Debt reduction requires a disciplined approach. You need to regularly siphon debt payments off of the top of your income as well as resist the tendency to treat credit lines as funds available for consumption. High interest debt needs to be paid off first. Start with credit card debt, then installment (e.g. car) loans, then home equity loans, and finally home mortgages. The more credit lines you pay off, the more money that’s available to accelerate paying off other debt.
Several options may be available for paying off high-interest debt including loan consolidation, home equity and 401k loans. These options don’t resolve indebtedness, but they may make debt more manageable and its payoff more attainable.
Loan (debt) consolidation entails taking out one loan to pay off many others. This is often done to secure a lower interest rate, secure a fixed interest rate or for the convenience of servicing only one loan. Debt consolidation can simply be from a number of unsecured loans into another unsecured loan, but more often it involves a secured loan against an asset that serves as collateral, most commonly a house. In this case, a mortgage secured against a house reduces the lender’s risk and allows a lower interest rate.
Home Equity or Equity Source Accounts take advantage of your home’s equity (i.e., the difference between what your home’s worth and what you owe on your mortgage). Due to the 2008 collapse of the housing bubble, many homes are under water (more owed that the house is worth), and consequently much of the home equity lines have been reduced or canceled. If this option is available to you, it provides the preferred solution. It is secured with your home as collateral, has its interest rate tied to an index such as the prime rate and therefore carries a very low interest rate. Depending on your income, you may also be able to claim interest paid as a home-loan itemized interest deduction.
401k Loans are generally available to those who are employed and have 401k plans with their current employer. These allow the employee to borrow a portion of their 401k’s balance and to pay themselves back through regular (usually payroll deductions) payments. Both the payments and loan interest are credited to the account’s balance. The down side of this loan and the reason that it should only be considered as a last resort is that only the remaining loan balance (excluding the loan principal) qualifies for investment growth. In other words the borrower foregoes any dividend, interest or market value growth on the “used” portion of his account.
As we’ve seen in the “Budget” section of this website, the sum of all of your debt is your total liability. Total liabilities offset assets to determine Net Worth. Since the size of your Net Worth most determines your retirement readiness and future lifestyle, it’s important to address debt before and in the early stages of retirement. Also, regular payments to your creditors reduces your ability to save and build investment assets.