Master Your Card

My friend called me up the other day and wanted to talk finances. Surprisingly, my friends don’t usually come to me for financial advice, it’s usually me offering it without being asked when I see a need. So, when they call me, I know they really need help.

Anyway, she calls me up and says she needs to talk to me about her debt. She doesn’t know what she’s going to do. She’s got about $10,000 in credit card debt - which she’s brought down from $20,000 - on about four cards. She’s also very concerned that she’s going to have to get a new car soon because hers is about to die. With a car comes car payments, something she hasn’t had in three or four years. She wants to talk about consolidating her debt.

So I meet my friend for dinner and we start talking about her options. Keep in mind, most of my friends are in their mid- to late-twenties, and while they’re all responsible people, they’re young and single and want to enjoy life. There’s nothing wrong with that, but sometimes I think it hinders their view of their finances. This seems to be the case with my friend.

As it turns out, my friend isn’t hurting financially. She’s fully capable of making her payments and affording a new car payment, but there are sacrifices she’s had to make, namely in her social life. She’s “tired” of not being able to go out and splurge on a nice dinner when she feels like it. She’s “tired” of not being able to do something other than what’s free. Personally, I think that stems from the fact that she doesn’t try a bunch of other free stuff, she sticks to one thing only.

At any rate, she doesn’t have any collateral except her car, which won’t help her. The value isn’t there. She’s so desperate in fact that she’s think of cashing in her 401(k) to pay off the debts. She figures she still young enough to do this and she’d still have enough time to start saving. I about choked on my dinner!

I tried to explain to her this wasn’t the answer. Yes, she’s young enough that if she did this and started over, she’d still have time to save and could probably make a decent return, but she’s already got quite a bit built up in her account and at the rate she’s going she could retire in her 50s as opposed to her 60s. If she took out $10,000 now, that would probably set her back 10 years or so. It’s not a lot, but she’s not looking at the big picture here. On top of that, she’s talking about paying 20% on the taxes. And let’s not forget, all of this is so that she can enhance her social life.

It’s her money, so I can’t really tell her what to do, all I can do is give her the information and hope she listens. But, if it’s not a dire emergency, my suggestion is to try other alternatives. So, we talked about the possibility of consolidating her debts, and what were her options.

Secured Loans

One option - and the best in my opinion - is to look for a secured loan. This can include things like:

• Home Equity

• Auto

• CD/Savings Secured

The home equity loan is usually the easiest option; if you own a home, that is. A lot of people freak out about a home equity loan because they’re afraid to lose their homes. Well, if they’re consolidating their debt into one payment and they make their payments on the loan every month, there’s no chance of losing the home. The problem comes in when the owners consolidate their debt and then run up their credit cards again. That’s obviously going to cause problems, so for those people I recommend working to pay off their credit cards individually as opposed to consolidating anyway. Obviously the temptation of free money is too much.

However, if you have self-control and can consolidate your debts into one payment without running the cards back up, then using the equity in your home is a viable option. Because it’s secured, you’ll get a better interest rate AND you may qualify for additional tax advantages from the interest paid (be sure to talk to a tax advisor). There’s not much to lose from this option if you’re responsible with your money.

The auto secured loan is a little more complicated because the security has to hold it’s value. That means that the car has to be worth what you want the loan amount to be, which can be difficult if you’re like my friend who has an old POS. Still, if you’ve got a vehicle that’s fairly new or that holds it’s value well, you can use it as collateral for a loan IF you own it free and clear. You can’t have a pre-existing lien on it, though. It’s not like a house where you can have two, sometimes three, liens on it. With a car, you only get one lien at a time.

The CD/Savings secured loan is usually the least used in these cases. If you had the money, you wouldn’t need the loan. However, these loans exist primarily for people who have money and just want to help build their credit scores. Still, it’s an option. In my friend’s case, her sister married into a wealthy family, but has been burned before by other relatives not paying her back. As such, she’s extremely hesitant to lend my friend money. I suggested this arrangement because her sister can put the money in a CD account and allow it to earn interest for her, while at the same time pledging it to cover my friend’s loan. The CD does get confiscated in the event of a default, but her sister does have a little more control over the whole deal. Not to mention, she’s earning interest while it sits there and she’s not directly responsible for the loan. I don’t think my friend was keen on this idea, though.

Unsecured Loans

These loans are a little harder to get, particularly when you’re talking about debt consolidation. They also carry a higher interest rate because they’re riskier - there’s no collateral to take if you default on the loan. Usually, these loans require decent credit scores and good debt-to-limit ratios on the credit report. Something else very heavily looked at is the debit-to-income, which is usually required to be below 50% on an unsecured, and the net-disposable-income, which they typically like to see above $500 at minimum.

In most cases, financial institutions will consider the DTI and NDI after combining the debt to help someone get the loan. However, it’s rare that these kinds of loans exceed $10,000. In most cases, lenders will offer something much smaller than the asking amount of the loan because they don’t want to extend the borrower any further than they already are. If you have poor repayment history, this type of loan is almost always denied.

Credit Cards

As funny as it sounds, consolidating to one credit card isn’t necessarily a bad thing, especially if you can work a 0% deal. I’ve talked about the affects of balance transfers on your credit in another post, so do be careful with this; however, if done effectively, you can reduce your debt and possibly swing some reward points out of the deal.

401(k) Loan

A final option - and one I hope people consider as a last resort - is a 401(k) loan. I mentioned this to my friend because I’d rather her do this than cash it in completely. Basically, you can borrow up to a certain percentage of what’s currently in your 401(k) and that money can be used for whatever you like. You have a monthly repayment plan, just like any other loan. However, the downside is that if you leave your employer for any reason while you still have a loan out, you’ll be required to pay the balance in full within 60 days (in most cases).

I say keep this as a last resort because this money is earmarked for your retirement, If you default or can’t make the payments, it comes out of your retirement account and that’s just as bad as taking it out in the first place. If it’s an absolute financial crisis and you need the money, then know that’s it’s available. However, if it’s just to help liven up the social life, there are probably other methods that would be better.

Personally, I think debt consolidation is a great tool to help people get out of debt. In my opinion, if people have the means to do it, I say go for it because it will ultimately save you money - and that’s my goal…to save people money.

What do you guys think about debt consolidation? Have you done it? What did you like or dislike about the process?