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Should you stop paying down your credit cards?

Mar 20, 2009 | | Comments Comments Off

Suze Orman has told her fans to stop paying down their credit card debt, no matter how expensive, and instead put the extra money toward building up their emergency funds.

Steve Rhodes, founder of GetOutOfDebt.org, recently echoed that advice (hat tip to CreditMattersBlog.com).

A Wall Street Journal columnist recently suggested borrowing against credit cards and using the cash to boost your emergency fund.

I know a few folks–homeowners and business owners–who tapped big lines of credit and stuffed the money into savings. They’re now patting themselves on the back for their foresight, even though carrying the debt is costing them hundreds of dollars a month.

Has the world gone mad? Not quite, when you consider:

  • Most American households don’t have enough liquid savings to cover a typical stretch of unemployment, which in this recession is creeping toward 12 weeks (3 months).
  • Half of households told MetLife pollsters that they were one month (or two paychecks) away from not being able to meet their financial obligations. More than a quarter–28%–would fall behind after missing a single paycheck.
  • In the past, many would have turned to their credit cards or home equity lines of credit to pay their bills, but lenders are slashing access to that credit. Bankers are freezing or lowering limits on home equity lines of credit across the board, and one banking analyst has predicted that card card issuers will cut total limits by more than half in coming months.

Still, carrying expensive credit card debt–or adding more to your pile if you don’t absolutely need to–is a risky proposition, to say the least. You’re paying unnecessary interest, courting damage to your credit scores and putting yourself further at risk of the whims of your lenders, which can jack up your rates or change your terms at any time.

Furthermore, you need to be suspicious of any “one size fits all” advice, because everybody’s financial situation is unique.

The key in knowing what to do know is to gauge your total financial flexibility–your ability to pay your bills and cope with setbacks based on your available resources.

Here’s what I recommend:

Take stock of your own situation. See how much unused credit you have on cards and your home equity line. Check your FICOs. Get an idea of how much your home is worth and what the sales trend is–flat, declining, sharply declining. Figure out how much money you’d need to survive for at least three months and compare that against your cash stash and your access to credit.

Gauge your risk. If you don’t have much equity and home prices in your area are plummeting, you’re at high risk of having your HELOC frozen or the limit lowered. If your credit scores aren’t good to excellent (FICOs of 720 or above), or you’re using more than 50% of your available credit card limit, you’re at greater risk of having your limits cut and not being able to fight back by persuading the lender to rescind its decision or transferring your balances elsewhere. If you have only a few cards or lines of credit, you’re more vulnerable than if you have several accounts at different lenders. As I said last week and in my MSN column yesterday, diversifying our credit has become as important as diversifying our investments.

Make a plan. If your credit scores are great, you have tons of accessible home equity and there’s plenty of space on your credit cards, your financial flexibility is high–which means you needn’t panic and change your debt-repayment plan. Otherwise:

  • If things are a little tighter, you might consider opening an escape hatch or two: another credit card if you can resist the urge to run up more debt, or a line of credit at your bank.
  • If you have accounts that have already been frozen–the lender’s told you that you can no longer draw on the account–paying the minimums and stashing your cash may make sense, since you won’t free up any additional credit by paying the debt down.
  • If you have a HELOC that’s at risk and you planned on tapping it in the next year–for college tuition, say, or to finish a remodeling job–get the money now.
  • If you’re already on the edge, you have little financial flexiblity and a layoff would push you over, then by all means, conserve cash now. Pay the minimums on your debt. Think about the expenses you’d cut if you lost your job, and trim them immediately so you can put the extra cash into savings.
  • If you’re really in deep, now may be the time to consider consulting a bankruptcy attorney–who can give you truly individualized advice, rather than generalizations that can turn around and chomp you on the butt.

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