Dogged by debt? Consider tapping home equity or retirement savings
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. 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 mortgage rates. In addition, you may get a tax deduction--check with a tax pro
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.
The downside of debt consolidation is that because you 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.
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."
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.
"One's total tax bite could be as high as 45 percent, meaning if you withdraw $100,000, you may only see $55,000 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.