usually Work

We expect consolidations to make our debt go away, and to do so painlessly. If it were possible then no one would have debt problems. The truth is if you’re not feeling some pain during the consolidation you’re probably headed in the wrong direction!

There are a few factors sabotaging most debt consolidations, and they usually include one or more of the following:

1. The debtor’s primary concern is usually with getting his monthly payments under control. The emphasis is on making the consolidation payment much lower than the combined payments on his old debts rather than on actual debt elimination.
2. Because the new payment is often substantially lower than the combination of payments on the debts that were paid off, the debtor quickly falls back into the familiar patterns of consumption and money management that got him into debt in the first place.
3. Most lenders are more concerned with monthly payment levels than with overall debt as well, and offers of new financing flood in to the consolidator, who in many ways is addicted to debt.
4. Consolidation is the process of converting short term debt (credit cards, auto loans and consumer loans) into long term debt; if a cash out mortgage is used, the debt is effectively converted to permanent debt.
5. The long repayment terms that accompany most debt consolidation loans — to keep the payments low — increases the likelihood of incurring major expenses that might involve new debt. Life is still happening while the consolidation is sitting out there.

Have you tried a debt consolidation? How did it work for you?

Photo by Orin Zebest.