Divorce & the Credit Card Debt Dilemma

We spend lots of time talking about assets in divorce but only rarely do we cast our eye to the dark side of the balance sheet. That’s the world of debt.

It comes in several flavors. The most common is mortgage debt; the stuff you bought your house with. Mortgage debt goes with the house because your house is security for the debt. You can sell your house and retire the debt, or you can refinance the house and pay off the old mortgage. Just be careful because many of you are benefitting from some low interest rates which will pop up to about 7% if you refinance at today’s prevailing rates. In a divorce if you have a $500,000 house and you owe $300,000 on your mortgage, a court would say you have a $200,000 house because if you sold the place, that’s all you would receive at settlement (less closing costs).

Auto debt gets essentially the same approach as with home mortgages. Your $25,000 Honda with $15,000 outstanding on the loan is viewed as a $10,000 asset.

Then there is student debt. About half of all students graduating from schools today leave with this encumbrance. And, Pennsylvania is at the higher end with an average student debt balance of $39,000. This debt is unsecured, but it is also essentially non-dischargeable in bankruptcy Bear in mind as well that typically this is debt contracted before marriage since today few people marry before they finish college. That usually means it is pre-marital and not subject to division in divorce. The exception here is debt associated with graduate school. If it involves professional schools the debt can be huge. Courts are called upon to deal with student debt that was contracted during the marriage but the common result is to make the student who got the degree or training absorb all of the debt because that student received all of the benefit of the education.

Then there is the nettlesome matter of consumer debt. The average bear in Pennsylvania is carrying roughly $6,000; about a third less than our neighbors in New York and New Jersey. The problem here is the interest rate. The average rate charged to consumers for consumer (credit card) debt is just over 20% per annum. Thus, if you are just cruisin’, which is to say paying the minimums, your interest alone is $100 a month or $1,200 a year. That may not sound too bad. But consider the lenders side of the transaction. The value of the money they are loaning you doubles every 42 months (3.5 years). That’s a nice return.

Consumer debt tends to creep up on us. But when you separate and look at divorce, it’s a good time to explore options. This is not about how the debt gets divided. That’s largely a function of whose name it is in and how it evolved. But, let’s assume that there’s $12,000 worth of credit card debt and you are allocated half of it. How do you exit the world of 20% interest? A sometimes-overlooked option is friends and family. That may sound preposterous. Why would they lend you money? Well, how about as a handsome investment return? My local bank is paying me just under 4% in on my “high yield” money market accounts. Assuming your parents are in the same league. How about you borrow from them the $6,000 to eliminate the consumer debt and you pay 10% to them instead of 20% to Mastercard or Visa. They double their interest on money they are not otherwise using and you cut your interest in half. Win/win; assuming you pay.

The less pleasant alternative is to dip into retirement. This is considered an absolute no-no but let’s look at the numbers. You can borrow from retirement if you have such an account. The investment community warns you that money borrowed from your own retirement is no longer earning investment experience returns because now you are just paying yourself. That’s true. And it’s also true that while you were paying 20% interest in the last 12 months, the S&P 500 has gone up by 32%. So, looking at one year only, you made money by not paying off your cards and keeping it in retirement. But the average return over the past 50 years is more in the 10-12% range which means your credit cards are running almost twice as fast as your retirement account over the long haul.

Does it make sense to make a distribution? A distribution from a qualified plan or an IRA means the amount is taxable income for the year in which it is made. Then you also get tagged for a 10% penalty if you are not 59.5 years of age. Let’s assume you make $75,000 a year and your taxable income is $60,000. A $6,000 distribution will cost you 22% in federal tax + a 10% penalty. You take the $6,000 and pay those taxes, leaving you with $4,560. You send that to the credit card people and they credit you such that your credit card debt is now reduced to $1,440. Now, for what we will call a holiday twist. January 1 is a brand new tax year so if you made a second distribution after January 1 to eliminate the debt that distribution is taxed next year. On January 2, you take a $2,275 distribution and pay the same tax rate. Then you mail the remaining money to Mastercard or Visa and your credit card debt is -0-. Yes, it cost you $8,275 to get rid of $6,000 of debt but you will recover that cost in just under two years because you are not sending a hundred a month to just cover the 20% interest rate. All you need to do now is manage your credit card expenses so you don’t resume paying 20% interest.

One other strategy for folks where one spouse has low income and the other higher. Let’s assume you are making the same $75,000 but your spouse is earning only $30,000. There is $12,000 of credit card debt between the two of you. In a divorce you agree to transfer $15,000 from your IRA to that of your spouse. He/she gets the $15,000 and pays off the $12,000. With only $30,000 in income the person getting the IRA money and paying the credit cards is only paying 12% taxes + 10% penalty. That means a $15,000 distribution will have 22% taxes leaving  $11,700 to pay off the cards. Up the distribution by $500 to $15,500 and the entire balance can be paid off for both spouses.

The tax rates we are using are different depending on your own income and that of your spouse. So, you may want to confer with a tax adviser who can “right size” the tax consequence to match your income. But a divorce is an opportunity to look at ways to creatively address high interest loans that drain your ability to save for productive events like retirement. It may seem counterintuitive to pay off credit card debt to save for retirement but realize that you pay your monthly consumer/credit card debt with money you pay tax on. Money that you put into retirement accounts is typically money on which income tax is deferred at the federal level.