Ask Liz Weston

Dear Liz: My spouse has extremely high credit card debt. All cards are in her name only. Where do I stand legally if she dies or we divorce? What can a person do about such uncontrollable abuse of credit cards? The interest alone is horrific, but she pays it.

Answer: If you live in a community property state and don’t have a prenuptial agreement, debts incurred during marriage are typically considered owed by both parties (even if there’s only one name on the credit card). Community property states include California, Arizona, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington and Wisconsin.

In other states, debts incurred by one spouse are usually that spouse’s responsibility alone, unless the money was used to buy family necessities such as food or shelter. If you divorce, she probably would be responsible for these separate debts. If she dies, creditors could go after her separate property and may be able to go after her half of any jointly held property.

The rules vary enough by state that you’d be smart to consult an attorney about your potential liability.

Wherever you live, though, this debt is affecting your union and your future together. The money she’s paying in interest isn’t available for other purposes, such as saving for retirement or your children’s educations, plus it’s clearly causing tension between you. If you want your marriage to succeed, you should invest in sessions with a marriage counselor and a fee-only financial planner.

Dear Liz: In a recent column, you advised someone to pay off credit card debt with his emergency fund. I agree that “Clinging to cash that’s earning less than 2% doesn’t make sense when your debt is . . . costing you a double-digit interest rate.”

But isn’t that “old school” thinking? Aren’t we all supposed to be in “survival mode” now and building up our emergency funds instead of paying off debt?

I am recently divorced at age 65, with no chance of getting a job soon. I did not get spousal support as my ex is on Social Security and a pension (which goes away when he dies). I got half of a very shattered IRA, which I am going to need to live on.

I am in the same boat, faced with carrying $8,000 of credit card debt or using funds that I need to live on to pay off the debt. What’s your answer to my problem?

Answer: Take a close look at what credit card companies are doing to their customers these days. They’re doubling or tripling interest rates, even for people with good credit. They’re lowering credit limits and slamming shut accounts, endangering people’s credit scores. They’re experimenting with new fees.

Why would you put up with that if you had a choice? People who don’t pay off their credit card debt with their savings when they can are choosing to bind themselves to companies that have made it quite clear they don’t care about their customers’ financial well-being.

The key phrase there is “when they can.” If you’re facing a layoff or already unemployed, you really do need to be in survival mode and conserve your cash. That means paying the minimums on your debt until your economic situation improves.

If your situation doesn’t improve, or if issuers raise your rates to the point where you can no longer pay your minimums, you may need to consider credit counseling or even bankruptcy to deal with this debt.

Dear Liz: I have $16,000 in the bank as an emergency fund. I’m trying to get serious about paying off my debt, including a $7,500 credit card balance. I was thinking of getting a fixed-rate loan from my credit union to pay off the credit card balance in 36 months.

I have another loan (for my son’s private school tuition) with an original balance of $4,950. I’m supposed to make 12 payments interest-free, which will leave a balance of $3,020, which then reverts to 12.5% interest for the next 14 payments until it is paid off.

What should I do?

Answer: Getting a fixed-rate loan from a credit union to pay off credit card debt is often a good idea — if you don’t already have cash sitting around to pay off the debt, which you do.

Unless you’re in real danger of losing your job, using your savings to pay off the cards is a virtual no-brainer. Clinging to cash that’s earning less than 2% doesn’t make sense when your debt is probably costing you a double-digit interest rate.

When the card debt is paid off, you can focus on rebuilding your emergency fund — until the interest-free period on the school loan is up. At that point you should pay off the rest of the debt.

It should go without saying, but you also need to fix whatever issue caused you to rack up the debt in the first place.

If you can’t afford to pay in full when the bill comes, you shouldn’t buy it. That’s as true for private school tuition as it is for credit card purchases.

photo credit: Andres Rueda

I’m a fan of having access to plenty of low-cost credit—as a proxy for an emergency fund while you’re building one, and to supplement your cash once you’ve got several months’ worth of expenses set aside. The future is uncertain, after all, and you can never tell when a cascade of events will wipe out your reserve.

What’s worrisome is that so many people never get beyond relying on their plastic as their only source of funds for unexpected emergencies—or even relatively predictable events like car and home repairs.

The national research center Demos recently published its second survey examining credit card debt among low- and middle-income households, which it defined as households whose incomes fell between 50% and 120% of the local median income.

“The Plastic Safety Net: How Households are Coping in a Fragile Economy” blows it in one sense by citing an “average” debt of $9,827 for these households. If you’ve been reading me awhile, you know how deceptive these “averages” are, since they’re skewed by big balances owed by a relatively small number of households.

A better measure of household debt uses medians, which describe the halfway point—half of the surveyed population owes less, half more.

The latest figures available from the Federal Reserve show that only 25.7% of the lowest-income households, 39.4% of lower middle income and 54.9% of middle income households have any credit card debt. Of those who have credit card debt, the median balances are $1,000, $1,800 and $2,400, respectively.

