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Question for the Money Doctors

Question submitted on Sep 17, 2012.

Question

Is it better to pay down my credit cards and reduce the debt to available credit ratio or build up savings? I am considering borrowing against or cashing out a small 401(k) plan (if that is even possible) to pay down some debt. We just sold our home and will want to buy in the next 1-2 years. Thank you!

Answer

You have a couple of things going on here.  The first thing I recommend is to avoid using your 401k to pay off credit credits.  Your 401k is legally protected from the credit card company - even in bankruptcy.  That said, recommend you do the following in this order:

1) Stop using your credit cards right away.  If you need something, pay for it in cash.  If you don't have the cash to pay for it, wait until you do.  

2) Build an emergency fund that would cover 3 months of critical living expenses should you lose your job. 

3)  After building an emergency fund, pay off your credit cards aggressively.  To do this, review your do a budget and try and live on just the essentials (i.e. food, rent, health insurance, utilities- think "needs" not "wants").  This means, for a short season in your life, you may need to forgo things like, going out to eat, movies, smart phone packages, etc.  Use these savings to pay off your credit cards. 

4) Once you have your credit cards paid off, then you can start saving for a down payment on a house.  Even though FHA offers 3% down on home mortgages, you should aim for 20%.

These financial principles are not easy and definitely are not sexy.    But if you follow them and sacrifice a little now, you will build actual wealth and experience peace and financial freedom later. 

For more information on these and other topics, visit http://www.360financialliteracy.org/

Good luck! 


For additional information visit http://www.360financialliteracy.org/