When paying off debt is a bad idea
By Liz Pulliam Weston
American households are staggering under near-record debt loads.
We have less equity in our homes and bigger balances on our credit cards than ever before. Bankruptcies continue to hit new highs, foreclosures are setting modern records and a big chunk of our disposable incomes pays for stuff we bought long ago.
Could anyone sensibly argue that now is not a good time to pay off your debt?
Yes, and that person is me -- the one who recently told you that debt was Financial Enemy No. 1 for many Americans. I haven't changed my mind about the importance of getting, and staying, debt-free. But I've seen enough examples of people who are taking the wrong approach to paying off their debts, and doing more financial damage to themselves in the process, that it's time to speak up.
Here are some examples of when it's not good to pay off what you owe:
1. When you're targeting the wrong debt. Soaring real estate values have convinced many people that they should increase their investment in their homes by paying down their mortgages. Several readers have told me the great satisfaction they get from sending extra payments with their regular mortgage checks. Others are opting for 15-year loans instead of the standard 30-year variety so they can pay off the note more quickly.
It's so much nicer, they say, to see their appraisals rising and their loan balances dropping than it is to watch their other investments buck and pitch in the stock market.
Unfortunately, in their rush to free themselves of their home loans, many of these would-be Mortgage Terminators are ignoring other debts and obligations that ultimately will cost them more.
It makes no sense, for example, to speed up paying off low-interest, tax-deductible debt if you've got any other kind of debt -- credit cards, car loans, personal loans, student loans, you name it.
When it comes to paying off balances, your first goal should be to pay off your highest-rate, nondeductible debt. Only after the credit cards, personal loans and car loans are retired should you even consider prepaying a deductible student loan or business loan. Mortgage interest is typically the last debt you want to pay.
2. When you're neglecting your retirement savings. This one seems to be a hard concept for younger people to grasp. Surely they've got years to save for retirement. Why not focus on getting out of debt now?
It's because tempus fugit -- time flies -- and you can't get back an opportunity to contribute to a tax-advantaged retirement plan once you've let it slip away.
Say your employer matches half of your 401(k) contributions up to 6% of your salary, which is a fairly standard policy among large companies. If you make $40,000 but don't contribute that 6%, you're missing out on $1,200 of free employer money. Worse, that money and your missing contribution can't grow tax-deferred over the next 30 years. If they could, and they earned an average 8% annual return over the years, that one year's contributions could have grown to more than $35,000. Ouch.
You can try to make up for lost opportunities once your debt is paid off by making extra contributions to your retirement plans. But you can't get back the free money you passed up or the value of time in helping your money grow.
One of our message board participants gave us a good example of such finite opportunities. She had $250 extra each month and was trying to decide whether to pay off her car loan or fund a Roth IRA.
If she used the extra monthly cash to accelerate payments on a $20,000, five-year car loan, she could be done in just under three years -- and at an interest savings of more than $1,000.
In those three years, however, she would have forever missed the opportunity to contribute the maximum $3,000 annually to a Roth. Those contributions, by contrast, could grow to nearly $78,000 in 30 years.
There may be some cases where saving yourself from debt might be worth temporarily suspending retirement contributions. But such decisions shouldn't be made lightly and you should understand the total costs of the decisions you're making.
3. When you're using your retirement savings. If there's anything worse than forgoing retirement savings, it's raiding what you've already stockpiled.
At least once a week, I get an e-mail or letter from someone who has concocted a scheme to tap an IRA or 401(k) in order to pay off credit cards, car loans or -- heaven forbid -- mortgages.
This lunacy must stop.
Most of the writers honestly have no idea how much they'll lose to taxes and penalties when they withdraw this money.
It can be a lot of money: Depending on your state and federal tax bracket, you'll typically sacrifice one-quarter to one-half of whatever you withdraw.
Even if they do understand the tax cost, they give short shrift to how much they'll lose in potential returns. Once the money's withdrawn from a retirement plan, you can't put it back, and you've lost all that lovely future tax-deferred compounding.
Some folks understand that outright withdrawals from a retirement plan are a bad idea, but try to make the argument that it's better to borrow from themselves -- via a 401(k) loan -- than to continue paying interest to a credit-card company. But I wonder how many of these people are using 401(k) loans to avoid their real problem, which is overspending.
