Debt Consolidation: The Dirty Truth

I compare credit card debt consolidation and other debt consolidation to liposuction. You may be getting rid of the appearance of indebtedness (or fat) by treating the visible symptoms, but you're not treating the root cause of your debt: spending too much (or eating too much).

I know this analogy has been rehashed more times than I can count, but credit card debt is like a sinking ship: you've got to plug the holes before you start bailing water. If you can't plug the money leaks, you're pretty much guaranteed to go down with the ship.

The problem with treating the symptoms of credit card debt rather than the root cause (spending too much), is that the symptoms will return. If you want to kill the debt, you have to hack it off at the roots. One of the best ways that I know to kill a spending problem is through a personal budget. You'll gain great insight into what you're spending your money on, and what you need to do to correct it, but only if you're willing to use a budget. It's the "little pain" right now that prevents the "big pain" later on.

Debt consolidation turns a lot of high-interest credit card debt into low-interest, low-payment debt. It's seemingly miraculous how the debt-consolidation companies do this. You might be tricked into thinking they're doing this out of the kindness of their heart, but look a little closer. They're actually turning your high payments into low payments by extending the term of your loan. Thus, a debt that might have taken four years to pay off if you made regular, consistent payments, will now take six or seven years to pay off. They haven't done you any favors by consolidating your debt.

According to an interview about debt elimination that I heard at Hard to Find Seminars, most people don't even complete the debt consolidation process. They'll quit after just a year or so, leaving them back where they started. But even if their clients do that, the debt consolidation companies still make money, to the tune of several thousand for each person.

One of the sneakiest things about debt consolidation that you'll probably never hear anywhere else, is that you could end up owing the IRS for the debt you didn't have to pay. Insane, isn't it? But it's true: it's called "imputed income". According to the tax laws, when you don't have to pay back a debt, you must recognize income because of the difference in what you were loaned and what you had to pay back. Here's an example:

You're loaned $100,000 by the bank. Even if you bought a house with the $100,000, you still count it as money received. The money received is offset by the $100,000 liability, or "mortgage", that you now owe. If you pay back the whole $100,000, then your "income" and "outgo" are the same, and you recognize no income.

On the other hand, if you are unable to pay back the $100,000, and the bank forgives $40,000 of the loan, the "income" and "outgo" are no longer balanced. You have $100,000 of income, and only $60,000 of outgo, and the difference between those two is $40,000 of imputed income.

So, even if you consolidate your debt, you're not out of the hole you've dug for yourself. You might end up owing taxes on that $40,000 even if you don't have the money.

If you're in debt, there are many ways out, but you really should not consider debt consolidation as an option. I suggest the Free Excel Spreadsheets section of this website as a good starting place for eliminating debt. There are several helpful debt elimination calculators for you there.