Save or Pay Down Debt?
Get rid of high-interest debt before you start setting aside cash.
By Cameron Huddleston
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Should you be putting money in savings or investments at the same time you're paying off a loan?
That's one of the most frequently asked questions we get at Kiplinger, and the answer isn't always obvious. Even if you have run up a balance on a high-rate credit card, you may hear a nagging voice in your head urging you to keep plowing money into savings for retirement, college for the kids or a new home.
The simplistic solution -- to invest if you can earn a higher interest rate than you're paying on your loans -- can be downright dangerous. That became clear when, in the late '90s, a wave of questionable advice suggested that homeowners actually create more debt to invest in the booming stock market -- by pulling out some equity via a cash-out refinancing or home-equity loan. Then came the bear market.
The best answer lies in separating good debt from bad debt. It's almost always a good idea to get rid of credit card and other high-interest loans before you start setting aside cash. However, you probably don't want to accelerate mortgage or student loans at the expense of saving for retirement.
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Begin by making a list of all your debt and the interest rates on those debts to prioritize which ones you should pay first, says Deena Katz, president of Coral Gables, Fla., financial planners Evensky, Brown and Katz. Then look at your alternatives for saving and investing and, if necessary, reset your priorities.
Step 1: Pay off the high-interest debt If you have high-interest credit card debt, tackle that first. It doesn't make sense to start saving or investing until you've paid off this debt. You'd have to make more than 20% after-tax return on stocks, bonds or mutual funds to make them a better investment than paying off a credit card with an interest rate above 15%, says Clark Randall, a financial planner with Lincoln Financial Advisors in Dallas.
There is one exception to that rule of thumb: If your employer offers a 401(k) plan and will match your contributions up to a certain level, fund it up to that level -- even if you have credit card debt -- because you're getting a 100% return on your investment, says Randall. Contribute more than the match level once you've paid off your consumer debt.
If you're drowning in debt, liquidate assets such as stocks and use your savings -- but not a 401(k) or IRA -- to pay off your credit cards. If you're in dire straits, you can borrow up to 50% (no more than $50,000) from a 401(k). Although you pay yourself back with interest, you give up tax-free compounding, and you will have to pay back the loan immediately if you leave your employer.
No matter how deep in debt, you can still work your way out. Get great debt management advice, savings suggestions and new spending habits.
- Debt Management
- Invest or Pay Off Debt
- Using Revolving Credit
- Saving for the Future
- Personal Net Worth
- Personal Cash Flow
- Managing Interest Rates
- Establishing a Budget
- More Money Basics
Step 2: Identify the good debt For the most part, it's usually not a good idea to pay off your home mortgage unless you have a lot of extra cash. After all, Uncle Sam refunds part of your interest payment if you itemize your deductions on your tax return.
Use your money instead to invest in liquid assets. However, Randall recommends paying off your mortgage (and any other debt you might have) by the time you retire so you can get by on less money.
Don't be in a rush to pay off student loans, either. The old rule that allows a tax deduction only for interest paid during the first five years of repayment is ending. Qualifying interest on student loans can be written off no matter how long it takes to pay off your loans.
However, you can ease the burden of repaying your loans. If you have more than one student loan from the federal government, you might be able to receive an interest rate reduction if you consolidate your loans. You can also lower your monthly payments this way, leaving you with more money to pay off consumer debt.
If you elect to have your loan payments automatically deducted from your bank account, you can get a 0.25% interest rate reduction on your student loans. The Education Department's Direct Loan Program has more about repayment incentives.
Step 3: Save and invest Once you've eliminated high-interest consumer debt, start saving as much as you can. The best place to begin is a 401(k). The next best option is an IRA (see Open Your First IRA).
In addition to putting money into a retirement account, you need cash that's readily available in an emergency so you don't have to rely on credit cards. (If you are paying down your credit card balances and still paying high rates, it is probably better to keep paying off the cards and borrow from them in case of an emergency, says Katz.)
Set aside enough money to tide you over for three months if your paycheck suddenly stopped. If you have less-than-steady income, such as from a commissioned sales position, or a job that has more exposure to economic fluctuations, consider setting aside six months' income.
