debt Avoiding Setbacks

Lesson 4: Avoiding Setbacks

Key points Don't attack debt so aggressively that you risk trading good debt for bad. Planning for emergencies is a key element to any debt management strategy. In particular, don't trade unsecured debt for secured unless you are well prepared for financial emergencies. So far, when we've discussed the details of debt, we've focused mainly on credit cards. In this lesson, we'll expand the topic and consider some common questions regarding other forms of debt. Q. Once my credit card debt is under control, should I aggressively pay down any car loans? Student loans? My mortgage? A. Ideally, we'd all be 100% debt free. But, for many of us, this just isn't a practical option, at least not in the near term. And if we have to carry a little debt, we at least want to control the terms. The risk in paying down debt too aggressively is that we can lose control of the terms. This is where saving for an emergency enters the picture. For example, let's say that -- in an effort to pay off their mortgage early -- a couple is making double mortgage payments every month. They're cutting it so thin, however, that they fail to save any cash for emergencies. Then, all of a sudden, one of them gets laid off. Now, instead of making double payments, they're having a lot of trouble making the required single payment each month. In the worst-case scenario, the couple is forced back to high interest credit card debt to make ends meet. So, we're all for aggressive debt repayment, but don't spread yourself so thin that it's hard to sleep at night. And don't neglect emergency savings. Moreover, the after-tax interest cost of mortgage loans can get down into the 6% range, a level at which investing any extra cash might be more profitable, over the long run, than paying down the debt. So be sure to start with the higher interest, non-tax-deductible loans, like car loans. For most homeowners, the mortgage should be the last loan you attack. Q. Besides emergencies, what other things can upset loan repayment plans? A. When we talk about saving for emergencies, we're talking about real emergencies like losing a job or suffering an extended disability. We're not talking about the car insurance payment that slipped your mind or even replacing a broken down refrigerator. Try to budget beyond the monthly must-pay bills to cover things like future appliance needs, vacations, and next year's tuition payments. Failure to do so can lead to a demoralizing step backwards -- to credit card debt -- just when you were starting to make real progress. Q. Should I consolidate multiple debts under one loan? A. Maybe, but there are some important pros and cons to think through first. The most obvious benefits of loan consolidation are: Lower Interest Rate. It may be possible to borrow at an attractive rate, and then use this money to pay off higher interest rate loans, effectively "moving" a chunk of your debt to a lower-cost loan. Simplification. It's easier to be disciplined if you're organized, and it's easier to be organized with fewer outstanding loans to track. But consolidation is not without risks. Just as we saw above, planning for emergencies comes into play: Trading Unsecured Debt for Secured Debt. Lower rate loans are commonly "secured," meaning that the debt is backed by your home, car, or some other tangible possession. Putting your valuable stuff "on the line," so to speak, is what gets you the lower interest rate. From the lender's perspective, it removes a lot of the bad credit risk from the deal. The down side to secured loans, though, is that if you hit an extended rough spot and default on the loan, you can literally lose your stuff. Even bankruptcy laws may not protect your home, for example, if your mortgage turns out to be the secured loan that you can't pay. For this reason, many personal finance experts lay down a firm line. They'll tell you never to trade unsecured debt, like credit card balances, for secured debt. For example, the standard advice is not to roll credit card debt into your mortgage or a home equity loan. On the other hand, this advice is too conservative for some. Borrowing against the value of personal possessions is sometimes the only way out of lousy, high interest rate loans. If you do decide to put your stuff at risk, be sure to consider whether you have adequate life and disability insurance, a secure and stable job, and some emergency cash set aside before you take the plunge. Summary When you get past credit cards, managing debt gets a little more complicated. Keep attacking aggressively, but be sure to plan ahead, especially for financial emergencies. You don't want to take a step backward into credit card debt or, worse, default on a secured loan.

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