11 replies to this topic

[sonicanatidae]

I have a friend that I've been helping with Credit Repair.

Summary:

She has roughly $16K in her 401K, $12K in credit debt and $7K in an autoloan.

Her income bracket is fairly low, so she'll spend the next 2-3 years paying off
her cards, now that I have talked her into cutting up most of them.

I know early withdrawl from 401Ks are "taxy". Regular taxes on the distro
as income + 10% early withdrawl penalty. Her plan does not allow a 401K
loan because she's no longer with the original employer that setup the 401K.

In her case, I'm wondering if it still might be worth it. When you consider
the interest she's going to pay over the next 2-3 years paying off her cards vs.
the hit on her if she clears her 401K.

A rough calculation shows she'll pay about $4000 in interest, if she sticks
to her plan and pays them off in 3 years. (About $500 per month in income
to use towards cards)

She's in her late 20s, so while she'll lose some time, I believe she
could easily make it up after most of her income stops going to high
interest cards and an autoloan.

To my barely educated eyes, it's slightly better in cost to take the
hit on the 401K, but I'm not an expert. I know her stress level will be
lower if her CCs are paid.


Thoughts?

[athensgaguy]

Rates on CCs and auto loan?

[sonicanatidae]

Rates on CCs and auto loan?

Her Autoloan is in the 12% range I think.

The cards varied but most are in the 18% range.

Edited by sonicanatidae, 31 January 2011 - 10:53 PM.

[Big Ed]

She should not take out that 401K now. You are smart in looking at the total interest she would end up paying versus the tax on distribution and penalty.

One big thing you/she needs to consider though is the "opportunity cost" of taking the money out now. Currently, she has 16K in now and the market is doing VERY well. If she takes the money out now, she will be losing the chance for further gains.

Suggest to her to throw all other extra monies she get's at her debt.

[lakpr]

I have a friend that I've been helping with Credit Repair.

Summary:

She has roughly $16K in her 401K, $12K in credit debt and $7K in an autoloan.

Her income bracket is fairly low, so she'll spend the next 2-3 years paying off
her cards, now that I have talked her into cutting up most of them.

I know early withdrawl from 401Ks are "taxy". Regular taxes on the distro
as income + 10% early withdrawl penalty. Her plan does not allow a 401K
loan because she's no longer with the original employer that setup the 401K.

In her case, I'm wondering if it still might be worth it. When you consider
the interest she's going to pay over the next 2-3 years paying off her cards vs.
the hit on her if she clears her 401K.

A rough calculation shows she'll pay about $4000 in interest, if she sticks
to her plan and pays them off in 3 years. (About $500 per month in income
to use towards cards)

She's in her late 20s, so while she'll lose some time, I believe she
could easily make it up after most of her income stops going to high
interest cards and an autoloan.

To my barely educated eyes, it's slightly better in cost to take the
hit on the 401K, but I'm not an expert. I know her stress level will be
lower if her CCs are paid.


Thoughts?

Multiple things struck me about this post.

1. If her income is low, why is her car $7K+ ? Did her income suffered a steep unexpected drop, or did she bought a brand new car at the start of her employment, with the balance now at $7K ? 12% on the auto loan is steep!

2. Why hasn't she rolled over the 401(k) balance yet into an IRA? Unless there are compelling reasons, you should not leave your retirement savings with an ex-employer. I know technically it's a custodian, not the ex-employer itself, but still .... 9 times out of 10, 401k plans have limited choices and higher fees compared to the world out there that you can tap.

3. Agree with Big Ed that moving the money out of retirement plans is a bad idea.

4. I'd concentrate on paying off the vehicle loan first. I will explain my reasoning:

My suspicion is that she is upside down on the vehicle, quite likely around 3 years since she bought the car? Unless she bought the car used, there isn't any new car selling for less than $12K, which means she paid off around at least $5K in principal, not likely with her supposedly low income unless she hasn't paid for years. Evidently also, the car is a lifeline for her, to commute to-and-from work (like myself). I also know that lenders require you to maintain comprehensive insurance on the vehicle as long as there is a loan on the vehicle outstanding.

If you take all these into account, the effective interest rate is quite a bit more than 12%, and likely exceed the 18% interest on the credit cards. Assuming you pay off the loan, and assuming you drop the comprehensive coverage (not needed on any car older than 3 yrs, IMO), frees up QUITE a bit of cash, you'll be surprised by how much. [ Example, in NJ, when I dropped comprehensive coverage on a 3 year old Honda Odyssey van, the difference in premiums came to about $600 for 6 months; YMMV ]

Given that a repossession of the car leaves her no way to earn "income" to pay off debts, it makes MOST sense to secure the car first. Even if she were to declare bankruptcy in worst case scenario, she'd be allowed to keep her car.

