Recently, many financial institutions have introduced new financial products designed to consolidate all banking assets (savings accounts etc.) and debts into a single, master account.

The advantage to the consumer is that every penny of savings is applied to repayment of bank debt rather than languishing in a bank savings account earning a pittance for interest. Recent newspaper articles suggest that the notion of debt consolidation is a trend that is catching on with banks and consumers alike. Debt consolidation can be a very good and powerful tool, however, it can also create a problem that is costly and irreversible – surely a bad combination.

This problem arises in situations where a consumer has a mix of tax-deductible and non-deductible debt. I like to think of tax-deductible debt as “good debt” and the non-deductible kind as “bad debt”. An example of “good debt” is borrowing for investment purposes; “bad debt” is borrowing for personal purposes such as buying a principal residence. If you consolidate “good debt” and “bad debt” you’ll be left with “contaminated debt” for lack of a better term.

Consider the case of Deb T. Free, a taxpayer paying tax at the highest personal rate of 50 per cent with two debts of $50,000 (Debt A and Debt B), each bearing interest at a rate of 7%. Debt A is “bad debt” having been borrowed to purchase Mrs. Free’s principal residence; Debt B is “good debt” incurred to buy publicly traded stocks. Without doing anything fancy, amortizing these loans over ten years will require a monthly loan payment of $580.54 for each loan or $1,161.08 in total

Assume that Mrs. Free played it really smart when she set up her two original debts. Knowing that the interest on Debt B is tax deductible, Mrs. Free established this loan as a line of credit requiring payments of interest only. Her thinking at the time was that she’d be better off to focus on paying off her “bad debt” first so she bumped her monthly payment on her non-deductible debt, Debt A, by the principal she would have otherwise paid on Debt B. Overall her combined monthly payment remained the same (i.e., $1,161.08 per month) as if the two loans were simply amortized in the normal fashion; the only difference here was the allocation of her monthly payment – a larger portion of her monthly payment was now being applied against her “bad debt”. This is a good thing.

By structuring her two debts in this fashion, Mrs. Free calculates that she’ll discharge her non-deductible debt in five years at which time she can then focus her sights on paying off the tax-deductible debt. In this case, with proper structuring, Mrs. Free will pay $133,663 ($100,000 of principal and $33,663 of interest) to discharge both debts.

Now let’s assume that Mrs. Free agreed to consolidate Debt A and Debt B into a single debt, Debt C. The total principal for Debt C is $100,000 being the sum of Debt A and Debt B. Assume that the monthly loan payment is $1,161.08 which is the same as the total monthly payment on the separate loans described above. Assume further that the tax saving generated by the tax-deductible interest is applied against the Debt C principal outstanding.

Following this approach, the total payments necessary to discharge the consolidated debt amount to $134,603 ($100,000 of principal and $34,603 of interest).

So there you have it – the simple act of consolidating two debts into a single debt has cost Mrs. Free $940. The difference between the two alternatives is attributable to the application of the lump-sum payments Mrs. Free is able to make by virtue of her tax-deductible interest. Under the separate loan option, Mrs. Free is able to apply the tax refund generated by her interest write-off directly to her non-deductible loan (i.e., Debt A) whereas in the consolidated debt scenario, half of Mrs. Free’s lump-sum payments are effectively reducing the deductible portion of her consolidated debt – in other words, consolidation is forcing Mrs. Free to repay part of her “good debt” with any lump-sum payments she makes.

What’s the lesson to be learned here? Don’t consolidated non-deductible and deductible debt – keep these types of debt separate and structure them properly. Once a debt is contaminated it is forever contaminated – there is no way to undo what has been done. Debt consolidation can be a good thing but it does reduce the borrowers flexibility and this can be costly in the long run.

Jim Maroney is a chartered accountant with Andrews Brown Maroney in Maple Ridge.