Q&A: Debt Reduction Strategy

A reader recently wrote in with what he termed a “complex question” about creative strategies for debt reduction.

My wife and I have FICO scores around 750. We have about $28K of debt on top of $238K in two mortgages (191K & 47K). The first is at 5.75% for another 5 years, while the second is at 11.25%. I just thought about loaning ourselves the $28K from our 401K in order to pay that portion of the debt off (temporarily), closing all open credit lines, then applying for AmEx cards that offer 4.99% lifetime rate on balance transfers in order to balance transfer back the $28K plus some of the second mortgage. Now the questions… How long would the loan be necessary before applying for the cards to ensure maximum credit from AMEX? How much credit might we expect?

First of all, it’s nearly impossible to predict how long it will take to secure new cards and get the balance transfer to come through. In fact, nothing is guaranteed, so there’s a risk of not being able to get enough new credit to pull this off.

Setting those issues aside for the moment, I’m not sure that cancelling the cards is the best course of action. Since he and his wife have high credit scores, it’s possible that they’d be able to get low (or no) interest balance transfers straightaway, without having to play games with their 401(k). This would also circumvent the risk of borrowing from the 401(k) and then being unable to come up with funds to pay it back.

Another strategy would be to apply for one or more 0% balance transfer credit card offers up front. While these offers won’t necessarily provide 0% for life, there are a ton of 12 month offers that can be rolled over to a new offer if/when they expire. These funds could then be used to kill off the high interest credit card debt as well as a portion of the second mortgage. The key here is to avoid piling up more debt while trying to dig themselves out from under. Moreover, you need to be dedicated to paying it off aggressively – you can’t borrow your way out of debt, but you can minimize your costs while paying it off.

Of course, the above depends on their ability to secure the additional low interest credit. But with high credit scores, they might be able to do it. A final tip would be to time the additional credit applications to happen on the same day. The prevailing wisdom is that this will increase their odds of getting the credit that they need, as the left hand (one card issuer) won’t necessarily know what the right hand (another card issuer) is doing.

If you have any thoughts on the above situation, feel free to share them.

This article is part of my Money Q&A Series.

Photo Credit: Brett L.

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12 Responses to “Q&A: Debt Reduction Strategy”

  1. Anonymous

    Having that amount of debt does not mean that he is “leveraged to the hilt”, it just seems that way to those of you who have little to no debt.

    I am in almost the exact situation this guy is, except for the high 11.25% interest on the second mortgage (ours is at 5.95%).

    We have $25K in credit card debt out of $89K of available credit. We are paying $1200 a month towards this debt and have worked down the interest rates by doing a couple of balance transfers. Mostly ones to existing cards, but we did open 1 card to get the introductory deal.

    I reiterate what others have said, that borrowing against your 401k is only an absolute last ditch option. Only if something were to happen to your ability to repay the $28K in debt (like a job loss or disability, or an increase in another spending area like college) should that be considered.

    I wish you the best of luck on getting out of debt and I hope you fully include your wife on the plans.

  2. Anonymous

    For anyone that leveraged, it might be tough to get anywhere near the credit line needed for a balance transfer. It is worth a shot though. I do have to side with vh on this, though. Sell the shack and start getting frugal.

  3. Anonymous

    Good grief….11.25%???? What sort of mortgage hell has this pair landed in?

    Dylan & Tim are right: some things don’t seem to add up, or else not enough information is given to make any sense of this.

    But IMHO, if you’re up to your teeth in credit-card debt, you have one mortgage with a usurious interest rate and another whose rate is probably going to go up (or that MUST be paid off in five years), it’s time to sell the shack, even if you have to take a loss. Get yourself into a rental, where at least you won’t be running up the AMEX bill at Home Depot and your renter’s insurance will be a fraction of homeowner’s.

    Then cultivate some frugal habits until you can pay off the plastic without raping your retirement savings (f’rgodsake!). If and when you get rid of the credit-card debt, then & only then consider buying another home.

