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Hi everyone. I have $4000 saved up and am trying to decide whether to pay off the $4000 we have in credit card debt at 9.90% interest or fund two IRAs for 2001 ($2000 for my IRA and $2000 for my wife's), or something inbetween. At first blush, the easy answer is pay the debt. But please hear me out.

I have two main reasons for not paying the debt: First, if I don't fund the IRA for 2001 by April 15, 2002, I lose that opportunity forever. Second, even if I don't pay off the debt now, I will definitely be able to do so within a few months after contributing to the IRAs. (We make good money (~$160,000/yr), and live well below our means, so we typically have about $1500-$2000 left over at the end of each month.)

You're probably wondering why we haven't paid off the debt sooner. Well that is because we made mistakes earlier in life, giving us a lot of debt. At the beginning of last year, we owed about $22,000 in CC debt--now it's down to $4000. I would like to finish it off and never carry a balance again, but I hate to miss this one-time opportunity (literally!) to fund the IRA for 2001.

FWIW, (1) retirement planning is an extremely important goal for us; (2)I already max my 401k, and my wife works part-time so she doesn't have a retirement plan; and (3) I am 27 and my wife is 26.

I would appreciate everyone's viewpoints. I would like to do the Foolish thing (capital F), rather than the foolish thing (lower case f).

Bagginses
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Hi - my son is $8000 in debt on his CC and I'm sure he'd like to hear how you managed to drop your amount so significantly in a short period of time. Any suggestions for him? Joan
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Greetings, Bagginses, and welcome. You asked:

FWIW, (1) retirement planning is an extremely important goal for us; (2)I already max my 401k, and my wife works part-time so she doesn't have a retirement plan; and (3) I am 27 and my wife is 26.

I would appreciate everyone's viewpoints. I would like to do the Foolish thing (capital F), rather than the foolish thing (lower case f).


Retirement planning is an important goal for you; the interest on the debt is very reasonable; you will repay the debt in a few months anyway; and if you don't make an IRA contribution for 2001 by April 15,
the opportunity to do so will disappear forever. Given all that, it seems to me that making the contribution rather than repaying the debt is a very Foolish move for you. Don't you agree? :-)

Regards..Pixy
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Yes Joan, we did three things.

First, my wife and I talked it over and made a pact to quit spending money we did not yet have, i.e., quit using the credit cards! We have not used them since. We use a debit card from our checking account instead, which makes us think twice before spending money since it has to be in the account. Also, we try not to pull out so much money from the ATM. It seems as though whether you pull $100 or $40, it's gone within the week, so we pull $40 (now).

Second, we tried to live frugally, and we paid as much as absolutely possible each month to the credit cards (there were 3 to begin with, totalling approx. $22,000). I started with the one with the highest interest rate and paid as much as possible to it, while paying the minimums on the other two. Once it was paid for, I started paying as much as possible to the one with the next highest interest rate, while paying the minimum on the third and final one. Once the second one was paid for, we started paying on the third one, i.e., the one with the lowest rate (9.90%), and that is the debt we have remaining.

Third, as I mentioned in my earlier post, we make very good money (~$160,000/yr), particularly for our age (26/27). That factor is not as important as the first two, in my opinion, but I can't deny that it helped. Nonetheless, the same procedure could and should be followed by your son, though it might take a little longer to accomplish the goal. The key is setting a goal and sticking to it.

Looking back now, I see how foolish it was to have so much debt. (Bad debt, as opposed to our mortgage, with I consider to be "good debt.") I am thankful that we recognized our mistake and are (almost) over it. I hope your son will pay attention to this. I am so excited at the thought of being out from under the "weight" of the debt. Good luck. I would be glad to answer anything else if you have other questions.

Bagginses
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Thanks Pixy. Yes, I agree. As you can imagine, I would probably get a different response from the Living Below Your Means board, though I haven't asked them. I think I just was looking for a nudge to make sure I was doing the right thing.

As I mentioned in my reply post to Joan, I am very excited to be done with the credit card debt, so part of me wants to just pay it off and be done. The other side of me says be patient, fund the IRA (which is better for the long term), and pay off the debt by June or, at the latest, July (basically, however quickly we can do it). Thanks for your response.

Bagginses
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A great big thank you from me to you. And probably from my son, too. I'm going to pass this post along to him. Right now he's feeling very much under-the-weight-of-the-world so it should help to read that others have been there and struggled through. Fortunately, he has a good head on his shoulders, a decent job for a 24 year old and the ability to see he's in trouble. That's the first step. Thanks again. Joan
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Joan,

Your son might also benefit from looking through the Consumer Credit / Credit Cards board. They have a large group of folks that are working on axing their CC debt, and provide a very good support forum for those of us in that process. Good Luck :-)

lobo

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sellers said:

A great big thank you from me to you. And probably from my son, too. I'm going to pass this post along to him. Right now he's feeling very much under-the-weight-of-the-world so it should help to read that others have been there and struggled through. Fortunately, he has a good head on his shoulders, a decent job for a 24 year old and the ability to see he's in trouble. That's the first step. Thanks again. Joan
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Also - congratulations on such an achievement. You and your wife are to be commended for recognizing your situation and reacting so quickly and with such vigor. I'm sure it was very difficult at times, but it will certainly be worth it in the long run. Keep up the good work and clear thinking. Joan
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lobo - thanks for that information, too. I'll pass it along :-) Joan
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What would be the cost of missing out on the IRA?

