Advice consolidate debt

Money management is key when planning to consolidate debt

C2For Jan and Mike, the "New Year's resolution season" has turned serious this year.

While the Lawndale couple has been watching many friends head off to the gym in a quest for better health and slimmer waistlines, Jan and Mike are looking at much bigger stakes -- notably, their mountain of consumer debt that they vowed to tackle in 2005 but have yet to start reducing.

"We have no good excuse for running up nearly $20,000 in useless debt, but with taxes coming up, we're almost out of time to address it head-on," Jan writes. Now the couple is in the all-too-common position of paying several hundred dollars a month in interest and annual membership fees to credit card companies. They know their only option is to consolidate and stop spending.

They need advice on how to best jump-start their plan and reduce their interest charges. They have some home equity, but wonder if they should explore other options, such as credit balance transfers or use of remaining retirement funds.

The financial picture

Jan and Mike, both 42, have a combined annual income of $94,000. Because they used retirement account funds to buy their condominium a few years ago and haven't saved much since, they have only $14,000 in those accounts. Their condo has appreciated well, however. It is worth about $395,000 with a mortgage balance of $228,000.

The average interest rate on their four credit cards (total credit limit is $28,000) is 15 percent, and monthly payments total $590.

Plan of action

Consumers paying high interest rates should always consolidate debt, if it's an option. However, it also should be the first step toward a commitment to prudent fiscal management. Too often, people who get a debt consolidation "break" end up continuing their bad habits.

Low-rate credit card balance transfers can be appealing, but are best used only when the debt can be paid off within either 18 months, or even better, before the low introductory rate goes away.

For example, if the couple moved $20,000 to an 8 percent rate that was good for 12 months, and only made a minimum payment of, say, $300 a month, they would be less stressed but only a little better off financially next year. For this strategy to work, Jan and Mike would have to commit paying at least $780 a month so that the debt would be halved within 18 months.

It's the terms, not necessarily the rate, that make the big difference with these offers.

One single late payment could double the rate, for example, and some offers include odd requirements -- such as a credit purchase of $500 within a specified time frame -- to keep the rate.

The equity loan is probably the cheapest option for Jan and Mike. Such loans are relatively easy to get and an interest tax deduction may be available. But the risks are considerable and the stakes high.

For starters, it's their only major asset and their abode is the collateral. That puts them at risk of losing the property if they hit hard times because of a job loss or other serious problem.

The other two risks are less apparent: 1) The interest rate on an equity loan floats, that is, it will rise as interest rates rise and 2) slow, relatively painless repayment terms. A 10-year, $50,000 amortizing loan at 5 percent interest, for example, would carry a payment of about $530, but at 9 percent interest, the payments would be $634 (or over $7,600 per year).

But that slow payoff -- lenders hope consumers won't pay off the loan quickly -- defeats one purpose of debt consolidation, which is eradicating all debt as quickly as possible.

If Jan and Mike elect this route, they should ensure there is no prepayment penalty and try to pay the loan off in five years. They also should commit to adding $300 a month to the regular payment, to ensure they begin building up equity again.

Following are other debt-consolidation options consumers might consider:

* A marginally better option, for people who don't have equity to tap, might be a loan from retirement accounts. But there are several potential drawbacks. For one, the interest isn't deductible, and if the money isn't paid back within five years, the IRS penalties and taxes could exceed credit card interest.

* Another possible option for debt-saddled consumers is borrowing from a whole life insurance policy if there's sufficient cash built up to leave a decent death benefit intact. The only problem with this strategy is that people sometimes sort of "forget" to pay back the loan -- risking the prospect that beneficiaries won't receive adequate funds in the event of the policyholder's early or untimely death.

Stephanie Enright owns Enright Financial Consultants of Torrance. Write to Stephanie Enright, c/o the Daily Breeze, 5215 Torrance Blvd., Torrance, CA 90503-4077. If you need financial advice, include a stamped, self-addressed envelope so you can receive a confidential questionnaire to return. Questionnaires are also available at the Daily Breeze. Only letters chosen for publication will be answered; your real name will not be used.