There's an additional, hidden risk of borrowing from your 401(k): If you lose your job, you have to pay back a 401(k) loan in short order, or it will be taxed and penalized as a distribution.
Furthermore, if worse comes to worst, your credit-card debts can be wiped away in bankruptcy. Instead, you've essentially secured that debt with your retirement plan.
4. When it's hopeless. When I started writing about personal finance eight years ago, I was inspired by tales of people who had paid off mountains of debt in short order. They got their lives on track and felt satisfaction from their accomplishments. I still believe, for most people, such happy outcomes are possible.
Since then, however, I've seen the other side -- people struggling with bills that are simply impossible to pay off. They empty their retirement funds, tap their home equity and scrape for years to pay enormous medical bills, bad business loans or credit-card debt. Many continue paying long past the point it makes any sense, with no real hope of financial recovery.
Some got slammed with accidents, disease, job loss, divorce or other setbacks. Others brought it on themselves through stupidity, ignorance, greed or bungling. There's usually plenty of blame to go around, and some of it belongs to a financial system that keeps spewing out credit to people clearly unable, for whatever reason, to handle it.
So I'm not a fan of bankruptcy, but there's a reason why it's there. Bankruptcy court is designed to give people a fresh start and to protect their essential assets, including homes and retirement funds, so that they don't have to face a destitute old age. Bankruptcy is not a perfect solution, nor even a good one, but sometimes it's the best of some very bad options.
How do you know if you've reached this desperate pass? It can be tough. Credit counselors are, after all, in business to convince you to pay off your debts, while bankruptcy attorneys are in business to help you file for bankruptcy court protection. You should probably talk to both before deciding what to do next.
Your decision may be made for you. Affiliates of the National Foundation for Consumer Credit, the oldest credit counseling network, say they turn away somewhere between 3% and 10% of those who seek help because they're simply in too much debt to repay their bills within the foundation's 3- to 5-year guidelines. The folks who don't make the grade usually aren't told directly to file for bankruptcy; instead, they're told in code to "seek legal advice."
So if you're told by credit counselors that you're beyond their help, it's probably time to file.
American households are staggering under near-record debt loads.
We have less equity in our homes and bigger balances on our credit cards than ever before. Bankruptcies continue to hit new highs, foreclosures are setting modern records and a big chunk of our disposable incomes pays for stuff we bought long ago.
Could anyone sensibly argue that now is not a good time to pay off your debt?
Yes, and that person is me -- the one who recently told you that debt was Financial Enemy No. 1 for many Americans. I haven't changed my mind about the importance of getting, and staying, debt-free. But I've seen enough examples of people who are taking the wrong approach to paying off their debts, and doing more financial damage to themselves in the process, that it's time to speak up.
Here are some examples of when it's not good to pay off what you owe:
1. When you're targeting the wrong debt. Soaring real estate values have convinced many people that they should increase their investment in their homes by paying down their mortgages. Several readers have told me the great satisfaction they get from sending extra payments with their regular mortgage checks. Others are opting for 15-year loans instead of the standard 30-year variety so they can pay off the note more quickly.
It's so much nicer, they say, to see their appraisals rising and their loan balances dropping than it is to watch their other investments buck and pitch in the stock market.
Unfortunately, in their rush to free themselves of their home loans, many of these would-be Mortgage Terminators are ignoring other debts and obligations that ultimately will cost them more.
It makes no sense, for example, to speed up paying off low-interest, tax-deductible debt if you've got any other kind of debt -- credit cards, car loans, personal loans, student loans, you name it.
When it comes to paying off balances, your first goal should be to pay off your highest-rate, nondeductible debt. Only after the credit cards, personal loans and car loans are retired should you even consider prepaying a deductible student loan or business loan. Mortgage interest is typically the last debt you want to pay.
2. When you're neglecting your retirement savings. This one seems to be a hard concept for younger people to grasp. Surely they've got years to save for retirement. Why not focus on getting out of debt now?
It's because tempus fugit -- time flies -- and you can't get back an opportunity to contribute to a tax-advantaged retirement plan once you've let it slip away.
