How to Determine Which Shovel to Use to Eliminate a Big Mountain of Debt
Q. My husband and I are currently in debt on our credit cards to the tune of $23,000. The interest rate is 9% and shouldn’t change. Our combined income is approximately $80,000. We have been discussing how to pay off this debt in the best manner. The three choices we have are: 1. Continue to pay $300 a month to the credit card companies. 2. Take out an equity loan on our home to repay the debt (we have $20,000 in equity and our current mortgage is a 30-year loan at a fixed 7.5% rate). 3. Borrow from our retirement fund and repay ourselves over five years. What are your thoughts on the best way for us to proceed?
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A. Each of the three options you’ve outlined has significant advantages--and drawbacks serious enough to threaten your family’s financial health.
You’ve got a low rate on your credit cards, which typically charge 16%. But you’re still paying about $2,000 a year in interest. It would take you nearly 10 years to pay off your debt at a rate of $300 a month--and that’s assuming you don’t incur any more debt, or that your interest rate doesn’t spike up. “Fixed” interest rates are fixed only as long as the credit card issuer wants them to be.
A home equity loan seems attractive, since the interest is tax-deductible. But you’re stretching your payments out for up to 15 years, meaning you’ll pay a heck of a lot more in interest over the long run. You’re also putting your home at risk for what may have been some frivolous purchases.
It’s probably a moot point, anyway. With only $20,000 in equity, traditional home equity lenders probably won’t be interested in lending you money. Typically, these lenders don’t want to risk more than 80% of a home’s value. That leaves you to the mercy of what are called high-loan-to-value lenders, who are likely to skin you alive with high fees and higher rates than you’re paying now. As an example, a traditional home equity lender would charge $200 or less to make a $20,000 loan at 8.5%; the lender who promises you up to 125% of the value of your home will charge you $1,000 to $2,000, with a rate of 14%. You would wind up paying more than $50,000, with only a portion of your payments being tax-deductible.
Borrowing from your retirement plan also seems attractive at first, because you can essentially pay yourself back with interest, rather than make the payments to someone else.
Depending on how your plan is set up, you may be able to borrow up to half of your balance and to pay it back over five years at 1 to 2 percentage points over the prime rate, which is currently 8.25%. At 9.25% interest, your monthly payments would be about $480.
There are several problems with this approach. When you take a loan out of your retirement plan, you’re taking that money out of the stock and bond markets so that it is no longer working for you. Should you lose your job, the loan becomes instantly due; if you can’t pay it back, you have to pay income taxes and you may owe a 10% penalty on the outstanding amount if you are under 59 1/2.
Perhaps most importantly, there’s the issue of falling deeper into debt. You and your husband haven’t shown much financial discipline so far. After you’re done paying this loan, chances are pretty good you’ll have piled up even more debt, requiring another loan. Keep doing that, and you’ll never have enough money to retire.
Your best hope is to first concentrate on scaring up the maximum amount of money you can to pay off your debts. That could mean slashing your daily expenses, having a garage sale, moonlighting or selling your cars and buying less expensive models.
The next step is to get rid of your credit cards except one for true emergencies. Freeze that one into a block of ice in your refrigerator, so you’ll have some time while you’re chipping away to reconsider whether the Nordstrom’s half-yearly sale is a true emergency.
If you’re actually willing to cut up your credit cards and incur no further debt, tapping your retirement plan is your best option.
If you’re not, you should start making the same-size payments, or more, to your credit card companies. The alternative is consigning yourself to a lifetime of bondage to debt.
If you need any more motivation, consider what would happen if that $23,000 you have on credit cards was instead invested at 8% interest. After 30 years, you’d have more than $250,000 to show--a heck of a lot better than the pile of credit card receipts, broken toys, discarded clothes and worn-out furniture that would be left after 30 years of credit card payments.
Liz Pulliam is a personal finance writer for The Times and a graduate of the certified financial planner training program at the University of California, Irvine. She will answer questions submitted--or inspired--by readers on a variety of financial issues in this column. She regrets that she cannot respond personally to queries. Questions can be sent to her at liz.pulliam@latimes.com or mailed to her in care of Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053.
