Welcome to the final post about high-interest debt in our “Am I Ready to Invest?” series! Some quick links to the other two posts dealing with high-interest debt, in case you need to catch up:
“Am I Ready to Invest?” Part 5: High-Interest Debt
“Am I Ready to Invest?” Part 6: Eliminating High-Interest Debt
The purpose of this post is to address what I would consider to be some frequently asked questions (FAQs) about high-interest debt and the methods to eliminate it. As you know if you’ve read through the blog to this point, I argue that high-interest debt works directly against successful investing by offsetting your investment gains and hindering investment growth by redirecting money that could have been invested.
I also argued that because of the severe effects of high-interest debt, you should do everything you can to eliminate it as quickly as possible. But even with all of that covered in the previous two posts, there are still some questions that tend to arise when discussing high-interest debt. I’ll try to cover those here in this post.
If, after this post, you still have questions, please feel free to leave them in the comments below, and I will do my best to respond to them.
Should I try to eliminate all debt before investing, rather than just high-interest debt?
No, you shouldn’t.
The reason is that for most people, if they had to wait until they had no debt at all before they invested, they would never invest. This is especially the case insofar as it concerns mortgages, as they are required for most individuals to purchase a home and are long-term debts (typically 15 years or 30 years for a fixed-rate mortgage).
You can’t afford to wait 30 years before you begin investing to reach your financial goals, particularly a financially secure retirement. That’s why the focus on eliminating debt is on high-interest debt: the debt that most damages your ability to invest successfully and the debt that needs to be eliminated as quickly as possible.
If you eliminate all high-interest debt and have only your mortgage, student loans, and/or a reasonable loan on a used car left, you’ll be in a position to benefit from investing.
What about a debt consolidation loan? If I consolidate all of my high-interest debt under one loan, is that not better than paying off each debt one-by-one, with some of the debts still having high rates while others are being paid off?
Debt consolidation loans can be tricky.
For readers who don’t know, the way a debt consolidation loan works is that you essentially take out a new loan with a lower rate than your high-interest debt, use the money from the loan to pay off the high-interest debt, then begin systematically paying off the new loan with the lower rate.
If you decide to go that route, you need to be very careful to ensure that you are actually getting a debt consolidation loan and not a debt settlement, to which you will pay a company who negotiated and settled the debt for you (severely damaging your credit score in the process).
Companies out there are tricky with the way they word things and hide things in the fine print, so if you’d like to be paying just one loan under which you can consolidate as much of the high-interest debt as possible, make doubly sure that it is indeed consolidation and not settlement.
The type of loan you’re looking for is what’s technically known in banking as an “unsecured personal loan.” The reason it’s called an unsecured loan is that you aren’t putting up any collateral, and the interest rate you receive for the loan is going to reflect that.
The rates on these are going to vary based on how much you’re asking for, your specific circumstances, and your credit score. But something to watch out for here are the terms of the loan, specifically the period of time it would take you to pay off the loan completely.
Although in such a loan, you may be able to consolidate high-interest debt and pay a lower rate overall, if you do not pay it off quickly enough, you could end up paying more in interest than you would have otherwise, had you just kept all of your high-interest debt as-is, and aggressively paid off the balances one by one.
Which is to say, when you find such a loan being made available to you, you’ll need to do the math yourself once the offer is made to see if you’re going to be able to pull it off with the lower rate in enough time to end up paying less in interest overall. Otherwise, you’re technically being ripped off with the debt consolidation loan.
Can such a loan work and be good for you, enabling you to pay less in interest? Yes. But you have to be very careful, and of course, all of this assumes you won’t be adding to the debt over the entirety of the process of paying it all off.
If I’ve already invested some in the past, should I use that money to pay off some of my high-interest debt?
That depends.
If your investments are in a taxable account (i.e., not a tax-advantaged retirement account), then yes, you probably should. If you sell some investments for a long-term capital gain, there’s a decent chance that if you’re in the target audience for this blog (ministers, seminarians, others preparing for ministry, and denominational employees), you’ll be below the income threshold to be taxed on them.
