Prioritizing Your Debt's
Getting Out of Debt
Quite often individuals find themselves under a pile of debt for various reasons. Sometimes we fall upon hard times due to a set of unfortunate circumstances beyond our control. Other times we may have simply lived irresponsibly for periods in our life and not given enough consideration to the longer term implications of our actions. Debt can come in many forms. While it’s easy to understand the importance of getting out of debt, sometimes we don’t prioritize how we eliminate these liabilities in the most effective way.
When eliminating debt it’s important to consider not only the interest rate you are paying but also the tax implications. Eliminating the primary mortgage on your home is typically a great idea by paying down the liability with extra principal payments. Yet keep in mind that the interest paid on your primary residence is most often tax deductible. So making extra payments towards the home may not be the first priority when other liabilities exist. In cases where one is subject to a substantial Alternative Minimum Tax (AMT) liability, this deduction along with others may be reduced or excluded, and the priority of which debts should be paid down first would have to be revisited.
In the cases of home equity lines (HELOC’s), the first 100k is usually only deductible if it were used for the purpose of home improvement. Borrowing for the purpose of other debt reduction is dependent upon when the loan was issued and the size of the loan in relation to the homes equity. Loans issued prior to Oct 13th 1987 are subject to different criteria. If the funds were used for home improvement, then the limit on deductible interest is a collective total of 1 million (500k for a single filer) in debt service in total taken against the home.
Deductions on a HELOC for a second home are more stringent. You can typically deduct the interest if you do not rent the property. If you do rent the property then you must reside in it for 14 days per year, or 10% of the days you choose to rent it. Essentially whichever is the greater. The interest rates on many HELOC’s are variable and therefore this should place a larger priority on this type of liability in terms of debt reduction when compared to the primary mortgage. Although often times variable rate HELOC’s can limit the number of interest rate increases per year, 2014 is a period of historically low interest rates by any measure. Therefore the longer term probability is that you can expect these rates to rise.
In such a low interest rate environment someone with good credit can often negotiate very low financing rates on an auto loan, sometimes as low as 0%. However, for most individuals there is no tax deductibility in an auto purchase. And if you’re buried in debt you may not have a great degree of flexibility or the best credit. In cases where there is sufficient equity in the home, debt consolidation through refinancing may be advisable to pay off auto loans by pulling the equity from the residence to lock in low rates. If it is a cash-out refinance, you may be transferring a non-deductible interest expense into a deductible interest expense. Most often an auto loan by itself is not enough to warrant a home refinancing opportunity, but it may be in conjunction with other debt consolidation and lower available rates. Individuals whom are self-employed and have a car that is used exclusively for business purposes can deduct the cost of the auto as a business expense along with various other transportation expenses when it is leased. If you opt to purchase the auto, the tax benefit will be realized at a later point. In such cases this type of debt consolidation may not be advisable. As your company eventually grows and earning increase, the auto lease will remain deductible and reduce business income. Yet home mortgage interest deductibility can be partially phased should AMT begin with a higher adjusted gross income.
As important as it is to reduce debt over time, it should not be done at the expense and sacrifice of your own retirement with the exception of desperate circumstances. In fact we should each target a minimum savings rate in our retirement plans of at least 10% of our income while employed. Your creditors will always be there, and the first rule of financial planning is “the first bill you pay is yourself.” Loans against retirement plans are not a good idea in general. They are really designed as a last resort in a desperate situation. However, should you have already taken one or are in need of one…they often are a better solution in an emergency than that of credit card debt. Although the interest on a 401k loan is not deductible, it is interest you pay back to yourself…not to a financial institution. The interest rate is typically fixed, and the loans are most often 5 years in duration, or 10 years if pertaining to a first time home purchase. The true cost is the time that the principal from the plan is not invested towards your retirement. Additionally, should you default on the loan your credit would not be impaired since you borrowed from yourself. However, you would be subject to ordinary income tax rates on any amount not repaid. Additionally, should you be below a minimum retirement age of 55 you would be subject to an additional 10% penalty on the amount not repaid.
The most dangerous of all debt to create is that of credit card debt. The reason is clearly the extreme interest rates often charged. While credit cards often offer wonderful rewards programs, it is important to pay them off immediately. They can go a long way towards establishing credit for those whom cover their expenses at the end of the monthly billing cycle. However, should you spend beyond your means you may find yourself paying financing charges in excess of 20-25% annually…with no tax deduction available for the interest expense. This is generally the first place you want to begin to reduce debt for those whom are already in over their head. In some cases it may be advantageous to consolidate debt into your home as stated earlier. Sometimes there are promotional opportunities to consolidate credit cards into another card that offers you a 0% percent interest rate for a period of time. While this may not be a bad idea in the short term, continuously opening new cards for balance transfers will negatively impact your credit.
Assuming you reaped the rewards of a plentiful and useful education, this may be debt well worth creating. The tax benefits of student loan interest can make prepaying such loans lower on the priority scale when compared to reducing things like credit card liability. The rates are typically much lower, and the interest is often a reduction to your adjusted gross income. Those individuals who are responsible with credit cards can often utilize programs like the NY State UPROMISE. Such programs offer the ability for the points accumulated on credit card usage to pay out a quarterly dollar value that can be sent directly to your Sallie Mae loan to reduce its principal amount.
While there are various forms of debt that one can find themselves in, it is important to prioritize the extra payments or cash flow towards the most logical areas. In doing so, you want to look at both the interest rate paid as well as the after tax interest rate paid on deductible loans. Even when an individual has the cash available, it must be weighed against what that cash would alternatively earn if not used for debt reduction. Consulting with your tax advisor on your tax status related to these issues can be helpful. It is important to try to avoid bankruptcy proceedings. While a bankruptcy can alleviate some short term issues, it will greatly impair your credit for years to come. Additionally, bankruptcy is about asset protection. If you are someone without any significant assets...it can be wasteful time consuming process.
Lastly, it is a good idea to take control of these issues on your own and educate yourself. There are numerous companies whom will advertise their ability to get you out of debt. Most of them time they are simply negotiating things like lowering the balance that a creditor is willing to accept on something like a credit card balance. This is something that you can easily do on your own without retaining their services for a fee. Such negotiations, even when you’re successful still impair your credit. For example, any unpaid balance owed on a credit card that is deemed settled by the creditors is TAXABLE INCOME to you in that year, adding yet another liability with the IRS.
It’s always advisable to live responsibly and avoid these issues. Yet, if you find yourself in a situation of a sizeable debt burden, be sure to prioritize the liabilities as discussed above. Itemize a budget by essential and discretionary spending so you can properly categorize what can be reduced or eliminated monthly. Sit down and put a plan of attack to paper, and follow it the best you can. Debt comes in many ways…and sometimes due to circumstances beyond our control. When we prioritize how we eliminate debt…like all financial decisions, weigh the entirety of the circumstance and alternatives.
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