ICFE eNEWS #14-03 - Jan 28th 2014

Getting Out Of Debt The Wrong Way

As a veteran financial counselor, I have seen numerous people who have sincerely tried to pay off their debt but with little success. Their desire was right but their method was wrong. Since experience is a good teacher (especially the experience of others), we can learn from their example and not follow them down the road to failure. That's what I call "learning from the school of hard knocks without having to be enrolled."

There are indeed ways to pay off debt, and there are ways to avoid because they simply do not work. That's the topic of our discussion today - methods of paying off debt that do not work. Here are some of the most popular.

  1. Paying down debt while continuing to use credit. Many couples make a concerted effort to pay off their debts but they continue to create debt while doing so. They pay on their credit cards each month, but continue to use them. They soon notice that the more they pay off the credit card debt, the more they have to use their cards. They are like a man trying to fill up a bucket that has a big hole in the bottom; whatever goes in at the top, comes out at the bottom!
    After years of doing this, with little change in their debt balance, they conclude in despair that they will never pay off their debt and stop trying.

    If we are to make any headway in paying off our debt, we have to "stop the leak," that is, stop using credit and start living within our means. We will discuss how to do this later.

  2. Paying down debt by only making minimum payments. Credit cards, for example, require a very small % of the balance for the monthly payment - normally around 1-2%. When credit cards were originally issued back in the early 60's, the monthly minimum payment requirement was 5% of the balance.

    Consider the progress we would make if we paid off the average family's credit card debt ($15,270) at the average rate of interest (15.06) with a 2% minimum payment (Source: CreditCard.com, December 24, 2013). The MSN.com credit card repayment calculator tabulates the results: With a starting monthly payment of $305.40 (which becomes less each month as we pay down the principle), it would take us 44.8 years to pay off the debt. At the end of that time we would have paid $25,173 in interest charges making our total debt payoff amount $40,443!

    So, if we started our plan to pay off debt at age 30, we would reach our goal just before celebrating our 75th birthday! Does that sound like a good plan to anyone?

  3. Paying down debt with a second mortgage. This is one of the most popular strategies, yet one of the most destructive. It not only does not work, it makes things worse!
    1. It does not pay off debt - it only "moves" it to a new location. To achieve less credit card debt by having more home mortgage debt is not a good trade. Yes, I am aware that the interest is less on a home mortgage loan and that that interest is tax deductible - but it still is not a good trade! Our home is not an ATM machine to make withdrawals to cover things we do have money for.

      That means that when it comes time to move, we will have little or no equity in our home, thus little down payment for our next home. And when it comes time to retire, we are forced to make house payments with our retirement income as we take on a part time job to make ends meet. A 2010 survey by the Federal Reserve showed 41% of the people surveyed ages 65-74 had mortgage debt. (Source: MarketWatch.com, June 5, 2013).
    2. It turns an unsecured debt into a secured debt. I know the interest is less on a home mortgage, and is also tax deductible. Nonetheless, it is rarely wise to exchange secured debt for unsecured, especially when it puts our home at even greater risk for loss. You can bankrupt unsecured debt, but if you bankrupt secured debt, you will lose it!
    3. It requires no change in our spending habits, and within three years our credit card debt returns with an even higher balance.

  4. Paying Down Debt With Retirement Funds. Borrowing against our 401(k) to pay down debt is also not a method to use. There often is a 10% penalty to tap into our retirement funds early, plus the proceeds are regarded as "income" and are susceptible to taxes. That means that if we borrowed $20,000 from our 401 (K), we could forfeit $2000 up front, plus potentially pay income tax on $18,000 of additional "income." The cost of tapping our retirement funds under these restrictions is not worth the cost.

Here are two lessons to learn by studying these four unsuccessful methods:

  1. Any plan to pay off debt that continues to create the very problem (debt) we are trying to solve will fail. In other words, borrowing to pay off debt is like digging a hole in our front yard to fill in a hole in our back yard.
  2. Any plan to pay off debt that does not require a change in our spending habits will fail. If the process that created the problem continues, we cannot expect the problem to vanish.

Our next discussion will talk about methods that do work.

Ask Mr. G
© Jim Garnett, The Debt Doctor
AskMrG Consulting, LLC
2216 SW 35th Street
Ankeny, IA 50023

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Sent by:

Paul Richard
President - Executive Director
Institute of Consumer Financial Education (ICFE)

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