Answering 2 Reddit Debt Questions (One Is a $250K Mistake)

Sydney Klein: Welcome back to Dvorkin on Debt. This week we are talking about Reddit users' financial issues. Are you ready? Reddit users are cool.

Howard Dvorkin, CPA: Yeah, they ask good questions too.

Klein: So listen to this one. This Reddit user says that they're carrying about $40,000 worth of credit card debt and they're suffering a major income reduction. They did what most financial experts recommend. They contacted their creditors before missing any payments, explained their situation, and asked for hardship assistance. Despite having a strong payment history, they say the banks offered little to no meaningful help, and now they can't even afford the minimum payments. Why would someone who tried to do everything right still end up getting turned away?

Dvorkin: The reality is the banks don't care until they have to care. The banks are not your friends. The only time a bank wants to work with you or talk to you is when you don't need them — you're already screwed. When you need them, they don't want to talk to you. That's the reality, because you're their profit margin. You are worth money to them. The reality is a consumer who makes payments every month, and maybe even misses a payment once in a while or is late, is their most profitable client. The problem is you're one in millions. When they really get interested in you is when you're 60 or 90 days delinquent. Calling early often gets consumers nowhere, but it's still a good thing to do, to say you tried. There's really nothing else you can do other than pay them.

Klein: So the user says, "I simply cannot pay these bills right now." For someone facing that kind of reality, what should their immediate priorities be?

Dvorkin: Well, the first thing is stop panicking. We're talking about unsecured credit. If you can't pay the bills, maybe you get some nasty letters, especially on credit cards. Maybe you get a few phone calls, but it's not like they can put you in jail. Although debtor's prison was a real thing back in the 1700s.

Klein: Really?

Dvorkin: Yeah, back in England. But they don't have debtor's prison anymore. The reality is you've got to take care of yourself and you've got to take care of your family. The first thing you do is pay your rent, pay your mortgage, put food on the table, buy groceries, keep the lights on, so pay your utility bills. Don't skip a meal to make a $35 credit card payment. Understand: if you can't make your payment, yes, you'll bang up your credit, and it may impact you down the road when you try to get a loan, but at the end of the day, you need to take care of yourself and your family first.

Klein: So, if the banks aren't providing real solutions and the debt continues to grow, what is the realistic path forward for someone carrying $40,000 worth of credit card debt after a major income loss?

Dvorkin: Going directly to a bank doesn't give you that much leverage to deal with them. They may refer you to somebody they work with. Certainly, going to a nonprofit credit counseling agency is a good thing, and there are some very good ones out there. They offer something called a debt management plan. What a debt management plan is: the counselor — and usually these counselors are certified and well educated and trained to help people out — will look at your income, look at your household expenses, and make recommendations to reduce your expenses. Then they'll look at your bills and act on your behalf with the credit card companies, negotiating to reduce your payment and lower the interest, and a lot of the time they'll get the interest waived. So then you're just paying back principal.

Klein: There's a lot of advice out there that says you could do this yourself. How come you can get further with a nonprofit credit counseling agency rather than doing it yourself?

Dvorkin: Some of these credit counseling agencies are very large, very sophisticated, and they have billions of the credit card companies' money under contract, under management. You might owe the credit card company $5,000, $10,000, $15,000, but these agencies control billions of dollars and have a lot more power. They send a letter electronically to the bank saying, "This client came to us. This is your payment. Thank you." That's it — it's already pre-negotiated. A lot of the time, the credit counseling agencies have more power. They know what they're doing. They're a known entity. Debt management plans work.

Klein: That's why it's better to go through a credit counseling agency than to try to do this yourself. That's really good advice, Howard. Thank you. So, we have a second Reddit question. This person is 26 years old and carrying $47,000 worth of debt. They're considering cashing out $29,000 from their 401(k), knowing they'll lose a significant portion to taxes and penalties.

Dvorkin: I knew that's the part I knew you'd hate.

Klein: Because they want to pay off one credit card and make a dent in the rest — that's why they want to do it. Now, is this a smart financial reset or a costly mistake?

Dvorkin: It's a costly mistake. You've heard of the seven wonders of the world — the eighth wonder of the world was named by Einstein.

Klein: Okay.

Dvorkin: He said compound interest — compound earnings — is the eighth wonder of the world. To understand that, you just keep building on it, but the main ingredient is time. If you take what you've built up over time and start at zero again, whether you have 20 years before retirement, 30 years, or 40 years, you're never going to make that money up. $29,000 today can easily become a quarter of a million dollars at a later date. But if you take away your ability to compound that $29,000, it's not so great. Also, we have to worry about the tax liability. When you liquidate $29,000, there's a penalty involved — actually two penalties. There's a 10% penalty for early withdrawal if you withdraw it before you retire, in your 50s. So you pay a 10% early withdrawal penalty, plus you pay tax on that, which could even push you into another tax bracket. So you pay a higher tax on that too. You're not getting $29,000 — you're not getting all the money you think you're getting. You may end up with only like $15,000, or you'll probably get more — let's just say $29,000 will turn into $19,000 to $20,000.

Klein: So this person is thinking about borrowing $29,000. Realistically, they might only get $20,000, but if they let it sit there, it could have been like a quarter of a million dollars.

Dvorkin: Yeah. So the problem is you don't destroy an asset to solve a liability. You need to create an emergency fund. A lot of my colleagues say you need six months of spending money to make sure that emergency fund works. The reality is, if you're somebody in debt, maybe you need two months, three months. At the end of the day, there are lots of gig deals you can do to earn some money on the side if financial problems occur.

Klein: So, after doing quite a bit of these shows with you, I think I've learned that one of your least favorite things is hearing that people are borrowing against their 401(k).

Dvorkin: I hate that.

Klein: But, if we're playing devil's advocate here, this person feels trapped with high interest rates and believes they're never going to make meaningful progress otherwise. If cashing out the 401(k) isn't the answer, what else should they do?

Dvorkin: You need to adopt a budget to what you can afford.

Klein: So what you're saying is there's always a different answer other than taking against your 401(k).

Dvorkin: Don't take against your 401(k). My god, I mean, people come to us —

Klein: Sing it together now: don't take your 401(k).

Dvorkin: However, sacrificing the future and taking money against your 401(k) now to pay off short-term bills is not the answer. You have to develop a budget and make sure you don't exceed the budget and build up debt. You need a plan to liquidate that debt. You have to protect basic household needs first.

Klein: From both of these Reddit users, what is the biggest lesson we can give them and the viewers at home? What should they take away from both of these situations?

Dvorkin: Don't let fear drive financial choices.

Klein: Beautifully said, Howard. Thank you. And that's all we have for this week. Thank you for giving us your advice.

Dvorkin: Thank you so much for having me.