It’s happened to me, and it’s happening to a lot of people right now. It’s been going on for the last few decades, and has reached its boiling point. I’m talking about consumer debt. We owe more and more each year, and it’s increasingly more difficult to get out of credit card debt. The offers are very enticing, the merchandise out there we can’t be without, and it’s just too difficult to avoid those impulse buys. It used to be that $20 was considered an impulse buy, something you’d pick up on your way to the cash register. Now, it’s not unheard of to spend $100 on impulse purchases on stuff you don’t need. So after years of uncontrolled spending, you end up deeper in debt.
I’m going to share a true story of a friend of mine. Her case is rather extreme, but not unique. Just this week she was sharing her problems with me and asked me for advice. It turns out that Janet had gotten into debt over the last 3 years or so on about 8 separate credit cards. She also had an interest-only ARM first mortgage and an equity line of credit on her home. As you may be aware, credit card companies and many banks recently have started to tighten up their risk tolerance criteria and decided to re-evaluate customers’ accounts and close them out or decrease credit limits depending on the customer’s credit score and risk. This is precisely what happened to her. Her 5.5% line of credit was closed out and she could no longer borrow against it, but still had to pay off the balance. When she called two of her credit cards to request an interest rate reduction, they re-evaluated her accounts and actually dropped her limits without giving her any reduction in interest rate. Within a few months, her available credit had been reduced to what she owed, and she was faced with about $25K in credit card debt between 5.9% and 24%. Her minimum payments were consuming all the money she made and was having a hard time paying her bills each month. Out of panic, she called her bank and asked for a debt consolidation package. The bank was happy to oblige, and, she ended up with a single consolidated loan of $25K at 15.99%. The monthly minimum payment came to $479. What closed the deal was that all her debt would be consolidated to a single payment, which would be easier to manage than half dozen or so payments to different credit card companies. However, what she didn’t realize is that the single payment was equal if not greater than the sum of all the previous payments she had before. In fact, some of the accounts that were rolled up into the consolidated 15.99% loan were at less than 8%. That was a bad deal. Other accounts were charging 22% and 24%, which made sense to consolidate, but not any accounts that were charging less than the consolidated interest rate of 15.99%.
In spite of the loan consolidation, Janet’s still facing difficulties paying off her debt, having to come up with almost $500 each month to make the minimum payment. At 15.99%, this loan will not go away for a very long time. She’d been toying around with the idea of liquidating a 401K retirement account from a former employer, and asked me what I thought. She still has another 401K account to fall back on, from her current employer. So we did some comparisons. I asked Janet how much her 401K was earning, was it 2, 4, 6% per year? Actually, it was earning nothing. It was all in mutual funds, which weren’t performing well. The value of the 401K account totaled just over $30K. Taking into account a 10% penalty for withdrawing before retirement, and income tax on the rest, she’d net about $15K (depends on her purchase price and actual gains, if any). So we looked at the pros and cons of deciding to sell or not to sell.
Pros of selling the 401K to pay off her debt
1. Eliminate a 15.99% debt at the cost of a 0% return from the investment.
2. Free up $500 each month by not having to make payments against the debt.
3. Improve her income to debt ratio and subsequently her FICO score.
4. Regain credit and have some available for an emergency.
5. Be better financially prepared for possible unemployment.
Cons of selling the 401K to pay off her debt
1. She has 30K less for retirement plus the future value of any potential gain
2. 10% penalty, or $3K goes to Uncle Sam
3. Regular income tax is paid on any capital gains
Well, from an economic perspective, let’s consider the cost of the debt vs. the potential gain from the 401K account. If the mutual funds were to return 15.99% each year, then having a debt of the same amount at 15.99% would be a break even proposition. If Janet’s investments were to return 20%, then she’d be better off keeping that money invested.
However, there are two situations to consider that make the decision rather easy. First, her 401K is not making any money right now. So eliminating a 15.99% interest debt would create a relative gain. That is, she wouldn’t be making a 15.99% return, but she also wouldn’t be paying it out to a bank in finance charges. That’s a net gain in relation to not having a loss. The other situation, and most importantly, is her poor cash flow and not having any left over cash each month available for discretionary spending or an emergency. Having to shell out $500 each month on a minimum payment that will take several years to pay off is a huge burden, especially in this economy with high unemployment and the risk of a layoff. What if she lost her job, how would she make the payment? Would she have to file bankruptcy? At the moment, she’s not able to save any money, so she can’t even build an emergency fund to cover her expenses in case she did lose her job.
The advice I gave Janet was to definitely sell off that 401K and get rid of the $25K debt as soon as possible. The goal is to eliminate that liability and get her cash flow situation improved. After the consolidated loan is paid off, she should take the $500 left each month and put it in savings. Create an emergency fund of at least 6 months worth of expenses, and keep it liquid in a money market account. After the emergency fund is properly set up, then start putting that money away in an IRA.
Having lived through this difficult experience, hopefully Janet will be able to avoid these situations. She’s felt the pain, and now she’s on her way to recovery. I hope she can stay afloat long enough to get out of debt completely, and then rebuild that retirement account with a clear conscience.
At the beginning of the article I said that it happened to me also. Back in 1996, an ex-girlfriend put me in a huge debt. I was about $13K in debt (which doesn’t seem like much now) and I was drowning in minimum payments. I could hardly buy food and pay my utilities. I was driving a $500 1982 Honda Prelude and couldn’t afford to go out with my friends. I mentioned to a friend my situation and he gave me the same advice I gave Janet. I had about $12K in stocks I’d purchased through Charles Schwab, but was hesitant to touch them because they’d gone under water. So my friend asked me how much I was paying in interest rates vs. how much my stocks were returning. The answer was 18% and 0%. The solution was then so obvious. I immediately put in a sell order with Schwab, and within 2 weeks had the cash in my hands. In the next 2 billing cycles, I paid off all my credit cards. Then I was pleased to find my checking account had a surplus of cash each month, because I no longer had to make those minimum payments. Being young and still unwise, I used the newly found money to make payments on a sports car. Maybe that wasn’t the best decision, but at the age of 26, my newly found economic freedom was refreshing and enlightening. I have since been more aware and very conscious of when I borrow, why I borrow, how I borrow, and what effect that will have on my cash flow and net worth. I hope to never repeat my mistake from 1996, and will take every opportunity to help friends like Janet with similar situations. I hope you found both of these true stories educational and enlightening. Best of luck.