We’ve all seen the damage from the out of control debt that led to the financial crisis. I’ve been encouraged by the determination to of so many people I’ve met lately to strengthen their finances and get on a solid footing. I only wish our government had the same attitude. That’s for another post… but in the meantime, let’s take a look at getting a handle on our debt—the good, the bad, and the ugly.
First, there is such a thing as good debt, most notably REASONABLE mortgage debt. There are advantages to keeping a mortgage on your home; being “house rich and cash poor” can’t help you eat or pay the bills if you have a cash flow problem and no money in the bank. Keeping some of your equity separate and invested (not spent!) gives you good leverage. The tax deduction most homeowners are entitled to is a bonus as well- although often overrated. Owning a home and keeping a mortgage is a good hedge against inflation too; your payment (with a fixed loan) will stay the same, while rent increases over time. With mortgage rates so low, now may be a good time to refinance or lock in a fixed rate if you have an adjustable mortgage. New homebuyers have a terrific opportunity to purchase their first home. Business loans and auto loans with very low interest rates would also be considered good debt, although paying cash is preferable. Education loans can fall into this category as well, but only in amounts that are manageable beyond graduation. Essentially, debt incurred on an appreciating asset is acceptable, and when used responsibly, debt can help you build wealth.
Buying a car with a long term loan and high interest rate is an example of bad debt. Especially for commuters, borrowing to buy a new car that will depreciate much faster than the loan is being paid down is a bad deal. If you find yourself in this situation, check into an auto loan refinance. Some credit unions like PSECU and Pen Fed offer low interest refinances in the range of 2%. Loans on vacation homes, boats, computers, furniture, and the like, would also come under the category of bad debt. Still, since they generally do last at least as long as the payments, they don’t fall under the Ugly category. Ugly is reserved for credit card debt.
Einstein called compounding the Eighth Wonder of the World, and for good reason. It can make a diligent saver rich. But compounding working against you, in the form of the interest you pay, erodes your finances as quickly as it can build them. This is especially true of credit cards where you are carrying a balance, continuing to charge, and only paying the minimum. Credit card debt is the most destructive kind of debt.
If you’re serious about getting rid of credit card debt, the first thing to do is to stop using your cards, and then look at why you have the debt in the first place. Most often, it is a result of spending more than you are earning, an unexpected repair with no emergency fund to draw from, or a job loss or income reduction. If your outflows are more than your inflows expenses need to be cut or income increased, or the hole will just get bigger. If the problem is the lack of emergency fund, it is critical to do whatever it takes to set aside at least $1,000 before working on a debt reduction plan. It may seem strange to put money in the bank rather than using all your resources to pay down the debt, but if you don’t have at least that much to fall back on, I guarantee, something will come up, the cards will come out, and you’ll be right back where you started. If your employment is in jeopardy, you may want to put even more in your emergency fund before paying the debt down more aggressively; if your credit limit is reduced after paying down the debt and you have little in the bank, you may have a difficult time getting access to cash or credit.
Make a list of what you owe, to whom, the interest rate, and the payment. Take whatever extra you can squeeze out, including tax refunds, bonuses, rebate checks, etc, and putting that toward the smallest debt. It may not have the highest interest rate, but the psychological feeling of accomplishment when that debt is paid off gives you motivation to keep going. When you have one paid off, roll that payment into the next largest debt, and so on.
It may be tempting to borrow from your 401(k) or your home equity to consolidate your debt. I strongly caution against that, except in certain circumstances, and with great discipline. Time and time again, people do that without dealing with the cause of the problem, and end up with double the debt. Especially now, you need to balance paying down debt with protecting your resources, to stay flexible in case even harder times come.