Let’s start by saying: Debt itself isn’t a bad thing. If we’re in a period of low-interest rates, and we expect our earnings to increase over time, the use of debt can be very helpful. It enables us to buy houses, cars, appliances, furnishings and all the other accouterments of The Good Life without denying ourselves the pleasure of enjoying them to their fullest extent until we’re too old to really do so.
But debt is a double-edged sword. No, make that a chainsaw, and it can chew up those who mishandle it. A new credit card is not, as some compulsive people seem to believe, the same as a raise in pay. But you don’t have to be a spendthrift to go into debt. Unexpected medical expenses and career interruptions can make those unpaid bills stack up as fast as that annual blur of Thanksgiving, Christmas, New Year’s, Super Sunday, Valentine’s Day, Mother’s Day, Father’s Day, graduations, weddings, summer vacation, and back-to-school shopping. And are you still paying off a student loan?
If you’ve reached the point where you’re not taking on any more debt – or have at least slowed your spending to the point where you’re actively paying debt off – then it’s time to strategize how to best free yourself from debt for good.
It’s not that simple
You’re probably thinking, “My credit card charges 14% and my home equity line of credit charges 6%, so I should just attack the Visa first.” And while that’s generally true, there’s more to consider.
A HELOC is essentially a mortgage, secured by the value of your house. That means you need to at least make the minimum payments on it just to make sure you get to keep that house. It’s hard to stay on top of the rest of your capital stack if you have no fixed address. So even though secured debt tends to have lower interest rates than unsecured debt, you need to make sure you keep up payments on the secured debt before you dig out from under the rest.
Another form of secured debt you might have incurred is an auto loan. The good news is that you’re not locked into it for 30 years like a first mortgage. If you want to unload debt, you can usually return the car before it’s fully paid off because the dealership is eager to get it on its used-car lot; you can call them, but odds are they’ll call you first.
If you still need wheels, consider buying a pre-owned vehicle. If it’s only two or three years old and hasn’t been involved in an accident, there’s probably nothing in the least wrong with it. Leasing is another option, and Carlease.com has got a great primer on the topic. Of course, if your car is already close to being paid off, why not wait for the title to come in the mail, then frame it and hang it on your wall? There’s no law that says you have to trade in your ride every four or five years. Consider driving it payment-free until you actually start having mechanical problems with it.
Before we talk more about unsecured debts – essentially credit card bills – we need to acknowledge one thing that often gets lost in the noise: You can walk away from them at any time. It means declaring bankruptcy, which is fraught with a whole host of other issues related to your credit score, your ability to take on other debt in the future for any purpose, your self-esteem, and perhaps even your sense of honor. But sometimes you do what you have to do, and that’s why bankruptcy laws exist in the first place.
Student loans, however, cannot be discharged by bankruptcy. Sallie Mae will find you, take you to court and garnish your wages, even if American Express and Mastercard walk away empty-handed.
It’s important to pay those student loans down. And that doesn’t mean just paying the interest. Make sure you’re on some version of the payment plan that includes principal. At that point, it becomes a judgment call how quickly you move on that.
Credit card debt
What informs that judgment call more than anything else is how much credit card debt you have and your interest expense on those credit cards.
If your student loan rate is lower than your credit card rates, and it typically is, then just make the minimum interest-plus-principal payment while you hack away at paying down the plastic. Otherwise, pay off the student loan first and make the minimum payments on the cards.
The general rule with unsecured debt is: Pay off the bill with the highest interest rate first. That said, a lot of people choose to pay off the smallest bills first. Objectively speaking, this means you’ll end up paying more interest. Subjectively, though, there is a sense of accomplishment to be gained by having one fewer payment to make each month. Take your pick, but understand there is an actual price to be paid for the satisfaction of retiring a lower-rate card ahead of a higher-rate card.
One last resort
It’s best to pay off debt from your income. For some, though, it might not be entirely feasible. There is one other possibility.
No, not payday loans. We’re just going to assume that the readers of this column are smart enough to never go near those.
Rather, you do have investments to tap. If they’re not in a qualified plan and you’re prepared to take the possible capital gains tax hit, then consider cashing out to the extent you need to retire your debts. You might miss out on some upside if this bull market keeps running, but if you’re paying more than 15% interest, you might wonder how realistic it is to project the 15% after-tax return your investments would have to net you over the coming year to break even.
If your money is tied up in qualified retirement plans – employer-sponsored funds or IRAs of any flavor – then it gets a little more complicated to tap those places to pay down debts. Generally, it’s a bad idea to crack open that nest egg. And it’s an even worse idea to do it to cover discretionary consumer purchases such as the ones that might have gotten you into credit card problems. But if there are legitimate hardships, you might be able to get the money out of your retirement account or perhaps borrow against those funds at a lower rate than your creditors are demanding.
Everyone’s circumstances are unique, so there’s no “one size fits all” answer. If you’re thinking of cashing out from your investments, though, you might want to talk to an expert. A qualified financial professional might not only give you advice on how to do it, but they might also even give you advice on how to not do it and still remain solvent. And they might even be able to help you put a plan in place to never get overwhelmed by debt again.