Sock it away in a high-yield account such as a money market fund on a monthly basis until you reach your desired amount.
10 Debt Consolidation Myths
By Julie Sturgeon
When Norm Bour was 24, credit was so hard to come by he couldn't get a gas station credit card without begging.
Today, a majority of the home equity lines he approves as owner of Priority Plus Lending will be used to pay off Americans' credit card debts. Nor is his route the only one to spring up in a capitalistic society: Where there's a need, there's a buck to be made, even among the broke.
So you can bet that where competition rules, advertising spin appears. If you are considering debt consolidation options, avoid these misrepresentations:
1. Credit counseling, debt management programs -- it's all the same. Credit counseling involves helping consumers develop a budget and the discipline to make steady payments to clear their debt loads. In a word, it's education. "Most of these individuals make a decent living, but at the end of the week don't have enough money and don't understand why," says Joel Greenberg, president of New Jersey-based Novadebt.
Debt management programs -- or DMPs as insiders like to shorten it -- are one tool in the credit counselors' kit. Basically, the DMP plays policeman, taking your monthly lump sum payment and distributing it to your creditors until the accounts stand at zero. They then close those accounts. According to Greenberg, less than 35 percent of the people who call consumer credit counseling agencies truly can benefit from a DMP.
No matter how deep in debt, you can still work your way out. Get great debt management advice, savings suggestions and new spending habits.
- Debt Management
- Invest or Pay Off Debt
- Using Revolving Credit
- Saving for the Future
- Personal Net Worth
- Personal Cash Flow
- Managing Interest Rates
- Establishing a Budget
- More Money Basics
2. Credit counselors can cut your monthly payments in half. No such luck. This is a numbers fudging claim that holds true only in the narrowest of circumstances. For instance, if you miss two $200 payments on a $10,000 balance, the third month's bill will make it $600 that you owe. DMP personnel re-age that bill, knocking your payment amount back to $200. You haven't escaped anything -- the missing money was merely tacked back into the total owed.
And most folks who walk through his doors haven't missed payments, says Greenberg. These harried souls will see a bit of relief from an interest reduction, but by no means will they magically owe only half their bills.
3. Some companies offer lower interest rates than others. It drives Richard Musci, chief lending products officer at Schwab Bank, crazy to see teaser ads for low interest rates on home equity lines. Any quotes that fall within prime minus 75 basis points to prime plus 2 percent are reserved for those who make the A credit list. Those lower down the credit spectrum can expect to strike deals for prime plus 4 percent or 5 percent, not to mention a point or two in fees.
- How Much Am I Spending?
- Pay Off Debt or Save?
- What Will It Take to Pay Off My Balance?
- How Much Should I Save for Emergencies?
- Cost to Raise a Child?
- Should My Spouse Work?
- See All Calculators
"They're using it to get people in and take them so far down the road that by the time they sign the loan papers, they're committed. They don't want to start all over again," he says. It also serves a second devious purpose: lower advertised rates push these companies to the top of the search engine lists.
But just how low is too good to be true? Bour's rule of thumb: If 90 percent of the lenders are advertising a 5.75 percentage rate, the lone shark waving even a 5.25 should send up a red flag. "But it doesn't because people always think they're smart enough to find the deal no one else has," he says.
4. Some agencies can negotiate lower DMP payments than others. That would be true if this debt management programs involved negotiation. They don't. A majority of creditors have existing programs where they automatically shuffle off 95 percent of individuals enrolled in a DMP, says Greenberg.
If a counselor indicates differently, you are in the clutches of a debt settlement program. This version accepts your monthly lump-sum payments, but holds that money until creditors scream. At that point, the debt settlement personnel negotiate to repay cents on the dollar. Your credit rating gets maimed in the process.
5. Debt settlement is the cheapest way to go. Greenberg urges anyone introduced to a debt settlement program to run hard in the opposite direction. "First of all, it's unethical," he says. "It's just wrong to make payments on an account and have the money sit in someone else's pockets until the creditor gives up on the collection calls." The real skunks insert a clause in the contract that says if you miss a payment to the debt settlement company, it keeps all the money in the ante as a fee.
