Debt Management
Reprinted from SmartMoney.com
DEBT USED TO BE a four-letter word. Paying by credit
card seemed profligate. Home equity loans were unheard of. And personal
bankruptcy made people ashamed. But today debt is commonplace.
Between 1990 and 1996, aggregate credit card debt
more than doubled, according to the Consumer Federation of America.
And this figure increased another 14% from the end of 1996 to September
1997 alone. We charge our groceries on our frequent-flier Visa cards,
invest using margin accounts and borrow from our 401(k)s to pay for
our children's education. Are we stupid?
Not necessarily. One reason debt has become more
palatable is that the prime rate has fallen from 21.5% in 1980 to 8.5%
today. At the same time, the stockmarket has had a seven-year bull run,
with the S&P 500 averaging 19.18% annual gains since 1992. That
has created an easy arbitrage. Borrow at 8%, invest at 19% and get rich.
That is the secret of the booming hedge fund business.
But not everyone is balancing their debts and investments
so successfully. In 1997, personal bankruptcy filings were nearly 55%
higher than they were in 1991, according to the American Bankruptcy
Institute. And that was a recession year. The credit card offers crowding
our mailboxes (also induced by low interest rates) are too much for
some individuals to handle.
Are you handling your debt wisely? The Debt Management
section at SmartMoney.com will help you decide. Here we tackle the issue
of whether you should pay off your debt. Sometimes the answer is obvious.
Say, for instance that your choice is between paying off a 19% interest
rate credit card and investing in an equity fund that has averaged 15%
per year. Pay off your credit card, and you'll get a guaranteed 19%
return.
But the answer is different if you are investing
in a 401(k) with a company match. Say your firm contributes 50 cents
for each $1 you invest. That's a guaranteed 50% return. A smart strategy
would be to make the contribution, get the match, then borrow from your
401(k) account to pay off your credit card loan. For more, see Should
I Borrow From a 401(k) to Pay Off My Debt?
And, unless you are 59-1/2 or older, it almost never
makes sense to raid your IRA to pay off debt. Why? You will owe a 10%
penalty and income taxes on all withdrawals except for funds held in
a Roth IRA account for more than five years or the original contributions
in a Roth IRA.
What's the real cost of your loan? It's probably
more than you think. Carry a $5,000 balance for five years at 15%, and
you will end up paying $2,137 in interest. You've just increased the
cost of your purchase by 42%. To make your own calculation, visit the
Smart-Money.com website and see How Much Is My Loan Costing Me?.
In future articles, we will add to our Debt Management
section with features like calculators for comparing credit card offers
and articles on other debt-related issues like bankruptcy.
SmartMoney is a joint publishingventure of Dow Jones
Company, Inc. and The Hearst Corporation.
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