Say your employer matches half of your 401(k) contributions up to 6% of your salary, which is a fairly standard policy among large companies. If you make $40,000 but don't contribute that 6%, you're missing out on $1,200 of free employer money. Worse, that money and your missing contribution can't grow tax-deferred over the next 30 years. If they could, and they earned an average 8% annual return over the years, that one year's contributions could have grown to more than $35,000. Ouch.
You can try to make up for lost opportunities once your debt is paid off by making extra contributions to your retirement plans. But you can't get back the free money you passed up or the value of time in helping your money grow.
One of our message board participants gave us a good example of such finite opportunities. She had $250 extra each month and was trying to decide whether to pay off her car loan or fund a Roth IRA.
If she used the extra monthly cash to accelerate payments on a $20,000, five-year car loan, she could be done in just under three years -- and at an interest savings of more than $1,000.
In those three years, however, she would have forever missed the opportunity to contribute the maximum $3,000 annually to a Roth. Those contributions, by contrast, could grow to nearly $78,000 in 30 years.
There may be some cases where saving yourself from debt might be worth temporarily suspending retirement contributions. But such decisions shouldn't be made lightly and you should understand the total costs of the decisions you're making.
3. When you're using your retirement savings. If there's anything worse than forgoing retirement savings, it's raiding what you've already stockpiled.
At least once a week, I get an e-mail or letter from someone who has concocted a scheme to tap an IRA or 401(k) in order to pay off credit cards, car loans or -- heaven forbid -- mortgages.
This lunacy must stop.
Most of the writers honestly have no idea how much they'll lose to taxes and penalties when they withdraw this money.
It can be a lot of money: Depending on your state and federal tax bracket, you'll typically sacrifice one-quarter to one-half of whatever you withdraw.
Even if they do understand the tax cost, they give short shrift to how much they'll lose in potential returns. Once the money's withdrawn from a retirement plan, you can't put it back, and you've lost all that lovely future tax-deferred compounding.
Some folks understand that outright withdrawals from a retirement plan are a bad idea, but try to make the argument that it's better to borrow from themselves -- via a 401(k) loan -- than to continue paying interest to a credit-card company. But I wonder how many of these people are using 401(k) loans to avoid their real problem, which is overspending.
There's an additional, hidden risk of borrowing from your 401(k): If you lose your job, you have to pay back a 401(k) loan in short order, or it will be taxed and penalized as a distribution.
Furthermore, if worse comes to worst, your credit-card debts can be wiped away in bankruptcy. Instead, you've essentially secured that debt with your retirement plan.
4. When it's hopeless. When I started writing about personal finance eight years ago, I was inspired by tales of people who had paid off mountains of debt in short order. They got their lives on track and felt satisfaction from their accomplishments. I still believe, for most people, such happy outcomes are possible.
Since then, however, I've seen the other side -- people struggling with bills that are simply impossible to pay off. They empty their retirement funds, tap their home equity and scrape for years to pay enormous medical bills, bad business loans or credit-card debt. Many continue paying long past the point it makes any sense, with no real hope of financial recovery.
Some got slammed with accidents, disease, job loss, divorce or other setbacks. Others brought it on themselves through stupidity, ignorance, greed or bungling. There's usually plenty of blame to go around, and some of it belongs to a financial system that keeps spewing out credit to people clearly unable, for whatever reason, to handle it.
So I'm not a fan of bankruptcy, but there's a reason why it's there. Bankruptcy court is designed to give people a fresh start and to protect their essential assets, including homes and retirement funds, so that they don't have to face a destitute old age. Bankruptcy is not a perfect solution, nor even a good one, but sometimes it's the best of some very bad options.
How do you know if you've reached this desperate pass? It can be tough. Credit counselors are, after all, in business to convince you to pay off your debts, while bankruptcy attorneys are in business to help you file for bankruptcy court protection. You should probably talk to both before deciding what to do next.
Your decision may be made for you. Affiliates of the National Foundation for Consumer Credit, the oldest credit counseling network, say they turn away somewhere between 3% and 10% of those who seek help because they're simply in too much debt to repay their bills within the foundation's 3- to 5-year guidelines. The folks who don't make the grade usually aren't told directly to file for bankruptcy; instead, they're told in code to "seek legal advice."
So if you're told by credit counselors that you're beyond their help, it's probably time to file.
posted by Jared Wash at 1:12 PM
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