Eight out of every ten American adults have some form of debt. Properly managed, debt can enhance a person’s lifestyle. For something so common, though, people often have conflicting emotions about it. In fact, debt is the top cause of financial stress in the United States. The situation is not helped by the hysteria and half-truths commonly found in the media. Myths about debt can cause confusion, discomfort, and distress.
Here are some of the biggest myths:
Myth #1: My credit does not matter.
The truth is that your credit does matter, even if you are not planning to obtain new credit. Poor credit could keep you from getting a job or security clearance. Not only does having poor credit make it more difficult to rent an apartment, it could also mean higher utility deposits. Did you know that people with lower credit scores often pay much more for auto and homeowners insurance premiums? In my home state of Florida, having a conviction for Driving While Intoxicated increases your auto insurance premiums by an average of $866 a year, while having poor credit increases premiums by a whopping $2,417 each year. A few states do prohibit the use of credit scores in determining insurance premiums (Maryland prohibits it for setting homeowners insurance premiums).
Myth #2: I don’t need an emergency fund because I have credit cards and/or a home equity line of credit.
It is true that you can use debt to pay for an unplanned emergency. However, doing so will add debt payments to your monthly expenses at a time when your budget is already under strain. If a person is unable to save to an emergency fund already, how will he be able to pay off that debt? The typical rule of thumb is to have an emergency fund equal to three-to-six months’ worth of expenses, but speak with your Wealth Manager to determine the amount that is right for you.
Myth #3: Once you marry, you are responsible for your spouse’s debt prior to the marriage / Your joint debts are separated when you get divorced.
The truth is that you do not automatically assume responsibility for your spouse’s debt when you get married. However, if you make payments on your spouse’s debt from your own income, and then you separate, you could very well be required to continue those payments until the time the divorce is finalized. In most states, a debt incurred during the marriage will be the responsibility of the spouse who incurred the debt. Upon a divorce, technically the debt remains the responsibility of the incurring party. In practice, however, that debt could still be included in the property settlement depending on the mediator or the judge, and the non-incurring spouse will have his or her settlement amount reduced by half of that debt.
In community property states (Arizona, California, Idaho, Louisiana, Nevada, New Mexico, Texas, Washington, and Wisconsin) a debt incurred during the marriage will be the responsibility of both spouses, even if only one spouse signed for it or the other spouse was unaware. Even if a divorce decree says you are not responsible for a joint debt, it means little or nothing to the lender unless the loan is refinanced and your name is removed. Your ex-spouse may be required by the divorce agreement to make payments, but if your name is still on the loan, your credit will suffer if those payments are not made. State law differs, so consult an attorney for the laws in your state.
Myth #4: Your heirs will have to pay off your debts when you die.
The truth is that anything that passes to an individual by beneficiary form (such as IRAs and life insurance) or by title will generally be outside of probate and will not be used to pay off your debts. This is one reason why it is important to keep your beneficiary designations current, so that money does not go into probate unnecessarily. Make sure that your 401(k) and other company retirement accounts also have correct beneficiary designations—I have seen many times when there were no beneficiaries listed. Anything else in your estate will go into probate and will be used to pay off your debts, then the remaining balance will be distributed to your heirs (absent a will or trust that indicates the contrary).
Debt will reduce the amount of inheritance that your heirs receive. If the debts are more than the value of the estate, then the heirs are not generally responsible, and the creditors will have to write the debt off. The major exception in many states is unpaid medical expenses. Check with an estate attorney for advice on your individual situation. If someone co-signed on the deceased person’s debt, then of course the co-signer remains responsible.
Myth #5: Mortgage and home equity interest payments are a great tax deduction.
This was true until recently… the new tax law passed in December 2017 greatly reduced the value of the mortgage interest deduction. Previously, you could deduct the interest on up to $100,000 of mortgage or home equity debt that was used for any other purpose, such as to buy a car or pay for college educations. Beginning in 2018 you can no longer do that. You used to be able to deduct the interest on up to $1,000,000 in home acquisition debt, but now you can only deduct the interest on up to $750,000 in new home acquisition debt (debt obtained before 2018 is grandfathered in). Most importantly, the tax law almost doubled the standard deduction and lowered marginal tax rates, thereby lowering the value of every itemized deduction.
