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When Debt Repayment Plans Go Awry

So how could anyone argue that paying off debt is a bad idea?

I can, if you’re approaching it in any of the following ways:

You’re paying off the wrong debt. In the late 1990s, banks started pushing biweekly mortgage payment plans aimed at helping homeowners pay off their houses faster. By making payments once every two weeks, instead of every month, the homeowner would effectively make one extra house payment a year, shaving years—and thousands of dollars in interest costs—off their loans.

As interest rates fell, the savings became somewhat less impressive, but you could still save money. For a $200,000 loan at 4%, making just one extra payment a year would shave four years off a 30-year mortgage and save over $21,000 in interest.

Volatile stock markets made these plans even more popular. People felt a lot better about “investing” money in their steadily appreciating homes than they did “throwing it away” on stocks.

The problem with this approach is that many who pursued it were neglecting other financial goals or carrying other, far more expensive debt—including credit cards and personal loans.

The average credit card carries an interest rate of about 16%, much higher than the mortgage in our example. Furthermore, you typically can’t deduct credit card interest on your tax returns. The deductibility of mortgage interest can reduce the effective rate you pay to 3% or even less, depending on your tax bracket.

There’s something else you should consider—inflation. Most people realize that higher prices gradually erode the value of the dollar, which means many things will cost more in the future than they do today. But inflation also makes debt cheaper as time passes. The fixed-rate mortgage payment that seems so onerous today will be much less so in 10 years and might seem almost an afterthought in 30 years.

“Most people don’t understand that even modest inflation makes a fixed mortgage payment cheaper every year it’s in existence,” wrote David, one of my readers on MSN. “My first mortgage, 28 years ago, was $271.60 a month. Had I stayed in that house, I would be spending far more today on my monthly utility bills than my mortgage.”

By contrast, money you invest has a chance of beating inflation over time. That means your purchasing power can actually grow, particularly if you invest it in stocks or stock mutual funds. If you’re forgoing the chance to invest while you prepay your mortgage, you’ve really got your priorities backward.

Mortgages are some of the cheapest money you’ll ever borrow. Such lowrate, tax-advantaged debt is usually the last kind of borrowing you want to pay off.

You’re limiting your financial flexibility. Carlos graduated from college in 1998 with $20,000 in student loans—more than most students at the time, but about average these days. He consolidated his loans to lock in the prevailing 7.455% interest rate. He decided to double his $237 monthly payment to retire his loan faster. Instead of taking 10 years to pay off the balance, he did it in just over five, saving about $5,000 in interest.

Then he lost his job.

If Carlos had put the extra payments into savings instead, he would have had an emergency fund of more than $11,000 by the time he was let go. He could have lived off the cash and asked his student lender for a forbearance while he looked for work. Instead, he had no cash, and his landlord, utilities, and car lender weren’t interested in giving him a forbearance; they all wanted their regular payments on time.

By paying off his debt early, he limited his financial options instead of enhancing them.

This issue of financial flexibility has become critical in the last decades as incomes have become more variable, layoffs more common, and bankruptcies epidemic.

About half of households live paycheck to paycheck, and fewer than one in three has enough cash saved to survive more than three months of unemployment. At the peak of the recession, the median duration of unemployment was over 20 weeks—more than five months. Six million people had been out of work for 27 weeks or more.

So many families are living so close to the edge that any crisis can tip them over the brink: a job loss, divorce, illness, or accident. (The Census Bureau estimates that 49 million Americans are uninsured, while millions more are underinsured.)

Instead of focusing single-mindedly on paying off all debt, today’s families need to figure out how to put themselves on sound financial footing overall.

You’re cutting yourself off from credit entirely. I often receive e-mails from folks who are paying off their credit cards and proudly closing down the accounts once the balances hit zero. They vow to never again use another piece of plastic.

Yet credit cards can be an important safety valve to help families survive job loss or other setbacks. If you don’t have enough cash set aside in an emergency fund, you can live off your cards temporarily until the crisis passes.

Furthermore, you generally need to use credit to get credit. The credit-scoring systems employed by most lenders require you to have and use revolving accounts like credit cards to get the best scores. You don’t have to carry debt to have good scores—that’s a myth—but you do have to have, and use, credit accounts.