Secondly, this route dings your credit history severely, as all those "pay us now" letters count against you, not the company. Finally, the amount the creditors forgive in the end is considered income for you, and you owe taxes on that amount. "If you're going to take this route, you might as well declare bankruptcy," Greenberg says.
Part II: 10 Debt Consolidation Myths
By Julie Sturgeon
- 10 Bankruptcy Blunders
- 10 Missteps that Lead to Debt
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6. You need a formal program to get out of debt. Many creditors will enroll you in their special reduced-interest programs if you approach them as an individual. The pain comes in making all those phone calls and knowing what to ask for.
Home equity lines don't require third-party guidance, nor does refinancing your first mortgage to get your hands on a lump sum of cash. On the flip side, these options still require spending discipline on your end lest you wind up with a mortgage payment, home equity line invoice and another $10,000 credit card debt six months down the road. This time, your house is on the line.
7. Debt consolidation always saves you money. Better ask a calculator to determine the truth of this statement for your situation. For example, if a lender assures you it can secure financing with no out-of-pocket costs, that doesn't mean it's a kinder, gentler source of funds. It's code for "We're rolling our fees into your loan, where they are also subject to the interest rate."
No matter how deep in debt, you can still work your way out. Get great debt management advice, savings suggestions and new spending habits.
- Debt Management
- Invest or Pay Off Debt
- Using Revolving Credit
- Saving for the Future
- Personal Net Worth
- Personal Cash Flow
- Managing Interest Rates
- Establishing a Budget
- More Money Basics
The truly unfortunate fall victim to flipping -- a process that ruined one of Musci's elderly clients. A lender offers a debt consolidation loan plus cash out, with no out-of-pocket fees. A year later, it calls again to say that since your home has appreciated, could you use more cash? Say yes, and they again sock you with fees hidden into those monthly payments. This cycle continues until you break.
"The consumer thinks this person is taking care of them. But in my client's case, the company ran up $15,000 in fees, and put her at 100 percent loan-to-value," says Musci. "She eventually had to sell her house to get out from underneath it."
Deciding on debt consolidation is a simple formula for Greenberg: Compare your existing minimum payments to what your payments will be for that same debt under the DMP, including fees and voluntary contributions. If the latter doesn't save you 5 percent to 10 percent, it's the wrong choice.
- How Much Am I Spending?
- Pay Off Debt or Save?
- What Will It Take to Pay Off My Balance?
- How Much Should I Save for Emergencies?
- Cost to Raise a Child?
- Should My Spouse Work?
- See All Calculators
8. DMP helps your credit rating. The second question Greenberg asks before signing with a DMP: Is your credit rating pristine? If you've managed to pay your bills on time to this point, know that this step will muck up your credit history. The home equity line might make more sense here, Musci says.
On the other hand, if you've missed payments and it already shows on your report, credit counseling won't make it worse. That's when a DMP can improve some situations, as creditors sometimes applaud your finally taking steps to handle debt appropriately.
9. Bankruptcy will ruin your life. A good credit counselor will level with you when your situation requires this final stroke. "I've had people with no other alternative -- they've spent years borrowing from every relative just to make ends meet. They're on a fixed income, usually elderly," Greenberg says. "Having to deal with bankruptcy in their background is a better alternative than going without food and shelter."
10. Bankruptcy is no big deal. Bour has talked to an amazing number of people in their 20s who filed bankruptcy for a $7,000 debt. "It's ridiculous because the damage will linger long after whatever the $7,000 debt was for," he says. Bankruptcy is an extreme solution, reserved for cases like someone on a $20,000 annual salary with a cumulative credit card debt of $50,000 or more.
If you file Chapter 7 -- exoneration of all debt -- the window is nearly 10 years. With Chapter 13 -- reorganization of debt -- that seven-year clock starts ticking after you pay off the debt. So if you need five years to get back on your feet, assume this cloud follows you for 12 years.
Employers look at credit reports, and occasionally refuse to hire based on what they find. If you deny bankruptcy on many forms, you can be held accountable later for lying on an application. Insurance companies can deny coverage as well.
In the end, debt management resembles weight loss: No one can do it for you, and the process takes four to five years on average. "There's no panacea," says Greenberg. "You have to buy into the process and really work to reach the goal."
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