Itemized deductions are only valuable to the extent that they are greater than the standard deduction and thereby reduce your tax bill by your marginal rate. As an example, if you were a single person in 2017, your standard deduction was $6,500. Itemized deductions up to $6,500 had no tax value because they would not lower your taxes, since your standard deduction was higher. If your itemized deductions were $11,500 though—and assuming you were in the 25% marginal tax bracket—the extra $5,000 of deductions would reduce your taxes by $1,250. If you had $17,000 of itemized deductions, you would reduce your taxes by $2,625.
Now in 2018, your standard deduction goes to $12,000 and you are in a 22% marginal bracket. Having $11,500 of itemized deductions is now of no tax value to you since they will not save you any money on your taxes. If you have $17,000 in itemized deductions, that would reduce your taxes by $1,100 (versus $2,625 in 2017). Because of the tax law changes, mortgage interest is not as valuable a tax deduction as it used to be.
Bonus Myth: Credit Scores are hard to understand.
Although many people are uninformed about the factors that impact a credit score, the truth is that it is not hard to understand. There are six factors that make up a credit score. The first three have a high impact and the last three have a lower impact. These are the only factors used to compile your credit score; things like your income, assets, or marital status have no impact on it at all.
1. Credit card utilization is the percentage of available credit that you use and is the most important factor in your credit score. As the saying goes, a bank is a place that will lend you money if you can prove that you don’t need it. For a good credit score, you want to have a credit utilization percentage below 30%. Many of the misconceptions about credit scores arise from being unaware of the effect of a particular action on credit card utilization.
Closing old credit card accounts reduces the amount of your available credit and can increase your credit utilization percentage, which is why closing old accounts can actually lower your credit score. On the other hand, credit limit increases will usually raise your credit score since they decrease your credit utilization percentage. Paying down credit card balances will quickly improve your credit score, while making extra principal payments on other types of loans will not improve it as fast. Of course, it is best to pay off credit card balances in full every month. If you do carry credit card balances, taking out a personal loan to pay off credit cards is one of the fastest ways to increase your credit score, since the personal loan balance will not be included in your credit card utilization percentage. Debit and prepaid cards do not help your credit score since the information is not reported to credit bureaus.
2. Payment history is the second big factor in your credit score. The best scores come when you make 100% of your payments on time. A 99% history is still acceptable, but anything below 99% has a significant negative effect on your credit score. Once you understand how important payment history is to your credit score, you can see that being debt-free will not necessarily give you a good credit score since you will not have a significant payment history. Since credit card utilization is as important as payment history, you can have a poor credit score even with a perfect payment history if you use 30% or more of your available credit.
3. Derogatory marks (such as tax liens, civil judgments, and bankruptcies) also have a high impact on your credit score. The impact can last up to ten years, but your credit score will start to improve slowly after two years.
4. Age of credit history, which is the average age of all your credit accounts is also a factor. For the best credit scores, your average credit history should be at least seven years. This is why closing a credit card that you have had for a long time or opening new credit accounts could lower your credit score. Length of credit history accounts for about 15% of your credit score.
5. The total number of accounts makes up 10% of your credit score. For the best scores, credit bureaus like to see at least 11 accounts.
6. New credit applications (known as “Hard Inquiries”) make up another 10% of your credit score. For the best scores, credit bureaus want to see 2 or less hard inquiries in the last two years. Applying for new credit will have a small negative effect on your credit score right away, but if approved, that decrease will likely be offset by the positive impact of a lower credit card utilization percentage. Hard inquiries automatically drop off after two years, and your credit score will increase when one does. Checking your credit is a ‘soft’ inquiry (since it is not an application for new credit) and will not lower your credit score. You can get a free credit report every 12 months from each of the three major credit bureaus at www.annualcreditreport.com, but it will not include your credit score. You can use a popular app like Credit Karma to follow your credit score (it shows scores from Equifax and Transunion) or go directly to the reporting agency, which is required to supply you with one report per year at no charge.
These are very simplistic, theoretical examples and everyone’s tax and credit situation is different.