Which is the best strategy to pay off our debt?
My wife and I have two kids in college and obtained loans to pay them off, some day. We have $50,000 in credit card debt, and $250,000 in beneficiary IRA money subject to penalty if withdrawn at our current ages (late 40s). We own our house but still owe 80% of its value in a mortgage. Our financial planner is recommending we obtain a loan to pay off credit card debt to avoid penalty and save our investments for our retirement, or to pay off a portion of student loans in a few years. Our income is about $150,000 per year. Which is the better strategy?
My answer: neither is the optimal strategy – but that the home loan is a less-bad strategy. Your financial planner is correct about it being worse to use your IRA money to pay the loans. When you take money out of the IRA you will have to pay the 10% penalty plus income taxes, which should be 22% based on your income. This means to pay off the $50,000 debt you would need to take out $73,529 from your retirement account. (Receive $73.5 k, subtract $7.3 k for penalty and $16.2 k for taxes to be left with $50k). This is a hefty price tag.
Using a Home Loan May Just Double The Debt
For the home loan, it is a mathematically viable strategy, but it would not be my preferred method of solving the problem. This advice is given so often, there are actually statistics in the banking industry about how well it works out in the real world. I haven't seen the statistics recently, but back when I worked at a credit union the statistics were that 2/3 of the people who used home equity loans to pay off credit cards had the same amount of credit card debt within 18 months. This means the strategy most often backfires and just increases the debt the family has.
Take More Time for Planning
If you were my clients, I would want to start with analyzing your cash flow and budget to try to find a way to devote more money to the credit cards without significantly impairing your other savings and lifestyle priorities. You might also need to cut some things that you enjoy, but that are less important to you than paying off the credit card debt. And it might mean finding ways to lower the cost of college for your family (but not taking them out of their college).
Once you have made significant progress on the credit cards, then we might discuss the home loan strategy and whether the potential interest savings outweighs the potential risks. I like to make significant progress on the credit cards first because this lowers the risk of getting back into credit card debt after the home loan.
A final consideration is whether you have the right planner. The fact you are asking for a second opinion is very smart (more people should do it), but explore if there are reasons you want a second opinion beyond just getting verification on the strategy. While the advice the planner gave is sound advice, too often it's the easy answer a planner gives to avoid losing their income by lowering the assets in the IRA. Our nonprofit has a guide to choosing a financial planner, which can also be a good tool for reviewing your existing planner. And we are always available to give you a more detailed second opinion.