Paying off credit card debt
Readers may wonder why a column that usually addresses issues regarding investments and the economy is digressing into one that pertains more to consumers. The reason is that we have recently received several telephone calls from listeners to our radio show on 810 WGY with investment portfolios, but who also have accumulated sizable credit card debt. Their questions are twofold, given the level of their debt as well as the interest rates being charged, should they pay off the debt with other assets and, if so, where to withdraw the assets from to pay off said debt.
Prior to responding to their concerns and perhaps the concerns of the readers, some facts need to be determined and some questions need to be answered. The first request that we have for the client is that they specify the outstanding balance of each specific card (assuming there is more than one) and the interest rate is being charged by each lending institution. The second consideration revolves around the financial resources available to tap should the client wish to pay down or pay off the balances on the credit cards. Regarding this issue, the tax ramifications and withdrawal of funds thereby reducing the liquidity of the client are both considerations.
The most appropriate manner in which to perhaps help the readers of this column regarding their credit card debt is to create several scenarios and outline our recommendation to each situation. Each scenario assumes that the client has credit card debt that they wish to eliminate through tapping other available sources.
Prior to outlining each scenario, let us first remind readers that the average interest rate being charged by credit card issuers is well in excess of the longterm historical normal returns of the stock market of ten percent and the fact that outside of utilizing the credit cards for business purposes, interest charged by the lending institutions are not tax deductible.
Scenario 1, assumes credit card debt of $10,000 owed by an individual or couple who are approximately 45 years of age. They currently have sufficient equity in their home to pay off their credit cards via a home equity loan and have balances in an employer sponsored pension plan such as a 401(k) or 403(b) plan. Given the above, we recommend that the client withdraw the balance owed from their home equity loan and set themselves up on a payment schedule not to exceed five years. We suggest this course of action due to the lower interest rate offered by a home equity loan when compared to credit card issuers and the fact that the interest charged for the home equity loan may be tax deductible while the interest charged by the credit card company is not. Regardless of the age of the client, we generally recommend tapping the home equity rather than create a taxable situation that would result should the client withdraw funds from an Individual Retirement Account (IRA) or other qualified investment. The only exception would apply to clients who have reached the age where they must take mandatory distributions from their IRA. In this case, it is often quite feasible to use these withdrawals rather than the home equity.
Scenario 2, assumes credit card debt of $10,000 owed by an individual or couple who are approximately 45 years of age. They currently have sufficient equity in their home to pay off their credit cards via a home equity loan, have balances in an employer sponsored pension plan such as a 401(k) or 403(b) plan and have nonqualified accounts (taxable brokerage accounts or mutual funds). Given the above, we recommend that the client withdraw the balance owed from their non-qualified accounts to satisfy the credit card debt. The money should be pulled from the areas of these accounts that have the least potential for growth, namely money market funds and/ or bond funds. In fact, generally speaking, regardless of the age of the client, this course of action is preferable to others. One note, be certain to rebalance your portfolio back to your intended percentages.
Scenario 3, assumes credit card debt of approximately $10,000 owed by a retired individual or couple and who are approximately 65 years of age. They currently have sufficient equity in their home to pay off their credit cards via a home equity loan, have balances in an IRA, but have no other assets. Furthermore, they do not have sufficient monthly income to pay for the debt. Once again, we suggest the home equity loan to satisfy the credit card debt. However, this nonetheless does not eliminate the issue of cash flow. We therefore generally recommend that the client withdraw money from their IRA to pay the monthly home equity charges, but amortize that loan over a five year period thereby reducing the tax burden resulting from the IRA withdrawal while potentially benefiting from the interest deduction from the home equity loan.
We could create dozens of scenarios, but tried to address those we thought most common. One note of caution, should you pay off all credit card debt only to build it back up, then our plan will not work. In fact, you have spent future income, some of which perhaps you are not able to afford.
Please note that all data is for general information purposes only and not meant as specific recommendations. The opinions of the authors are not a recommendation to buy or sell the stock, bond market or any security contained therein. Securities contain risks and fluctuations in principal will occur. Please research any investment thoroughly prior to committing money or consult with your financial advisor. Please note that Fagan Associates, Inc or related persons buy or sell for itself securities that it also recommends to clients. Consult with your financial advisor prior to making any changes to your portfolio. To contact Fagan Associates, Please call 518-279-1044.