Closing accounts can actually hurt your scores, potentially making it more difficult to get future credit. The next time you need a mortgage or a car loan, you could be denied or pay higher interest than if you’d kept your credit scores in good shape. Also, most insurance companies use credit information to determine your premiums. Poor scores or thin credit files could cause you to pay more for coverage.

None of this means that you shouldn’t learn to live on cash alone while you’re repaying your debt. Just don’t close the accounts once you’ve paid them off unless you really and truly can’t keep from using them otherwise.

There are certainly people who have completely lost the ability to control their spending. One of them e-mailed me after filing bankruptcy for the third time. He wasn’t the victim of bad luck, bad health, or unemployment; he simply spent too much money.

“If I make $150,000, I spend every single dime,” he wrote. “What can I do to get my credit back and stop this madness?”

Credit to this man is like booze to an alcoholic. There is no safe way for an alcoholic to have even a single drink, and there may be no safe way for a chronic credit abuser to have plastic.

If that describes you, consider getting help through therapy or a 12-step program like Debtors Anonymous or Overspenders Anonymous.

Most people, however, can survive a credit crisis and move on to responsible credit use.

You’re neglecting your retirement savings. One of the pieces of debt advice that most disturbs me is when people are urged to forgo retirement contributions to free up cash to pay their credit cards.

Yes, this will get the cards paid off more quickly—but at what long-term cost?

The problem is that contributions to retirement plans are usually a use-itor-lose-it proposition. In other words, you can’t get back an opportunity to contribute to a tax-advantaged retirement plan once you’ve let it slip away.

Many employers, for example, will put 50 cents into your 401(k) for every dollar you contribute, up to a certain cap—typically 6% of your salary. If you make $45,000 but don’t contribute that 6%, you’re missing out on $1,350 of free employer matching money each year. Even worse, you’re passing up all the future, tax-deferred growth of your contribution and the employer match.

Let’s say you suspend contributions to your 401(k) for five years while you pay off debt. We’ll assume that you resume contributions at that time and retire 30 years down the road. If your account earns an average 8% annual return—which, given long-term historical trends, is a reasonable assumption for a portfolio invested 70% in stocks and 30% in bonds—your five-year hiatus could cost you more than $200,000.

You can try to make up for lost opportunities once your debt is paid off by making bigger payments to your retirement plans. But the amount you can contribute to tax-deferred plans is limited by law and may be limited further by company policy. Even if you could somehow compensate for the contributions you failed to make, you simply can’t get back the free money you passed up in company matches, or the value of time in helping your money grow.

Here’s another example of how this trade-off works. One of the posters on a message board I monitor at MSN was trying to decide what to do with an extra $250 a month: pay off her car loan or fund a Roth IRA.

Accelerating the payments on her $20,000 car loan would save two years on the five-year loan and save her more than $1,000 in interest, and it’s the option many posters on the board urged her to take.

I pointed out that the same money, contributed to a Roth, could grow to more than $175,000 of tax-free money in 30 years.

This isn’t just an academic issue. Saving for retirement is critical, and by all reports most Americans are doing a pretty lousy job. Few of us will have the cushy, traditional pensions that previous generations relied on to fund their retirements, and some worry that Social Security won’t be much help either. We need to be saving more and starting earlier—not delaying or interrupting our contributions.

You’re raiding your retirement funds. Chris and Suzanne in Tennessee have $40,000 in credit card debt and $18,400 in an old retirement plan at Suzanne’s previous employer. They want to pull it out to pay off part of their debt. They e-mailed me, asking if this was the right thing to do.

“We have been in debt for many years, and this could help kick-start us in getting out of debt,” they wrote.

Most people have at least a vague notion that carrying credit card debt is a bad idea. So when they leave a job and their employer sends them a check for their 401(k) balance, they think they’re being responsible by using the money to pay off credit card balances.

But if there’s one thing worse than suspending retirement savings, it’s raiding what you’ve already set aside.

