Saturday, October 3, 2015

Paying Off Debt With Debt?

Should you use debts to pay off debts?   It can work, but it requires a lot of discipline.

A reader writes:
"What do you think if I have really bad credit card debt and I can get loan to pay it back. The loan is actually cheaper than paying minimum amount on my card forever... Is it good idea to get more debts to pay of worse debts?? I don't think it is covered in your blog."
Actually, I have covered this a lot.   And while the idea has some merit, it can be a trap as well.

For most of us, debt is like a habit - a drug habit.   We need our "fix" of shopping or dining out, or whatever, and we put it all on a credit card, until one day we realize we have $10,000 in credit card debt at 25% interest and our income isn't enough to pay it off.

What to do?   Refinancing the debt at a lower rate seems like one answer - getting the 25% interest monkey off your back.

You could do a balance transfer to a lower rate card:

You could refinance your home or take out a home equity loan to pay off the card:

You could go to a crowd lending site and get a lower rate loan:

There are banks that will even refinance your car loan:

Or you could even go to the bank and get a debt-consolidation loan:

Yes, all of these could work, but they have one problem:   So long as you remain a credit junkie (addict) the underlying issue won't be solved.  Moreover, you are just pouring gasoline on the debt fire. And I know this from experience!

For example, I had a lot of debts - credit cards, car loan, etc. and the monthly payments were staggering. We refinanced our house at a lower rate and took cash-out to pay off the debts.   We had a lower monthly payment overall.  Sounds like a good deal. right?

Well, it could have been.  The credit card companies, after I paid off the balances, send me letters saying "Congratulations!!  Due to your great credit history, we've raised your credit limit!"  It was the drug dealer enticing the addict.  And being young, I fell for it.

Needless to say, within about five years, we were back where we started - only this time, with a much higher mortgage balance AND credit card debt.  If we hadn't sold out at the height of the market, well, we'd be in a world of woe right now.

And we did sell out at the height of the market and were debt-free..... for about a year.   Then we decided we needed a fancy house and we needed to remodel it and it needed new furniture, and so forth.  Within a short period of time, we went from debt-free to back-in-debt.   A once-in-a-lifetime deal, and we sort of blew it.

Refinancing a loan can work, but it requires the DISCIPLINE to cut up the credit cards, stop spending, work out a budget, and use the experience as a wake-up call to get one's financial house in order.

Several years later, I found myself in the same pickle.  We had a lot of debt, and due to a fiasco with Capital Gains tax, had to charge tens of thousands of dollars in taxes to a credit card (why I had such high limits is beyond me).   At the high interest rates of a "rewards" card, the balance would never have been paid off.

I finally realized what a fool I had been.  I did a balance transfer to a 0% interest rate card (with a 4% transfer fee, of course) and started aggressively paying off the balance before the 12 month "introductory rate" expired.

I also started selling off "stuff" - the vacation home, cars, boats, and things.  And I started this blog.  I began to realize that I had fallen for a carefully laid trap - again and again - over my life.   And I realized that in order to be independent of these bankers and lenders, I would have to start paying down and paying off debts rather than merely moving them around.

It took a few years and it took some realization that our priorities needed to be reorganized.  But we are again debt-free, and now for more than a decade.   We got a second chance, although it wasn't as easy as the first time around.

It is SO TEMPTING once you refinance debt to think, "Gee, I have all this extra income now, I can go and spend more!"

A better idea is to use the extra monthly cash-flow to pay down and pay off that debt.
If you decide to get a loan to pay off a loan, make sure you have a plan in place to use that extra monthly cash-flow to pay off the loan, not to run up more credit card debt.

Here are some suggestions:

1.  CUT UP credit cards if you have more than one. 

2.  Keep the lowest rate card or seek out a low rate (7.15%) card available.   Eschew airline miles and come-on crap designed to entice the junkie in all of us.

3.  SET A LIMIT on the card that you can pay off every month.  Tell the credit card company you want to stay to this limit and no, you don't want the "overdraft" feature enabled (that socks you with a $50 fee when you go over the limit).  My limit is $5000.   Pick a number you feel comfortable with - a number you can realistically pay off.

4.  check your credit card balance daily - you can do this with a smart phone or computer.   Track how much you are spending and make sure you are not using the funny-money of the credit card to spend more.

5. Consider paying cash for most things, at least a while, until your discipline is established.

6.  Mark your calendar (on your phone, whatever) with the statement date and payment due date for your card.  You should know these better than your Mother's birthday.

7.  Set up autopay to pay at least the minimum balance due every month so you are not jacked to a "penalty rate" if you miss a payment or something.

Credit cards are like loaded handguns.  Powerful, yes.   Dangerous?  Only if handled improperly, which is quite easy to do!

Good Luck!