If your debt got out of control during the recession, you're probably looking for ways to cut it down to size. The Federal Reserve considers a debt burden of more than 40 percent of your gross income an indicator of financial distress.
Since you don’t want to trash your credit with a bankruptcy or debt settlement, you might consider using a home equity loan or your retirement savings to tackle that debt.
Here are the pros and cons of using these solutions to deal with your debt.
Utilize your home’s equity
Consolidating debt is not the same as getting rid of debt; you still owe the money, your debt is just structured differently, with more manageable payments. Debt consolidation with a home equity loan should reduce your payment by:
- Stretching out the balance owed over a 15- to 30-year amortization schedule
- Replacing expensive unsecured financing with a home equity loan at today's low mortgage rates.
It can be difficult to secure a home equity loan. Since the housing bust, banks have tightened their lending standards and issued far fewer of these loans than they did during the housing boom. But it's still worth a try. Many lenders still offer a variable-rate Home Equity Lines of Credit, and some allow you to convert a portion of the line into a fixed-term, fixed repayment loan.
The downside of debt consolidation is because you may stretch out the repayment period, you could end up paying more interest over the life of the loan even if your interest rate is lowered. However, by making extra principal payments you can accelerate the payoff and pay much less over the life of a home equity loan. Of course, if you're only making minimum payments on a high-rate, high-balance credit card you will likely be paying over a much longer basis than any new fixed-term loan.
Another potential problem with debt consolidation is the likelihood of running up more debt -- some experts put debt consolidation's failure rate at 80 percent.
"It's unfortunate that many people who consolidate debt to lower interest payments or benefit from tax breaks don't change their spending and budget habits to avoid repeating the behavior that mired them in debt in the first place," says Mike Sion, author of "Money and Marriage: How to Choose a Financially Compatible Spouse." "They must firmly focus on consistently shrinking their debt balance by making payments a part of their budget."
It used to be that a strategy of debt consolidation using a home equity loan or line also allowed you to deduct the interest paid on any draw, providing an ancillary benefit. However, that's not been the case since the passage of the Tax Cuts and Jobs Act in 2017, when interest paid on home equity loans and lines for purposes other than to "buy, build or substantially improve" a home was disqualified.
Tap your retirement accounts
To pay off your debt, you could withdraw funds from your 401(k) or IRA. The upside of withdrawing from retirement accounts is that your debt is now extinguished, not just restructured.
However, the cost is extremely high if you are younger than 59 1/2.
"To me, cashing in retirement savings to pay down debt is a short-term solution that sacrifices long-term gain," says Walnut Creek, Calif.-based wealth and tax planner Mark Greenberg. "We need the retirement assets to help support ourselves in retirement…especially with the pressure on the Social Security system is under which puts into question how much we will receive."
Greenberg also points out that taking money from retirement plans means having to pay federal and state taxes, plus a 10 percent early withdrawal penalty for those under age 59 1/2.
If you're subject to the top withholding rate, "One's total tax bite could be as high as 47 percent, meaning if you withdraw $100,000, you may only see $53,000 left in your pocket," he says. "Not a good use of money."
If you have a Roth IRA, you may be able to withdraw the contributions from it with no tax consequences. However, an unqualified withdrawal of earnings triggers income taxes, plus a 10 percent penalty.
You also may be able to borrow up to half of your balance (to a maximum of $50,000) against your 401(k) if your employer allows it. Borrowing is preferable to withdrawing because it does not create a taxable event, and you will not have to pay penalties. You usually get five years to repay the money, and the interest rate is usually within a percentage point or two of the prime rate.
Borrowing from yourself does have a catch, though. If you were to leave your job either voluntarily or involuntarily, the loan becomes due in full. If you can't repay it, the remaining balance is treated as an early withdrawal and you get the 10 percent penalty and the tax bill.
The worst part of withdrawing or borrowing from an IRA or 401(k) is that you may give up a lot of retirement savings. And it's difficult to play "catch-up" down the road because you are only allowed to contribute so much per year.
Before you consider either method of debt consolidation you should consider talking to a tax professional or a financial planner for advice specific to your circumstance.