Assumptions:
- $4000 drops in your lap on April 16, just missing the IRA deadline
- if you decide to pay off the debt, then when you get the $4000 you will buy stocks in a non-IRA account.
- tax regulations don't change

If you put your money in the IRA, your debt would accrue $4000 x 9.9% * 2/12 = $66 worth of interest before you get money to pay it off.

If you put your money into paying off the debt, you lose out on $4000 of IRA contributions. In 2 months you put $4000 into stocks or a tax-managed mutual fund. Assume you will sell in 40 years and you earn 7% CAGR on your stocks, the stocks will be worth around $60,000, leaving you with a capital gain of 56,000, taxed at 20%. That's $11200 it'll cost you. Even accounting for the time value of money, that's significantly more than the $66.

If I were in your situation, I'd let the debt continue for a little longer, so as to be able to contribute to the IRA. In fact I'd make the year-2002 IRA contribution before I'd pay off the debt!
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Thanks jrr7. FWIW, people on other TMF message boards disagree with our line of thinking, which I suppose is why I posted here instead. You and Pixy have confirmed my thinking, so we will pay into the IRA for 2001.

Also, FYI, once we fund the IRAs for 2001, we intend to pay off the remaining CC debt AND pay the $6000 into our IRAs for 2002, plus continue to max my 401k. It's a tall order, but we paid $18000 in CC last year while maxing my 401k, so I know we can do it. Thanks again for the post.

Bagginses
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Second, we tried to live frugally, and we paid as much as absolutely possible each month to the credit cards (there were 3 to begin with, totalling approx. $22,000). I started with the one with the highest interest rate and paid as much as possible to it, while paying the minimums on the other two. Once it was paid for, I started paying as much as possible to the one with the next highest interest rate, while paying the minimum on the third and final one. Once the second one was paid for, we started paying on the third one, i.e., the one with the lowest rate (9.90%), and that is the debt we have remaining.


I think this 'snowball' effect combined with LBYM ("live frugally") is under-valued by most people who have never done it (kind of like compound interest).

About a year ago, my wife and I budgeted to pay off our CC debt within 18 months. It worked out to about $1200/month (or about 25% of our take home pay), which made things a bit tight at times, but that was the 'budget'. Paying off a card, then rolling those funds to the next card causes the balanced to drop fast on your 'target' card. Also as you eliminate cards, you have more funds going to individual cards. EX: You have four cards, each with $1000 on at 18%, 16%, 14%, and 12% respectively. Say they all have minimum's of $20. With a $200 budget, you would apply $20 to each of the three lower interest cards and $140 to the highest interest card. Once card one is paid off, you are now paying $160 on card two ($140 from card one + $20 you were already paying). Then $180, etc. Combinded with less money being eaten by 'finance charges' (because you've paid off your higher interest cards first), before you know it you're out of debt :)

This is something people who see a mountain of debt in front of them really need to realize. It's not as hard as it looks, especially if you are diciplined.

-Warthog
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To piggyback on what Warthog said (sorry about the pun, but I couldn't resist):

The snowball approach, as I guess it's called, is quite satisfying. Because you are concentrating your efforts and cash at just one CC -- the one with the highest interest rate -- its balance declines relatively quickly. In other words, you have the satisfaction of seeing that you are making progress. I can tell you from experience, it is indeed quite satisfying. (My wife and I went out to a very nice dinner after we paid off the first card ($12,000) to celebrate. While that didn't exactly fit within the LBYM portion of our plan, we deserved it!)
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To piggyback on what Warthog said (sorry about the pun, but I couldn't resist):

Hee hee, no problem. I actually chose 'Warthog' for a handle because it is the unofficial nick name of my favorite aircraft...the A-10 'Warthog'.

Just in case you were wondering :)




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Joan, regarding getting out of debt, see the following link:

http://www.fool.com/credit/credit.htm?ref=PFinAg

(Sorry, I don't know how to make it automatically link up, but you can copy and paste it into your address line.)

Bagginses
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Thanks for the link. I already heard back from the son about your prior post. "Wow", is what he wrote and went on to say he's already trying your first suggestion, is going to get busy on the second and is excited to know others have been successful. Now I'll forward this link. Thanks again. Joan
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If you put your money into paying off the debt, you lose out on $4000 of IRA contributions. In 2 months you put $4000 into stocks or a tax-managed mutual fund. Assume you will sell in 40 years and you earn 7% CAGR on your stocks, the stocks will be worth around $60,000, leaving you with a capital gain of 56,000, taxed at 20%. That's $11200 it'll cost you.

But their AGI is over $160,000 so this is a traditional non-deductible IRA, not a Roth. In 40 years they are likely to be in a 30% tax bracket, the $56,000 will be taxed at $16,800. The tax-managed fund wins, hands-down.
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Oops! Thanks, WPatch, didn't notice that!

Okay, in that case, it doesn't make any sense to use an IRA to buy-and-hold of non-dividend stocks or tax-managed funds.

It still could make sense to use the traditional nondeductible IRA for high-dividend stocks, bonds and bond funds, and most mutual funds. But since the AGI is so high, there isn't as much benefit to using the IRA.
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