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| The Basics | A do-it-yourself plan for tackling debt
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Liz Pulliam Weston helps readers face up to massive credit-card debt -- and decide whether it makes sense to borrow retirement funds for home improvements.
By Liz Pulliam Weston
Question: My husband and I have managed to get ourselves into a serious debt problem. Our credit-card tab alone is $30,000, and that doesn't count the money we owe on our car, our recreational vehicle and our house.
We are not behind in any of our payments, but it has reached the point that almost all of our income goes to pay the credit cards. I have always paid more than the minimum, but lately the minimums are huge as we have charged the maximum on all the cards.
We thought about an equity loan or line of credit to pay this down, but we really don't want to take any money out of the house. The equity in our home is the only "retirement fund" we have right now, and we are terrified of messing that up.
We have already cut up the cards except one that has a low fixed rate. Can we contact a nonprofit credit-counseling agency and have our interest lowered or eliminated, and then pay it a certain amount of money so it can then pay the creditors? We see this advertised all the time as the "rescue" solution, but we have heard that this means we will be late on our payments. If we are candidates for this type of assistance, what kind of damage will this do to our credit rating?
Answer: Credit counseling, by itself, typically doesn't hurt your credit score. The modern FICO credit-scoring formula ignores any reference to credit counseling that might be added to your file.
But some customers who sign up for credit counseling do run the risk of having their payments reported as late if they fall below the required minimum, which sometimes happens under repayment plans.
Other lenders will see the credit-counseling notation in your credit file and decide not to lend to you as long as you're in the program. (That's usually not such a bad thing; you probably shouldn't be applying for new loans anyway.) This is why credit counseling isn't the best solution for people who aren't already behind on their debts.
What's more, there are some pretty bad apples in the credit-counseling world -- outfits that will take your money but won't necessarily pay off your creditors. If you decide to go this route, you'll want to stick with agencies that are affiliated with the National Foundation for Credit Counseling.
You have other options, though, and you should explore these first. Your best choice would be a do-it-yourself program that would not only pay off your debt but also whip your money habits into shape so you don't find yourself in the same position down the road. Some steps to take:- Stop using credit -- period. That includes the card with the "low fixed rate." There's no such thing as a true fixed rate anymore, and any day now the issuer could decide to jack it right up. Besides, you can't get out of a debt hole if you're still digging.
- Sell whatever you can. That includes the RV if you don't owe more on the thing than it's worth. A big yard sale and a few auctions on eBay could result in enough money to make a serious dent on what you owe.
- Ask for lower interest rates. You're unlikely to get them because you've maxed out your cards, but you can always try.
You're right to be scared of tapping your home equity, especially because you don't have any other money set aside for retirement. Too many Americans are blowing this all-important source of wealth because they can't figure out a way to live within their means.
If you're committed to a debt-free life, however, and have retired your credit cards, then a home-equity loan or line of credit can speed you to your goal.
Question: My wife and I are considering tapping her 401(k) for home improvements. But we've heard there could be some penalties involved if she loses her job and can't pay the loan back. What's the worst that could happen if we borrow, say, $10,000?
Answer: If you can't pay the money back in short order, what was a loan becomes a taxable distribution. You would owe a 10% federal penalty plus income taxes on any outstanding balance. If you're in the 25% tax bracket, you would have to come up with $3,500 to pay the Internal Revenue Service -- plus any penalties and income taxes your state might assess.
The greater damage, though, is the loss of future tax-deferred earnings that money could have made for you. The $10,000 could have grown to $100,000 in 30 years, assuming an average 8% annual return.
That's why it's not a good idea to tap retirement funds, particularly for discretionary spending such as home improvements. Trim your other expenses and save up the money instead. You'll be better off in the long run.
Liz Pulliam Weston is the author of "Your Credit Score: How to Fix, Improve and Protect the 3-Digit Number That Shapes Your Financial Future." Questions for Money Talk can be submitted to her at 3940 Laurel Canyon Blvd., No. 238, Studio City, CA 91604, or at LizWeston.com.
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MSN Money's editorial goal is to provide a forum for personal finance and investment ideas. Our articles, columns, message board posts and other features should not be construed as investment advice, nor does their appearance imply an endorsement by Microsoft of any specific security or trading strategy. An investor's best course of action must be based on individual circumstances.
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