5. Speaking of bankruptcy ... (forgive me for trying to bring up the worst case scenario) ... leaving money in retirement accounts is wise, since courts have ruled that that money is immune from creditors.

To sum up, pay off the vehicle loan first. Then snowball the remaining debt.

Best of luck.

--------------------
Edited to add: Please look into a credit union. DCU (Digital Credit Union) is running advertisements about "second chance car loans". If her scores are halfway decent, she can cut down quite a bit on the car loan. It is a credit union that anyone can join.

Edited by lakpr, 01 February 2011 - 03:55 PM.

[sonicanatidae]

Thanks all for the intelligent and useful replies.

Her effective income did drop last year due to a divorce.
I dont know the specifics of her auto loan, but I believe she's
had it for more than 18 months at this time.

Her income is a single mother's income. She makes reasonable
money ($30K + Child Support, I think), but with 2 kids it doesnt
leave mountains of disposable income to work on debt. We worked
up her budget numbers and it looks like she can *consistently*
pay $500 towards debt and thats what I was looking for, a number
she could meet consistently.

I wasnt advocating her wiping her 401K, but it was an option
I wanted to look at and get some more experienced feedback on.

I'll have to research on what makes a Roth better than a 401K,
if someone isnt planning on touching the money. Hell, my money
is currently in a 401K as well...lol

I suggested she look for a very low fee Index fund for her
401K.

RANT:
It murders me inside when companies charge 1%+ fees on Index funds
when their entire job is TRACKING THE STUPID INDEX.. sheesh.
My current Index has a fee of .09%. I can live with that.
/ENDRANT

Thanks again for the feedback and ideas. She's a good person, so
I'm trying to help her a bit. She deserves it after the drama
of last year..


After-Thought: You think 12% is high?... in Dec/2008, my credit
was so poor, I "qualified" for a 21.5% APR?!?!?! from CitiAuto.
The same @#%!@#$%^#^ that were taking out .25% interest loans from
the Federal Reserve... I needed a vehicle and wanted to build an installment
history, so I did it.

By paying 2X the monthly note, I was able to lower the effective
interest somewhat. Thanks to CB, I re-fied a couple months ago
@ 5.5% APR.. SUCK IT CITI

[smart1n]

My answer depends on 2 things: 1)her job is stable 2) She isn't a debt "junkie" or was and is now reformed.

I would roll the 401k into the a 401k at her job where she works currently (I am assuming there is one available).

I would take a loan for the 7,000 and pay off the auto loan. She will save at least 7%

I would have her take the difference between what she is paying now with the auto loan and the 401K , split it and put part of it in a saving account for emergencies and the other part towards the credit card. Whatever raises she gets should be split in 4: credit card debt, emergency fund, Roth IRA contribution, general savings

Once she has paid the auto loan off, I would take out a second 401k loan for the remainder of the credit card debt and repeat the process as defined before. Once she if finished paying both off, split the difference as defined above.

This will help her
1) pay the loans off with a lower interest rate
2)force her to give the money back to her 401k with at least an additional 4.5% in interest
3)Keep the 401k intact
4)Increase her contributions to the 401k
5)Start an Roth IRA, and generate an emergency fund, and savings account from the "bill" money.

I had bad credit and high interest rate loans and did something similar. I was able to pay off my debt much faster and save more because of it. I know max out my 401K and Roth every year, my credit score is in the 800's any my net worth is very positive. (no house or car included in my calculations)

[sonicanatidae]

My answer depends on 2 things: 1)her job is stable 2) She isn't a debt "junkie" or was and is now reformed.

I would roll the 401k into the a 401k at her job where she works currently (I am assuming there is one available).

I would take a loan for the 7,000 and pay off the auto loan. She will save at least 7%

I would have her take the difference between what she is paying now with the auto loan and the 401K , split it and put part of it in a saving account for emergencies and the other part towards the credit card. Whatever raises she gets should be split in 4: credit card debt, emergency fund, Roth IRA contribution, general savings

Once she has paid the auto loan off, I would take out a second 401k loan for the remainder of the credit card debt and repeat the process as defined before. Once she if finished paying both off, split the difference as defined above.

This will help her
1) pay the loans off with a lower interest rate
2)force her to give the money back to her 401k with at least an additional 4.5% in interest
3)Keep the 401k intact
4)Increase her contributions to the 401k
5)Start an Roth IRA, and generate an emergency fund, and savings account from the "bill" money.

I had bad credit and high interest rate loans and did something similar. I was able to pay off my debt much faster and save more because of it. I know max out my 401K and Roth every year, my credit score is in the 800's any my net worth is very positive. (no house or car included in my calculations)

Brilliant.. Yet again, CB shows its value to people...

