The economic recession has taken its toll on millions of Americans. Unemployment, foreclosure, and the devalued dollar are just a few of the unfortunate byproducts. Moreover, careful consumers are becoming more vigilant about credit repair, causing significant national debt reduction to the tune of $3 trillion since 2008. If you are thinking of joining that responsible group, consider the issues below before taking the leap.
- Debt reduction is credit repair. Paying off debt can breathe new life into your credit reports. The long-term benefits of a healthy debt-to-income ratio and a well-balanced portfolio could save you thousands of dollars in the future. When it comes to repairing your credit reports, paying off debt is the best way to rejuvenate stagnant credit scores.
- Consider the value of liquidity. So, if debt reduction is so important, why wouldn’t you jump right in? While it seems logical to take the fast track to becoming debt-free, think twice before emptying your bank account. Regardless of your financial situation, an emergency fund is imperative to managing your life and preparing for the unexpected. Consider the following scenario:
Jim and Amy are newly married and have recently bought their first home. Eager to start a family, they decide to pay off debts and plan for the future. Amy emptied her personal account to pay off their cars, and Jim invested most of his savings into a mutual fund for the kids’ college expenses. Three months later, the couple’s plans are halted when Jim loses his job in a mass layoff. Now Jim and Amy are faced with the difficult choice of making ends meet with new credit card debt or by dipping into the mutual fund and incurring fees and penalties.
Jim and Amy had the best intentions, but the outcome of their planning was far from positive. Rather than falling victim to the same unfortunate ending, balance your finances by building a savings account to cover at least 3-6 months of expenses. Use leftover funds to pay down debt at the end of the month. Ridding yourself of debt is admirable, but not at the risk of your financial security.
- Learn about interest rates and long-term commitments. Credit financing is a great option for big-ticket items, but not every purchase is good for your financial health. If you landed a zero percent interest auto loan, you have nothing to lose by paying it off evenly and slowly. On the other hand, if your credit card balance is climbing due to an outrageous 22 percent interest rate, it’s time to get serious about your debts. Review your balances, calculate the total cost of those long-forgotten purchases, and prioritize your itemized debt reduction. You may end up paying more than you realize.
- Consider the tax breaks. While it may seem counterintuitive, some debt is good for your credit score. Not only does it illustrate your commitment to financial responsibility, the tax benefits help to put money back in your pocket. Consider the following scenario:
Mark has $78,000 in graduate student loans. His rates are locked in at a reasonable 4.5 percent, allowing him to repay his debt in $500 monthly installments. He has been hired as a clerk for his county’s local court system, earning a modest starting salary $57,000 a year. He wants to pay off his loans but isn’t sure how aggressive to be.
Mark’s desire to be debt-free is admirable, but he should weigh the pros and cons of his decision. Since his annual income is less than $60,000, he qualifies for a $2,500 student loan deduction on his federal income taxes. His best bet is to look at the big picture and decide if debt reduction is the most beneficial route. Can he pay down his debt while also building an emergency fund? Are the tax benefits greater than the cost of shouldering the debt? How will his situation change as he earns more money? When it comes to tax-deductible debt, answering these questions is vital.
- Get creative. When paying off debt isn’t beneficial (i.e., the tax breaks exceed the cost of carrying the debt), look for alternative sources of credit repair. While obliterating your mortgage may not make sense, refinancing is a great way to lower your monthly payments and add to your emergency fund. If consumer credit is on your mind, call your creditors and ask for a limit increase. The bump will lessen your credit utilization ratio automatically.
- Scour your credit reports. Everything that appears in your credit bureau files must have been reported both fairly and accurately. Take a close look, and seek assistance from a credit repair law firm who may be able to help you formulate the right questions about what’s there.
Bottom line: small credit repair steps can result in major impacts. Find the angle that fits your situation and pursue active solution.