The other data Demos cited, though, was revealing. Particularly:

•    3 out of 4 low- and middle-income households reported using their credit cards as a safety net–relying on credit to pay for car repairs, house repairs, layoff or job loss, money given or loaned to relatives, college expenses or starting or running a business.

•    More than 1 out of 3 households reported using credit cards to cover basic living expenses, on average for 5 out of the last 12 months.

•    The most important predictor of higher “debt-stress” levels was whether a household relied on credit cards to cover basic living expenses such as rent, mortgage payment, groceries, utilities or insurance.

•    For 1 in 2 households out-of-pocket medical expenses contributed to a families’ credit card debt, with an average of $2,194 dollars related to out-of-pocket medical expenses.

•    The average interest rate paid on a families’ card with the highest balance was 14.8% with close to 1 in 4 indebted households paying more than 20% interest on their card.

•    In the past five years credit card indebted homeowners used an average of $14,344 in home equity to pay down credit card debt.

•    The majority of credit card indebted households used tax refunds toward debt reduction and nearly half of respondents worked extra hours or took on an extra job in order to get out of debt.

That last finding shows most households realize they have a serious problem and are trying to do something about it.

Demos’ recommendations to reduce dependence on high cost debt include:
1.    Promote increased savings, not increased debt, to help families meet unexpected financial emergencies.
2.    Modernize the unemployment insurance system and expand coverage and benefit levels.
3.    Strengthen the position of low-wage workers in the labor market.
4.    Address rising health care costs and the growing number of uninsured.
5.    Establish a new agency focused on consumer financial protection.

I think numbers 2 and 3 are longshots, particularly in this economy, but 4 and 5 are in process and the first suggestion–promoting savings rather than plastic–has always been a good idea.

If you want to break your own dependence on plastic, read the following:

• How to plan your ‘emergencies’
• How much should you spend on…
• Why you need budget buckets
• The $0 emergency fund
• Want to sleep better? Save $500

photo credit: eric731

This month’s AARP poll includes some rather shocking figures about consumer debt–shocking enough that somebody should have asked a few questions before publishing them.

AARP had research firm ICR survey 1,005 adults and asked the ones who had debt–loans, mortgages or credit cards–how much they owed each month on their debt. The answers were:

• 17% said they owed more than their monthly income
• 25% said they owed 75% of their monthly income
• 23% said they owed half their monthly income
• 33% said they owed less than half of their monthly income

Read that again. Only one out of three people with any debt said their debt payments consumed less than half their monthly income.

That just doesn’t jibe with other debt surveys, particularly not with the most comprehensive, which is the Federal Reserve’s Survey of Consumer Finances. The Fed found less than 15% of all families owed 40% or more of their incomes to debt payments. When you eliminate the quarter of households that have no debt, that still puts fewer than 18% of indebted households owing more than 40%.

Granted, the latest survey is from 2007, and many folks’ debt situations have gotten worse in the recession. But it’s hard to imagine they’re THAT much worse.

I think what we’ve got here is a failure to communicate. Perhaps the respondents were confused by the wording of the survey question, which asked them, “Compared to your monthly income, would you say what you owe in total each month on your debt is….” The “in total” phrase could have thrown them off and made them think they were supposed to compare their total debt to their monthly income.

Or maybe a good number of respondents confuse “debt payments” and “bills.” Certainly a lot of indebted families live paycheck-to-paycheck, and that might explain the wonky figures.

You can check out the AARP survey by CLICKING HERE, but this survey seems destined to join the myth of the average $9,000 credit card debt in the statistical trash bin.

It’s kind of a wonderful dilemma: there’s so much personal finance writing going on that it’s easy to miss some great stuff. Here are some picks for what I liked in the past few days:

1. Want to find more bargains? Use Twitter. Writer Melinda Fulmer offers some great folks to follow to find coupons, deals and freebies. CLICK HERE to learn more.
2. Instead of a mental health day, the New York Times’ Ron Lieber took a fiscal health day and tackled a laundry list of financial tasks. CLICK HERE to see what he accomplished as well as some great suggestions and links.
3. Social networks are a great way to share information, but Smithee at Consumerism Commentary raises a good point that broadcasting the fact you’re on vacation may not be such a great idea. CLICK HERE to read about the perils.
4. If you’re struggling with massive debt and have questions about what to do, you might want to check out Steve Rhode’s site GetOutofDebt.org. I met Steve back in the days when he ran MyVesta, a consumer credit counseling service, and he has deep knowledge of the world of credit, debt repayment, debt settlement and bankruptcy. We don’t always agree, but I think he gives straight answers based on his considerable experience rather than the dogma, cheerleading or press-release twaddle you might find elsewhere. CLICK HERE to start checking out his site.
5. I constantly tell people not to borrow more for an education than you expect to make your first year out of school, but researching that figure can be tough. A new peer-to-peer private lending service, People Capital, is attempting to estimate your future earning power via a new calculator in beta. The site hopes this Human Capital Score will fill in for folks who have no credit score to determine who’s a good risk for repaying a loan and who’s not. CLICK HERE to read a Smart Spending blog entry about the calculator, then follow the links.