If you’re not below the income threshold and will be taxed on the gains, it’s still probably a good idea to sell investments and pay off the high-interest debt so that the compounding interest is no longer working against you. If selling investments in your taxable account results in a net loss, it’s again still likely worth making the sale and applying those funds to the high-interest debt for the very same reason. The sooner you can get completely out of high-interest debt, the better.
Additionally, a loss in a taxable investment account means you’d have a loss that could offset short-term or long-term capital gains (depending on the cost basis of what you sold) as well as offer a tax deduction to your ordinary income that, in some cases, could be carried over for multiple years (depending on the amount). I realize that’s more advanced than where many of you probably are right now with your investing knowledge, but it’s worth mentioning.
If your investments are in a tax-advantaged retirement account (such as an IRA, 401k, or 403b), then no, you should not use those funds to pay off any high-interest debt. The reason why is two-fold.
First, pulling those funds out prior to age 59 1/2 results in you paying a 10% penalty to the IRS for accessing the funds early (prior to being close to retirement age). Secondly, on top of that penalty, the IRS will tax you that year on the funds you pulled out of your account at whatever your tax bracket is for the year, since those funds were previously tax-advantaged.
Each of those is quite a hit, but taking them together is an even more severe blow. You’d be losing a lot of money to pull funds out of a tax-advantaged retirement account to pay off high-interest debt, which is why you shouldn’t do it.
That said, there is such a thing called a “hardship withdrawal” from a tax-advantaged retirement account, but the IRS has very stringent requirements for them, and high-interest debt doesn’t technically qualify. Additionally, if you do make a hardship withdrawal, though you won’t have to pay the IRS a 10% penalty, you’ll still owe taxes on that money, once again at whatever your tax bracket is for that year.
Since having high-interest debt is so bad, is it worth having a credit card at all?
It can be, assuming that the credit card is used responsibly, i.e., you do not accrue a balance that carries over into the next month.
Credit cards can be useful in three ways:
- Credit cards can be used to make emergency payments that your normal checking/debit account can’t cover, but your emergency fund can. If you have your emergency fund set up correctly (in a high-yield savings account or money market fund in a brokerage account), then it will be available for your emergency quickly, but not immediately.
So when an emergency arises and you need the funds right then and there, a credit card can be used to pay for the emergency on the spot. Then you can pull money out of your emergency fund to pay off the charge on the credit card. - Credit cards can be used to increase your credit score. If you have a credit card, and you know you can keep yourself from accruing a balance that carries over into the next month, you should consider making a few normal-budget purchases on it each month and paying the balance of the credit card each month.
If you do this normally, month after month, then over time you are demonstrating creditworthiness to credit issuers because they see you are using a small amount of the credit that is available to you on the card and are responsibly making payments every month. This should, in most instances, increase your credit score over time. - Credit cards can be used to benefit you through reward structures (like cash-back), if available. Again, this assumes that you will not build a balance that carries over into the next month. Some credit cards do offer reward structures, and with the right reward structure on a credit card, you can actually better your finances.
For example, we use a credit card that offers 2% cash-back on all purchases. So we put as much of our normal monthly budget on that card as we can to take advantage of what effectively amounts to a 2% discount on everything. Since these are all normal budgetary expenses, we pay the card off completely every month with our monthly budgeted funds from our bank account.
So yes, it can be worth having a credit card, even though its interest rate is so high. The catch is that you have to ensure through your own behavior that you will never have to pay that interest because you pay off the balance of the card every month.
I’m not you, so I don’t know your personality and tendencies. For some, credit cards may be simply too dangerous. For others, they may be a useful tool.
Only you can make that decision, but please do make it carefully.
Conclusion
I’m sure there are other questions out there regarding high-interest debt, but I hope that I’ve done a decent job of covering the ones that would arise the most frequently. If you have an additional question, please leave it in the comments below. I’d be happy to try to answer it when I have availability to do so.
Next time, we’ll wrap up the “Am I Ready to Invest?” series with its final post, a post about adopting the investor’s mindset. See you then.