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The Honolulu Advertiser
Posted on: Thursday, July 7, 2005

Best strategy for debt consolidation a 'no-brainer'

By Rick Daysog
Advertiser Staff Writer


Got a question? If you have a personal finance question, Akamai Money can help. Send questions to David Butts at dbutts@honoluluadvertiser .com or call 535-2453.
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Q: I have $10,000 in credit-card debt that carries a high interest rate. I want to know if it makes sense to take out a home- equity loan or borrow against my 401(k) plan to pay off the debt.

A: With the recent run up in local real-estate prices along with low interest rates, home-equity loans and lines of credit have become a popular method for local homeowners to pay off their credit-card debt.

These days, you can get a fixed home-equity loan or line of credit with an annual percentage rate of 6 percent to 7 percent, which is far less than the 15 percent to 25 percent annual percentage rate that some card issuers are charging their local customers.

So the 9 percent to 18 percent difference in annual interest rates on $10,000 of debt can amount to savings of $900 to $1,800 a year, said David Kirkeby, principal and certified financial planner at Pacific Island Financial Management.

And unlike credit cards, the interest payments on a home loan are deductible from your income taxes, Kirkeby added.

"This is kind of a no-brainer when you put the pencil to the paper and do the math," Kirkeby said.

Borrowing against your 401(k) is a similar strategy. Depending on your employer's 401(k) plan, you can take out up to 50 percent of your vested balance or up to $50,000. The loan, which has to be paid back within five years, carries an annual percentage rate of 6 percent to 8 percent, which could be a far lower rate than you get on your credit card.

What's more, the interest is paid to your retirement account and not the credit-card company.

The downside is the interest payments aren't deductible and your contributions are made in pre-tax dollars while the loans are made in after-tax dollars, said Bill McRoberts, who heads Kailua-based investment and tax-planning firm McRoberts & Associates.

Also, the loans can be due immediately if you quit or lose your job.

To be sure, debt consolidation can have negative consequences, especially when the consumer doesn't have disciplined spending habits.

Financial planners like Kirkeby and McRoberts often advise their clients against getting new cards or accumulating new debt once they pay off their old debt.

But consumers who consolidated their debt are often besieged with new card offers and are tempted to rack up new debt, said Wendy Burkholder, executive director of Consumer Credit Counseling Service of Hawaii.

Burkholder said she recently counseled a Moloka'i family that got caught up in a vicious debt cycle. The family had owned a home with no debt but wound up taking out a first mortgage to pay off credit card and other expenses. They continued to spend beyond their means, forcing them to take out a new line of credit.

Eventually, the debt accumulated to the point that the family couldn't meet their daily expenses and cover the debt, Burkholder said.

The lesson here is that consumers won't solve their credit problems unless they can curb their underlying spending problems first, she said.

"Consolidating your debts can make a lot of sense, but for some it can be like rearranging the deck chairs on the Titanic," Burkholder said.

"If you keep taking on water, eventually the ship is going under."