Debt used to be a four-letter word. Paying by credit card seemed profligate. Home equity loans were unheard of. And personal bankruptcy made people ashamed. But today debt is commonplace.
Between 1990 and 1997, aggregate credit card debt more than doubled, according to the Consumer Federation of America. And this figure increased another 27% from 1997 to 1998 alone. We charge our groceries on our frequent-flier Visa cards, invest using margin accounts and borrow from our 401(k)s to pay for our children's education. Are we stupid?
Not necessarily. One reason debt has become more palatable is that the prime rate has fallen from 21.5% in 1980 to 8.5% today. At the same time, the stock market has had over a seven-year bull run, with the S&P 500 averaging 19.07% annual gains since 1992. That has created an easy arbitrage. Borrow at 8%, invest at 19% and get rich. That is the secret of the booming hedge fund business.
But not everyone is balancing his debts and investments so successfully. In 1998, personal bankruptcy filings were nearly 55% higher than they were in 1992, according to the American Bankruptcy Institute. And that was a recession year. The credit card offers crowding our mailboxes (also induced by low interest rates) are too much for some individuals to handle.
Are you handling your debt wisely? The features in our Debt Management section will help you decide. Sometimes the answer is obvious. Say, for instance that your choice is between paying off a few 19% interest rate credit cards and investing in an equity fund that has averaged 15% per year. Pay off your credit card, and you'll get a guaranteed 19% return.
But the answer is different if you are investing in a 401(k) with a company match. Say your firm contributes 50 cents for each $1 you invest. That's a guaranteed 50% return. A smart strategy would be to make the contribution, get the match, then borrow from your 401(k) account to pay off your credit card loan.
And, unless you are 59 1/2 or older, it almost never makes sense to raid your IRA to pay off debt. Why? You will owe a 10% penalty and income taxes on all withdrawals except for funds held in a Roth IRA account for more than five years or the original contributions in a Roth IRA. A better option: perhaps a loan from Mom.
If Mom isn't willing to open her purse, it may be time for some professional help. Finally, before you make your next purchase on credit, consider the real cost of that loan. It's probably more than you think. Carry a $5,000 balance for five years at 15%, and you will end up paying $2,137 in interest. You've just increased the cost of your purchase by 42%. Is it really worth it?