I think she was a debt junkie in the past. Her recent situation
however *seems* to have brought her down to earth, but we wont
know until she runs her plan for awhile and actually sticks with it.

I like this solution because it allows her to access the funds
to address current needs, and then forces her to repay it,
so she doesnt have to wipe out the account.

I dont think her current employer offers a 401K, but she
should be able to find one somewhere she can roll it into
and still do a loan.

I've used 401K loans in the past myself to solve problems
and it was a success for me. I think I discounted that as
an option because her current plan doesnt allow loans since
she's no longer employed by them, but rolling into a new
plan should fix that.

Thanks again

[rgw]

My answer depends on 2 things: 1)her job is stable 2) She isn't a debt "junkie" or was and is now reformed.

I would roll the 401k into the a 401k at her job where she works currently (I am assuming there is one available).

I would take a loan for the 7,000 and pay off the auto loan. She will save at least 7%

I would have her take the difference between what she is paying now with the auto loan and the 401K , split it and put part of it in a saving account for emergencies and the other part towards the credit card. Whatever raises she gets should be split in 4: credit card debt, emergency fund, Roth IRA contribution, general savings

Once she has paid the auto loan off, I would take out a second 401k loan for the remainder of the credit card debt and repeat the process as defined before. Once she if finished paying both off, split the difference as defined above.

This will help her
1) pay the loans off with a lower interest rate
2)force her to give the money back to her 401k with at least an additional 4.5% in interest
3)Keep the 401k intact
4)Increase her contributions to the 401k
5)Start an Roth IRA, and generate an emergency fund, and savings account from the "bill" money.

I had bad credit and high interest rate loans and did something similar. I was able to pay off my debt much faster and save more because of it. I know max out my 401K and Roth every year, my credit score is in the 800's any my net worth is very positive. (no house or car included in my calculations)

Brilliant.. Yet again, CB shows its value to people...

I think she was a debt junkie in the past. Her recent situation
however *seems* to have brought her down to earth, but we wont
know until she runs her plan for awhile and actually sticks with it.

I like this solution because it allows her to access the funds
to address current needs, and then forces her to repay it,
so she doesnt have to wipe out the account.

I dont think her current employer offers a 401K, but she
should be able to find one somewhere she can roll it into
and still do a loan.

I've used 401K loans in the past myself to solve problems
and it was a success for me. I think I discounted that as
an option because her current plan doesnt allow loans since
she's no longer employed by them, but rolling into a new
plan should fix that.

Thanks again

Unfortunately she cannot "find" a 401k plan just anywhere. A "new" 401k plan must be one offered by her current employer. If the new employer doesn't offer one she is out of luck.

The only other option I can think of is to roll the 401k assets into a Self Directed IRA. Then convert the IRA to a ROTH IRA. Check and see if she can spread the tax over two years. I am not sure if that is still valid. She can withdrawal the principal from the ROTH tax free and pay off the loans or maybe just the car loan then apply what she WAS paying towards the car loan to the CCs. She could also choose to convert ONLY enough to cover the car loan lessening the tax due and leave the rest in the original IRA. In any event she should be in the lowest tax bracket anyway given her income and deductions.

I don't like it but I can't think of any other way.

Edited by rgw, 02 February 2011 - 08:41 PM.

[Athena53]

I don't think her current employer offers a 401K, but she
should be able to find one somewhere she can roll it into
and still do a loan.

I'm not fond of rolling a former employer's 401(k) into a new employer's plan even when you can- I did that once and it turned out to be a crappy plan, and there was no way to get it out till I quit. Another disadvantage is that if you quit (or are canned), if they don't have provisions allowing you to keep the loan active, you have to pay it all back within something like 60 days or it's considered a taxable withdrawal.

Having said that, though, I don't know if there are any brokerages that will let her take loans against it if she rolls it over into a self-directed IRA.

[Operation_Home_Ownership]

If she does NOTHING else, roll that old 401K into a ROTH IRA!

Wonderful tax shelter [who knows where tax rates will be in our twilight years], better earnings than ANY money market/CD account if untouched, and if needed the contributions she makes going forward can be taken out penalty free [not growth] in case single mom needs emergency funds down the line.

[rgw]

If she does NOTHING else, roll that old 401K into a ROTH IRA!

Wonderful tax shelter [who knows where tax rates will be in our twilight years], better earnings than ANY money market/CD account if untouched, and if needed the contributions she makes going forward can be taken out penalty free [not growth] in case single mom needs emergency funds down the line.

Don't forget she must pay tax on the conversion to a ROTH. I think it can still be spread over two years, however.