Debt is so common, yet so personal. One person's $10,000 debt burden is another's $10,000 borrowing deal. And while the general rules of thumb are always good to follow -- find the lowest interest rate, pay more than the minimum amount due, lather-rinse-repeat -- there are plenty of times when the rules don't apply.
Take, for instance, Molly, an Oakland, Calif., Fool. She recently asked about the wisdom of paying off her debt ASAP. Here's her situation:
I've got a credit card that offered me 2.9% fixed interest on any balance I transferred, with no transfer fee, for as long as it takes me to pay off the balance. I had an auto loan of about 10K that carried an interest rate of about 5.9%. So, I used the credit card to pay off the car loan.
Now, according to the 'pay it off' school of thought, it's still better to put my money toward paying off that credit card than investing it. I have the $10K to pay it off, but it's currently invested in a portfolio that's showing a return of 11.36% (mainly thanks to one stock that's doing well).
Isn't this one of the cases in which I would want to pay off the credit card as slowly as possible, and continue to put my money into the more successful portfolio? Or at least not empty out the portfolio to pay off the debt? Is there such a thing as 'good debt?'
With so many low-interest credit card offers clogging our mailboxes, a lot of people like Molly wonder if the standby rules of debt payment apply to their debt situation. Here are some considerations.
When debt's a good deal
The "pay it off" school of debt management is less cut and dry when you can secure a sweet interest rate. Low interest is one of the things that characterizes what the experts call "good debt," something worth borrowing money to obtain. Mortgages and student loans are two prime examples.
They also have another attribute of good debt -- they tend to appreciate in value. Perhaps you've noticed what has happened with real estate prices in the past several years. The propensity to gain value can even describe student loans -- given that having a higher degree can help your earning potential and widen your dating pool.
Cars, however, start losing value -- depreciating -- the moment you drive it off the dealer lot. And just because you can buy a reclining sectional sofa with cup holders and built-in heated massager at 0% interest for the first six months doesn't necessarily make it a good -- or stylish -- reason to get a loan.
Low interest rates are turning up all over the place, blurring the line between good and OK-but-not-great-but-still-doable debt. Lenders use the lure of single-digit interest rates as a tool to get you to sign up for their cards. (Hey, we're guilty as charged, too! Though we think the Fool Credit Card has a lot of other lovely qualities besides the low interest rate.)
We thank lenders from the bottom of our hearts for these enticing deals. Used Foolishly, they actually make credit cards a tool for getting out of debt, instead of a drill that drives us deeper under. By transferring a balance from a higher-interest rate loan to a low-interest rate card as Molly did, you can effectively shave hundreds -- or thousands -- of dollars from your loan.
But there are many cautionary notes on such deals:
- What does the offer apply to? Balance transfers? New purchases? If you plan to use the card to move an existing balance over, make sure the balance you transfer falls within the credit limits of the new card.
- Check how long the low rate lasts. The offer Molly found, where the rate applies for the life of the transferred balance, is preferable. Not everyone will qualify for offers like that, so look for one that lasts for a reasonable period of time. Six months is a good starting point.
- Make sure you qualify. The best place to start looking for a better deal is in your wallet. Start with your current lender and negotiate for a lower interest rate. If you don't get one that is satisfactory, shop around. Lenders are tightening their requirements for the best deals. Still, competition is fierce.
- Be diligent about paying your bill. Make minimum payments (hopefully more than the minimum amount due) on time, or else you can pretty much kiss that low rate goodbye. Lenders are always looking for a way to eke out more money from you -- whether through interest or late/penalty fees. Late payments are just one event that'll give them a reason to hike up that interest rate.
- Avoid putting new charges on the card, since chances are new purchases are subject to a higher interest rate. Plus, they will be the last charges your payments will be applied to. That means that if you take your time paying off the $10 grand, but have put another few grand on the card at, say, 14% interest, your payments won't touch the new charges until the old, lower-rate ones have been paid down. You don't want to be accruing interest on those new charges for any length of time.
- If you plan to move any remaining balance over to a new credit card once the special rate expires, make sure you line up the new line of credit ASAP. Also consider closing the old one. You don't want to have too much credit available in the eyes of the lending industry -- you might make a run for the hills.
Cashing out to pay off debt
Let's say you've set aside some extra cash for that just-in-case scenario. Under what circumstances is it worthwhile to dip into the till and pay off your debt?
If it's sitting in your checking account earning a paltry .08% interest, chances are it'd do your finances more good if you sent it to Mr. Visa. How much of it to devote to debt payment is your call. If it is your emergency cash cushion, and you tend to be accident-prone, you may want to leave a little in your account for another emergency. Having cash at the ready can save you from future credit card debt.
For many people, though, having debt is an emergency worth liquidating their cash cushion. It's much easier to do if your cash is in an asset that is easy to get to -- say, in a money market account or certificate of deposit (though you will probably have to pay a small penalty to get your hands on the greenbacks).
In Molly's case, she's got $10 grand "available" to pay off her car loan. But given that the money is currently invested, it probably doesn't make sense to liquidate that account to pay off the debt. A few reasons:
- Since her portfolio has gained value, she would be subject to capital gains taxes on her investments should she liquidate them.
- If her investment is in an IRA or other tax-advantaged account, she will also pay an early withdrawal penalty, plus taxes, if she is younger than 59 and a half, which she is.
- There's a psychological cost to cashing out investments to pay off debt, which I'll go into in a moment.
Even if the investments are not doing well, most of the time it pays to keep your mitts off the balance. Dipping into this money to pay off a depreciating asset -- in this case, Molly's car -- is like robbing her future self. (By the way, Molly promised to drive her new car into the ground, just like the last one she owned.)
Even if your investments are not doing well or if you can cash them out without paying all the steep penalties, doing so comes at a cost.
Sometimes it pays to ignore the black-and-white numbers and do what feels right. While the calculations on the Excel spreadsheet build a strong case for holding off on investing and funneling extra cash towards debt, there are other, less tangible reasons to modify the plan.
"While it might make a small difference to put all the money toward the debt, I needed to feel like I was planning for my future and my retirement -- that I was getting into a good pattern that I could continue. I just wish I'd started even earlier," Molly writes.
Getting into the habit of saving is critical. Knowing that you are building something for the future -- even if you are paying for the past at the same time -- can do wonders for the psyche. Dipping into saved money can undermine that sense of accomplishment.
For some, that means striking a balance by investing some of their extra cash and allotting a portion to paying down the debt, even if the investments are doing well and the debt carries a very low interest rate.
It's hard not to be enticed by low-interest offers. But there's something to be said for carrying little to no debt -- that feeling of outright ownership, and watching your investments truly add value to your bottom line. How you get there is your choice.
Dayana learned a lot about balance and finding a "happy medium" from the folks she interviewed for Couples & Cash: How To Handle Money With Your Honey. You can see if her investment chakras are aligned in her profile.