People can find themselves under a pile of debt for a variety of reasons. Sometimes we fall upon hard times due to a set of unfortunate circumstances beyond our control. Other times we may have simply lived irresponsibly for periods in our life and not given enough consideration to the long-term implications of our actions. Debt can come in many forms. While it’s easy to understand the importance of getting out of debt, sometimes we don’t prioritize how we eliminate these liabilities in the most effective way.
When eliminating debt it is important to consider not only the interest rate you are paying, but also the tax implications. Eliminating the primary mortgage on your home is typically a great idea that is easily accomplished with extra principal payments. Yet keep in mind that the interest paid on your primary residence is most often tax deductible. So making extra payments towards the home may not be the smartest first priority if you have other debts. In cases where one is subject to a substantial Alternative Minimum Tax (AMT) liability, this deduction, along with others, may be reduced or excluded, and the priority of which debts should be paid down first would have to be revisited.
In the case of home equity lines of credit (HELOC’s), the first 100k is usually deductible only if it were used for the purpose of home improvement. If you took out a home equity loan to pay off other debts, then the deductibility of the interest is depends on when the loan was issued and the loan-to-value ratio of the loan. Loans issued prior to Oct. 13, 1987 are subject to different criteria. If the funds were used for home improvement, then the limit on deductible interest is a collective total of $1 million ($500k for a single filer) in debt service in total taken against the home.
Deductions on a HELOC for a second home are more stringent. You can typically deduct the interest if you do not rent the property. If you do rent the property then you must live in it for at least 14 days per year, or 10% of the days you choose to rent it, whichever is the greater. The interest rates on many HELOCs are variable and therefore you should place a larger priority on this type of loan, when compared to the primary mortgage. While many variable-rate HELOC’s have limits on the number of interest rate increases per year, we are currently in a period of historically low interest rates, which means rates are almost certain to rise.
In such a low interest rate environment someone with good credit can often negotiate very low financing rates on an auto loan, sometimes as low as 0%. However, for most individuals, auto purchases aren’t tax deductible. If you’re buried in debt, you may not have a great degree of flexibility or the best credit. In cases where there is sufficient equity in the home, debt consolidation through refinancing may be advisable to pay off auto loans by pulling the equity from the residence to lock in low rates. If it is a cash-out refinance, you may be transferring a non-deductible interest expense into a deductible interest expense. Most often an auto loan by itself is not enough to warrant a home refinancing opportunity, but it may be attractive in conjunction with other debt consolidation and lower available rates. People who are self-employed and have a car that is used exclusively for business purposes can deduct the cost of the auto as a business expense, as they can with other transportation expenses, including leased vehicles. If you opt to purchase a car, the tax benefit will be realized later. In such cases, this type of debt consolidation may not be advisable. As your company eventually grows and earnings increase, an auto lease will remain deductible and can be used to reduce business income. Yet home mortgage interest deductibility can be partially phased out should the alternative minimum tax begin with a higher adjusted gross income.
As important as it is to reduce debt over time, it should not be done at the expense and sacrifice of your retirement, with the exception of desperate circumstances. In fact, we should all target a minimum savings rate in our retirement plans of at least 10% of our income while employed. Your creditors will always be there, and the first rule of financial planning is “the first bill you pay is yourself.” Loans against retirement plans are not a good idea in general. They are designed to be a last resort in a desperate situation. However, if you have already taken one or are in need of one…they are often a better solution in an emergency than adding to credit card debt. Although the interest on a 401k loan is not deductible, you are paying that interest to yourself…not to a financial institution. The interest rate is typically fixed, and the loans are most often five years in duration, although they can be ten years if it is for a first-time home purchase. The true cost is the time that the principal from the plan is not invested towards your retirement. Additionally, should you default on the loan, your credit would not be impaired since you borrowed from yourself. However, you would be subject to ordinary income tax rates on any amount not repaid. Additionally, if you are below the minimum retirement age of 55, you would be subject to an additional 10% penalty on the amount not repaid.
The most dangerous of all debt to create is credit-card debt. The reason is the extreme interest rates that are frequently charged on credit card borrowings. While credit cards often offer wonderful rewards programs, it is important to pay them off immediately. They can go a long way towards establishing credit for those who cover their expenses at the end of the monthly billing cycle, but if you spend beyond your means, you may find yourself paying financing charges in excess of 20 or even 25% annually…with no tax deduction available. This is generally the first place you want to begin to reduce debt if you are already in over your head. In some cases, it may be advantageous to consolidate debt into your home mentioned above. Sometimes there are promotional opportunities to consolidate credit cards into another card that offers you a 0% percent interest rate for a period of time. While this may not be a bad idea in the short term, continuously opening new cards for balance transfers will negatively impact your credit.
Assuming you are reaping the rewards of a useful education, this may be debt well worth creating. The tax benefits of student loan interest can make prepaying such loans lower on the priority scale when compared to reducing things like credit card liability. The rates are typically much lower, and the interest is often a reduction to your adjusted gross income. Those individuals who are responsible with credit cards can often use programs like the UPROMISE program in New York. Such programs offer the ability for the points accumulated on credit cards to be applied to paying down principal on student loans.
While there are various forms of debt that one can find themselves in, it is important to prioritize the extra payments or cash flow towards the most logical areas. When doing so, you want to look at both the interest rate paid as well as the after-tax interest rate paid on deductible loans. Even when an individual has the cash available, it should be weighed against what that cash would earn if not used for debt reduction. Consulting with your tax advisor on your tax status in connection to these issues can be helpful. It is important to try to avoid bankruptcy proceedings. While a bankruptcy can alleviate some short-term issues, it will greatly impair your credit for years to come. Additionally, bankruptcy is about asset protection. If you are someone with no significant assets…it can be wasteful, time-consuming process.
Lastly, it is a good idea to take control of these issues on your own and educate yourself. There are numerous companies that advertise their ability to get you out of debt. Most of them time they are simply negotiating things like lowering the balance that a creditor is willing to accept. This is something you can easily do on your own without retaining costly debt-reduction services. Such negotiations, even when you are successful, can still impair your credit. For example, any unpaid balance owed on a credit card that is deemed settled by creditors is taxable income to you in that year.
It’s always advisable to live responsibly and avoid these issues. Yet, if you find yourself in a situation with a sizeable debt burden, be sure to prioritize the liabilities as discussed above. Itemize a budget by essential and discretionary spending so you can properly categorize what can be reduced or eliminated monthly. Sit down and put a plan of attack to paper, and follow it the best you can. Debt comes from many sources…and sometimes due to circumstances beyond our control. When we prioritize how we eliminate debt…like all financial decisions, weigh the entirety of the circumstance and alternatives.