  4. Anonymous

    Let’s put it into perspective. 10% plus taxes equate to much more loss than the 11.25% interest. There isn’t enough information to really be able to provided any kind of assessment. FICOs around 750 and high interest rates doesn’t add up. Sell the house or take out a HELOC to pay off the credit card debt. I would side more on selling both and getting something affordable until they get their finances in order.

    if maxed out already, hardly doubt that they could get anything close to $28k to cover.

    touching 401k is just a bad idea. curb spending and look at selling the property.

  5. Anonymous

    Is the first paid off in 5 years or is it going to have a new Interest rate re-set at that point? By the way it is written, it sounds like it will be paid for by then.. So I wonder why you wouldn’t consider refinancing the whole mess together.

  6. Anonymous

    I echo nickel’s sentiment that’s it’s important to decrease debt and cut back on spending, and that there are also creative ways to pay down debt more quickly. I used to have a 2nd mortgage. I used 0% and fixed APR Balance transfers save myself boatloads of interest. These balance transfers also forced me to pay down my debt MORE quickly. On low balance transfer credit card the minimum payment is often much higher than what a 30 year home equity would be. The amortization period could effectively be 3-5 years. I still have one credit card with a 1.99% fixed APR for life I continue to have. My after tax gain from a savings accounts is closer to 3% so I’m still better off not paying it off. Obviously these kinds of techniques aren’t for everyone. The most important part to paying down debt is the desire and commitment to spend less and pay it obligations off.

    I think this guy is looking to tackle his problems. I don’t know exactly how committed he is to it. Does he want to pay off his credit so he can spend more? I don’t know that. But if he’s committed to paying his debts then I think 0% Balance transfers aren’t a bad idea. In a year timeframe if he were to offload his current debt to 0% balance transfer he could reduce his debt by a couple thousand compared to making the same payments and paying interst. However, it all depends on his approach his tenacity. Two things i don’t know.

  7. Anonymous

    “Moreover, you need to be dedicated to paying it off aggressively – you can’t borrow your way out of debt, but you can minimize your costs while paying it off.”

    It can’t be said any better!!!!

    The day that I turned up the heat and aggressively went after my debt was the day that I started really becoming debt-free! In 14 months, I became debt-free except for the house, and the house is on the way (within 4 years).

  8. Dylan: I suspect that you’re right about being fully leveraged on the house (as a sidenote, I was shocked by the 11.25% rate on the 2nd mortgage). Under other circumstances, I would point out something like PenFed’s 5.99% 20 year home equity loan and say “cut up the cards, and consolidate those balances with the second mortgage on the much cheaper HEL.” Of course, the next step is to attack that joint debt with great fervor.

    In the end, all the games in the world won’t get you out of debt if you don’t make a commitment reducing your expenses and devoting a bunch of extra money to debt reduction.

  9. Anonymous

    There are a number of things that scream, “red flag!” about this situation and would concern me about this guy applying for more credit. First, from the mortgage amounts, it looks like he is probably fully leveraged on his house (I would not be surprised if they’re interest only also). With $28K in credit card debit and asking about borrowing from his 401K, it sounds like he has no other savings.

    And the biggest, reddest flag of them all is his interest in a fixed “lifetime rate on balance transfers.” These offers are designed to attract folks that expect to carry the transferred balance for a long time.

    This sounds like someone that is overextended, regardless of what he says his FICO score is. If that’s the case he needs to wake up, change his habits, and aggressively pay down his debt.

    The question sounds a lot like someone standing on the edge of a cliff with one foot hanging over and asking how to get a better view!

  10. Noah: You are, of course, right that overspending is what gets people into situations such as this. But that doesn’t mean there’s no room for getting creative when it comes to getting out of debt. An awful lot of people have saved tons of money in interest while digging themselves out of debt by taking advantage of low or zero APR offers. The key to success is to pay it down aggressively and, as I said above, avoid piling up any further debt while you’re doing this. Othrerwise you could end up in a worse position than where you started.

  11. Anonymous

    I have an idea, how about stop trying to play games with credit. Moving debt around like this is only a temporary fix to a much deeper problem: overspending. Pay it off, and quit borrowing money.

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