Paying Off Debt: Smart Approaches and Stupid Ones

There are smart ways and stupid ways to get out of debt.

The smart ways get us back on track quickly, minimize the total amount of interest we pay and allow us to meet our important financial goals.

The stupid ways have us scrambling for easy solutions that don’t fix the real problem, cost us more in the long run and trash our credit rating.

Now is the time to know the difference, as bills from holiday spending pile up like snowdrifts on the Eastern Seaboard.

We can stuff those bills under the couch, just pay the minimum balances and continue down the easy road to financial servitude. Or we can confront the real cost of debt and do something about it.

The household that carries a $6,000 credit card balance at 17% pays about $964 in non-tax-deductible interest each year. Most of us, if we thought about it, would probably rather have that money in our pockets than send it to a credit card company.

You could be even further ahead if you invested the money. If you didn’t have the card debt and you invested $964 each year, you could produce a nest egg of more than $426,000 in 40 years if you earn 10% annually.

With that to motivate you, here’s an assessment of the best and worst ways to tackle your debt:

* Smart way. Stop spending! Or at least retire the credit cards for a while. You can’t work your way out of a hole if you keep digging.

Some people lock their cards in their safe deposit box; others freeze them in a block of ice (although that ruins the little magnetic strip on the back). Pay cash for purchases until your debts are paid.

* Stupid way. Transfer your balance to a credit card with a 3.9% teaser rate, and then keep charging to take advantage of that great low rate. First of all, the rate for buying stuff may not be the same as the rate for balance transfers; many cards have different, higher rates for new purchases. Even if the rates are the same, the teaser rate is going to expire eventually, leaving you with a bigger debt at a higher rate.

* Smart way. Find a card with a low “fixed” rate (one that isn’t scheduled to expire in three to six months) and transfer your other card balances to that card. The credit experts at Good Advice Press (https://www.goodadvicepress.com) agree that this is one of the cheapest and best ways to pay off debt. You can find offers for low-rate cards at Bankrate.com (https://www.bankrate.com) and CardWeb (https://www.cardweb.com).

* Stupid way. Move your balance from card to card every few months, chasing low teaser rates. Sooner or later you’ll get caught by a rate that jumps before you expect it or a hidden transfer fee that boosts your balance.

Opening lots of credit card accounts also is a good way to trash your credit rating; lenders are suspicious of people who open many accounts in a short period.

* Smart way. Pay off your highest-rate, nondeductible debt first, then apply the same size payment to your next-highest-rate, nondeductible debt, until all your nondeductible debts are paid off.

Say you have $200 a month to put toward paying off your debts. You have $2,000 on a department store credit card with a 17% rate and $3,000 on a bank card with a 9.9% rate. If you split the payment between the two cards, it will take you nearly three years and cost you $829 in interest before you are debt-free.

But if you pay only the minimum on the lower-rate debt and apply the rest of the $200 toward the higher-rate debt, you will pay off the entire debt six months faster and save about $80 in interest. Boost your payment by just $50 a month, to $250, and you can pay off the debt in less than two years and save $254 in interest.

The debt-reduction calculators at Web sites such as Quicken’s at https://www.quicken.com can show you how this works for your own debt.

* Stupid way. Make extra payments on your tax-deductible mortgage or home equity loan while carrying high-rate credit card debt.

There’s nothing wrong with wanting to pay your mortgage off a little early with extra payments toward the principal--unless you’re doing so while carrying much more expensive debt. Also, most people would be better off putting any extra money into their 401(k) retirement accounts or funding a Roth IRA before paying off a 7% or 8% mortgage.

* Smart way. If you are deep in credit card debt and your repayment plan will take five years or longer, consider a home equity loan (assuming you have some equity) to consolidate your card debt and (usually) make the interest tax-deductible--but only if you cut up your credit cards and are committed to not running up debt again.

Home equity loans are a fast way to financial oblivion for people who can’t control their spending; you’re putting your home at risk should you be unable to repay the loan, and you’re also eating up equity that you might need later in a financial emergency.

Home equity loans also are a bad idea for people who could pay off their debts in a few years, because such loans stretch out the debt for 10 years or longer and can ultimately increase your interest costs--even after taxes.

* Stupid way. Tap your retirement funds to pay off credit card debt. Borrowing from your 401(k) means that money is no longer earning tax-deferred returns for you. And you wind up paying taxes twice on the money you use to repay the 401(k) loan--once when you earn it, and again when you take it out in retirement.

Taking money out of an individual retirement account is even worse; you lose the tax deferral for good, and you also face income taxes and penalties that can eat up more than half of what you withdraw.

* Smart way. If you’re really in over your head--if you have to borrow from one credit card to pay another, if you can’t make your minimum payments or if debt is ruining your life--you can turn to a nonprofit credit counseling firm such as Consumer Credit Counseling Service of Los Angeles (https://www.cccsla.org).

This service can negotiate with your creditors for lower interest payments and better repayment terms. Such a debt management plan will show up on your credit report and can make it difficult for you to get new credit for a while--but that’s probably a good thing if you’re already in trouble.

* Stupid way. Turn to a high-interest debt consolidation loan or a for-profit, fly-by-night company that calls itself a credit counseling firm but that really makes its money by charging you excessive fees.

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Liz Pulliam Weston is a personal finance writer for The Times and a graduate of the financial planner training program at UC Irvine. She regrets that she cannot respond personally to queries. Questions can be sent to her at [email protected] or mailed to her in care of Money Talk, Business Section, Los Angeles Times, Times Mirror Square, Los Angeles, CA 90053. For past Money Talk questions and answers, visit The Times’ Web site at http://arstechnica.netblogpro.com/moneytalk.

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Card Debt: The Real Cost

Paying only the monthly minimums required on your credit cards can be expensive. The following examples assume that you have a $5,000 balance on a credit card with a 17% annual interest rate:

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* If you pay the 2% monthly minimum, the actual amount you pay each month will shrink along with your balance, meaning you pay less and less each month and stretch out the debt repayment. *

For help in figuring a debt reduction plan, check out https://www.quicken.com/saving/debt.

Sources: “Slash Your Debt” by Gerri Detweiler, Marc Eisenson and Nancy Castleman; Liz Pulliam Weston.

Compiled by NONA YATES/Los Angeles Times