One of the reasons I hate the bogus statistic that “the average American has $9,000 in credit card debt” is that it paints such an inaccurate picture of U.S. household finances. (In reality, more than half of American households have no credit card debt, according to the Federal Reserve; the median owed for those that do was $3,000.)

But clearly, plenty of people have big problems with debt, and finances in general. Here are just some of the relevant stats:

• 3.1 million households started the foreclosure process last year, and 861,664 families lost their homes, according to RealtyTrac.
• Over 1 million personal bankruptcy cases were filed in 2008, and the American Bankruptcy Institute predicts 1.4 million more this year.
• 14.5 million people were officially unemployed in May, for an unemployment rate of 9.4%. Some economists expect that rate to peak at just over 10%.
• About 15% of U.S. households, or 17 million families, funneled more than 40% of their incomes toward debt payments in 2007, the latest year for which Federal Reserve statistics are available. The 40% mark is considered a “compelling indicator of distress” by the Fed.
• 28% of U.S. households had “no spare cash” after paying bills in 2005, an ACNielsen poll found.
• About 46% of U.S. households carry credit card debt, according to the Fed. Card debt seems to peak among households headed by people in their 40s; of that group, 14.3% owe $10,000 or more.

To me, the two most worrisome stats are the 15% that owe 40%, and the 28% that live paycheck to paycheck. These are the households who were living on the edge before the recession, and are most likely to tumble off.

My gut feeling is that about a third of U.S. households are in financial distress; for about half of those, the distress is acute.

Dear Liz: Do you recommend taking funds from a money market account to pay off high-interest credit cards? We are ages 57 and 60. One of us is retired and one is still employed.

Answer: The answer to this question is more complicated than you might think.

All things being equal, it makes sense to use cash in a low-interest money market account to pay off much higher-rate debt. But all things are rarely equal.

You may be taking a big risk if the money is all the cash you have in the world and paying the debt would wipe out this emergency fund. Card issuers are reducing credit card limits, so you might not be able to access your credit again in an emergency, such as a job loss.

If that’s the case, you may want to use only a portion of your cash to pay down the debt and pay the rest off out of your current income.

Graduation ceremonies are just around the corner, which means there will be a bumper crop of advice coming graduates’ way.

Here’s what I wish every graduate knew about money:

It’s up to you to watch your overhead. If you want finances that work, you’ll need to limit your “must haves”–rent, food, utilities, gas, minimum loan payments and insurance premiums–to no more than half your after-tax income. Some grads blow 40% to 50% just on rent in high-cost areas, which means they’re guaranteed to struggle to make ends meet.

Ditch that credit card debt. It’s toxic, and you want it out of your life. The smartest habit you can develop is paying your credit cards in full each and every month of your life.

Stretch out the federal loans, pay off the private. Federal student loan debt is cheap and flexible, so it’s okay to consolidate it into a loan for the longest possible term (up to 30 years if you owe enough) to minimize your payments. Concentrate instead on paying off that private student loan debt, which is far more expensive and offers fewer options if you get into a financial jam.

Start contributing to your retirement. Yup, the market’s scary, but you’ll need stocks’ inflation-beating returns if you want to retire someday. And procrastination will hurt you big time. Someone who starts saving for retirement at 22 can wind up with a 30% bigger nest egg than someone who waits just 5 years to start. Sign up for a 401(k) if you’re eligible; otherwise, start contributing to a Roth. (You probably aren’t in a high-enough tax bracket to get much of a break from contributing to a traditional IRA, and Roth contributions, though not tax-deductible, grow tax free for retirement.)

Weave your safety net. You’ll want enough cash and access to credit to tide you over in an emergency. Just $500 in the bank is a good start; after you get the cards paid off and get signed up for retirement, start building up that emergency fund.

Dear Liz: The 401(k) plan at work has been terminated. We have $51,000 in credit card debt and $45,000 in the 401(k) account. Should we pay the 20% withholding tax and early penalty to get out of debt?

Answer: Of course not. Using retirement money to pay off debt is stupid on a number of levels.

The 20% that’s withheld when you prematurely withdraw money from a 401(k) often isn’t enough to cover the actual tax bill. You’ll pay taxes at your regular federal and state income tax rates on the money, plus penalties. (The federal penalty is 10%, plus whatever penalty your state adds.) Even if you’re in the 15% tax bracket, you’ll have to pay taxes equal to more than a third of the money you withdraw. At higher tax brackets, you could lose half or more of the money you take out.

Once the money is withdrawn, you can’t put it back. That means you lose all the future tax-deferred gains the money could have earned. Assuming an average 8% annual return over 30 years — and the stock market has achieved that, even counting in the years of the Great Depression — you’ll wind up losing $10,000 or more in retirement money for every $1,000 you withdraw now.

Furthermore, money in a retirement account is protected from creditors should you wind up in bankruptcy. Before you use protected money to pay off a debt that could be erased in a bankruptcy filing, you should talk to an experienced bankruptcy attorney.