Chris and Suzanne would face a tax bill come April 15 for taxes and penalties that will equal one quarter to one half of the withdrawal they just received. Furthermore, they’re giving up all the future tax-deferred returns that money could have earned. (Figure that every $1,000 you withdraw will cost you $10,000 or more in future retirement income.) What they should do is roll the money into an IRA and find other cash to pay off those credit card bills.

Otherwise, they’re just opting for another quick fix that simply makes their financial situation worse. That kind of approach—grabbing for a short-term Band-Aid rather than the long-term cure—prevents many people from overcoming their debt problems.

Remember how I said there were worse ways to spend retirement money? I often get e-mails from people asking how they can withdraw money from their retirement funds so that they can pay off their mortgage early.

Think about that. They’re proposing giving up tens of thousands of dollars in tax-deferred future gains and incurring a fat tax bill, so that they can pay off a low-rate, tax-deductible debt. That’s just nuts.

Some people propose a variation on the theme. They understand that withdrawals from retirement accounts are stupid, but they think it’s a good idea to borrow from themselves via a loan from their 401(k) rather than continue paying interest to a lender.

The big problem with this approach is that 401(k) loans typically come due if you lose your job. If you can’t pay back the money quickly, it can be taxed and penalized as a distribution.

There’s something else to consider. If your financial situation really takes a dive, you may be able to wipe out your credit card debts in bankruptcy. Once you’ve paid them off with a 401(k) loan, that option is gone.

I also wonder how many folks who use 401(k) loans to pay debts are really covering up a serious spending problem. As long as they can keep shuffling loans around, they may never address the real cause of their financial problems. Forcing yourself to leave retirement plans for one purpose—retirement—can lead you to find real solutions that will ultimately create, rather than destroy, future wealth.

Your debt situation is hopeless. Like many others, I used to think that most people could avoid bankruptcy if they really tried. Now, after writing about the issue for more than a decade, I’m not so sure.

I’ve heard from too many people who faced six-figure medical bills or credit card debt that totaled more than their entire year’s salary. They could struggle for years and still never pay off what they owe. Some empty their retirement funds, drain their home equity, and scrimp for years without ever making an appreciable dent.

Sure, many of these folks could have avoided the fix they were in. But many were as much victims of bad luck as bad choices. And some made decisions that the rest of us would be hard-pressed to fault.

Paul, a military officer, found himself $70,000 in debt after his wife Debbie was diagnosed with breast cancer. The conventional treatments didn’t work, so the couple opted for experimental therapies their insurance didn’t cover.

For Paul, there didn’t seem to be any choice: Go into debt or say no to the only hope his sweetheart had.

“Debbie didn’t survive,” Paul wrote me, “but I would do the same again in the same circumstances.”

Richard’s long slide into bankruptcy started when he was laid off from a defense industry job at age 47.

“I worked hard, was a company man, and did the 50-to-80-hour work-week week after endless week, for years,” said Richard, who lives in California. “I soon found, however, that my defense-specific knowledge and skills were nearly worthless in the commercial world.”

Richard eventually found work, but not before racking up debts that proved unpayable on his new, lower salary.

Dan and Leah were managing just fine until their young son developed reactive airway disease and landed in the hospital with pneumonia. Dan’s employer fired him because he missed too much work while attending to his son; without health insurance, the medical bills had to be paid for out-of-pocket.

“We filed for bankruptcy, and that was very difficult,” Leah said. “I remember crying at the courthouse. I felt like such a failure for not being able to take care of our own debt.”

Of course, some people feel such a strong moral obligation to repay their debts—however they were incurred—that bankruptcy is not an option.

Many people, though, are simply ignorant of their alternatives or the true gravity of their situation. If anything, they wait too long before they file, continuing to throw money after impossible debts when they could be using that cash to rebuild their lives.

Bankruptcy court is meant to give people a fresh start while protecting their homes and retirement funds, to prevent them from facing a poverty-stricken old age. Bankruptcy should never be the first choice, but sometimes it’s the best of very bad options.

How can you tell if it’s the right option for you? In the next chapter, you’ll see how to evaluate your financial situation, prioritize your debts, and find the expert advice you may need to make that decision.

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