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How Can I Escape the Debt Cycle? Mint Answers

photo: SqueakyMarmot

Got the holiday spirit yet? Walk into a shopping mall and you’ll walk out with plenty. Retailers are already playing Christmas carols, sporting red and green decorations and, of course, with America’s biggest shopping holiday (a.k.a. Black Friday) right around the corner, you’ve got ample opportunity to succumb to one of the worst sins in personal finance: credit-card abuse.

Millions of Americans are in danger of falling in debt over the holidays, if anything, because of the sheer pressure to buy, buy, buy.

So this week, we decided to focus on just the opposite: let’s talk about reducing debt and managing credit wisely. Below, we feature four debt questions from the Mint Answers community, along with some of the responses from members like you.

Click on the links to read more answers or to chime in with your response.

What credit card should be paid off first? Higher bill or higher interest?

I have two credit cards. One has a higher balance, with a lower interest rate than the other. The other has a lower balance, but high interest. Which should I try to pay off first? Making minimum or close to minimum payments is getting me nowhere.

Answer:

Financial math says you should pay for the card with the higher interest rate first.

Debt Snowball says you should pay the lowest balance off first then roll the payments into the next lowest debt.

Both methods point to the same card in your situation.  I can’t think of any reason to pay the low interest/high balance card first.

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Should I cancel my credit cards?

I have two credit cards that I signed up for to raise my credit score. I have to pay monthly for them, so I really would like to cancel them. However, I was told this could hurt my credit. Now that my credit is in better shape, should I keep these credit cards or cancel them?

Answers:

1. Part of the score is based on a percentage of how much of your total available credit is being used.  By canceling cards you will reduce available credit which can hurt your score.  Additionally, the length of time an account has been open also has a big effect.  A lot of people (including me) keep around a card that isn’t the best one they have, but is the oldest. 

As for your question on whether or not you should cancel them…that’s up to you and your life circumstances.  Although I have great credit, I have never applied for a loan and probably won’t for 10 more years.  I think I just maintain my credit score for the sake of maintaining it.  But hey, never know.  Life happens and you might need a strong credit score when it does.

2. If you are paying a fee, cancel them.  Period.

If you can’t get a card without a fee, let your credit repair itself by paying other bills on time.

Never, ever, pay a fee for the sake of “protecting” your credit score.  It will never make enough of a difference to offset the cost.

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Should I cash in my 401K to pay off credit cards?

I think my credit cards are charging me more interest than my 401(k) is earning. Should I cash in the 401(k) to pay them off or will that hurt me more in the long run?

Answers:

1. Your credit card is most definitely charging more than your 401(k) is presently earning.  But consider the implications of cashing your 401(k).  It gets taxed at the marginal tax rate as income tax, then you pay an additional 10% penalty on top of that. 

To use a real example, I am in the 25% federal marginal tax bracket.  That means 35% of the 401k cash out amount is taken from me.  That’s before we consider state taxes.  Cashing out will cost you quite a bit, consider stopping contributions and tightening your budget until the debts are paid off, if possible.

2. Can you take out a loan from your 401(k)?  If so, this is almost certainly the better option.  You wouldn’t pay any taxes on that, and you would be getting a fixed return on your money at a time when the market is poised for a correction.

It would be very hard to justify cashing out your 401k to pay off credit cards.  Depending on the exact circumstances and numbers, it may even be better to file for bankruptcy (though not typically.)

 

If you are getting any decent matching contributions (.5:1 or above), do not cut down what you’re putting in below that level, or you’d be losing out on more money by doing that than by cashing out and taking the tax hit.

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How do I escape the Debt cycle?

I have experienced significant debt, as have most Americans in this day and age. I have attended classes trying to teach myself how to become debt free, but many principles of the classes don’t translate well into daily practice. Do you have any advice on how to better follow guidelines and advice set forward in debt management programs when considering the randomness of life?

Answer:

1) Stop borrowing money.
2) Pay of your debt.

If your expenses exceed your income, start getting rid of expenses until they don’t (and as many more as you can after that.)  Don’t buy things you don’t need.  The less debt you have, the more you can afford on the same income because you’re not throwing money away on interest.  Which of these concepts are difficult?

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Do you have a money question that you feel has no black-or-white answer? Go to Mint Answers and ask away! While you’re there, feel free to answer questions from other community members. Come back often, as we introduce new enhancements to this feature.