Consumer Interest Expense
This book detailed two situations where you can obtain a significant tax deduction for the interest expense you pay on borrowed monies. The first was the home mortgage interest expense (explained at page 16). The other was the deduction that you or your child may obtain on interest expense paid on a student loan (see page 103).
Now let's talk about another form of interest expense that you are likely paying: interest expense on consumer debt. Consumer debt comes in many forms. For example, the interest expense on your family car loan, the financed refrigerator or television set you bought from Sears, and last but not least, the interest expense on your personal MasterCard, Visa or Discover Card. There are a number of problems with running up consumer debt apart from the fact that it probably eats into a large amount of your disposable income.
Let's start with the fact that interest expense on consumer debt is not tax deductible. Add the fact that you are probably paying a very high rate of interest (10 – 15%) and you come up with a horrible mix. If you are hip deep in this common problem, here are some things to consider.
If you do have cash reserves, use them to pay off the entire balance on your credit cards. It makes no sense to be earning 3 or 4% on a certificate of deposit when you are paying 10 – 15% on non-deductible consumer interest expense. What if you don't have readily available cash reserves but do have assets you could liquidate to pay down the consumer debt? If you have assets other than your home and outside of your retirement plan, strongly consider liquidating them (remember that if they are appreciated in value there will be a taxable gain – a capital gain – on their sale) and use the after-tax sales proceeds to pay off the consumer debt.
In certain cases, I might advise that you utilize your retirement plan assets if you are a participant in a company sponsored pension, profit-sharing or Section 401(k) plan. You would do this only if you took the necessary steps (discussed below) to assure that you would not simply run your credit card debt back up again after pursuing this strategy. Here it is.
Most company sponsored retirement plans allow participants to borrow against their account balance in the plan. Most plans additionally allow participants to secure such loans from the plan by the participant putting a second mortgage on his or her home as collateral. Generally, because of the mortgage security, interest expense on this retirement plan debt would then be an Itemizable Deduction as mortgage interest expense (see page 20). To make it even better, what you are doing at this point is repaying what you owe to yourself. That is, the principal and deductible interest expense you are repaying the plan is all being credited to your account balance under that plan.
Where to Get Help on Credit Problems
Back in the Budgeting section of the book (page 4), we noted that a formula for disaster is to borrow money on your credit card to meet recurring and non-recurring expenses. If you engage in that type of credit card use repeatedly and in an undisciplined manner, you will quickly run up a balance that you will not be able to easily repay. As we have just noted under the Consumer Interest Expense analysis, the interest expense you pay to the Bank issuing the credit card is nondeductible consumer interest expense. Additionally, Visa, MasterCard, or Discover Card debt is almost always unsecured. Therefore, you are likely paying a very high rate of interest (maybe triple the prime rate of interest that banks charge their most credit worthy customers).
At this point, you are something of a slave to the bank – probably just making the monthly minimum payment and doing little to pay down the principal amount of the debt. If, as often happens, you continue to borrow on the card, you are merely compounding the problem. What are you to do when things seem impossible to control and a bad problem just continues to get worse?
As mentioned above, if you have any source of cash, utilize that cash to pay down your cards and then cut them up. Utilizing available cash to pay down credit card debt is particularly advisable if your cash reserves are earning a return that is less than the nondeductible interest expense you are paying on the credit card debt.
What if you don't have the cash reserves? Many individuals simplistically think of filing for personal bankruptcy in this situation. This is not the way to go if you find yourself in this predicament. Going through a personal bankruptcy will significantly harm your financial universe. Although certain assets such as a limited housing allowance and your retirement plan assets may be exempt, virtually everything else will be liquidated to pay for the attorney's fees and to provide some repayment to your creditors. Additionally, your ability to borrow money and otherwise obtain credit will be impaired long-term. Also, the implications of this are far reaching – your name will be financial dirt far into the future.
A much more advisable route would be to attempt a negotiated settlement and workout with your creditors. There are many resources and public interest groups available to assist you in this process. The function of these advisors is to negotiate with your creditors, write down some of your debt obligation and to go through a budgeting process (not unlike what we did in the Budgeting section of this book) that will take into account your assets and cash flow and formulate a workable monthly debt repayment methodology. A big part of this counseling will be an examination of why financially and psychologically you created this significant debt in the first place. You can find these debt counselors listed in the Yellow Pages or you can study those available at my Web site by clicking on Miscellaneous and then Debt Counselors.
Emergency Rainy Day Fund
One of the first things we studied in this book was how to establish a budget. The Budgeting section of the book (page 4) introduced a process by which we determined our in-flow (our revenue stream) and reasonably estimated our recurring monthly expenses as well as our significant non-recurring expenses (our out-flow).