Ask Paula: Use One Debt to Pay Off Another?

0:00Hey, Joe, you used to be in a lot of debt, right? I was in a ton of debt. Did you ever use one debt to pay off another? I did. I used consolidation loans to stop using my credit card, get them all in one place and have just a single payment. Ah, interesting. Okay, well, we are about to tackle a question from a listener who is thinking about using one debt to pay off another. And we're going to do that because this is the Afford Anything Podcast, the show that understand you can afford anything, but not everything. Every choice that you make carries a trade-off. So what trade-offs are you willing to accept?

0:38That's what this show is here to explore. I'm Paula Pant, the host of the show. And this is my buddy, former financial planner, Joe Salcihai, who joins me every other week to answer questions that come from you, the community. I'm glad that we're recording a show because I thought you just want to remind me that I used to be in a lot of debt. I was like, why would a friend do that to me? I know, right? Such a nice way to open the morning. Remember, Joe, how bad you felt all those years? Aww. Well, our first question hopefully comes from somebody who doesn't feel quite as bad, or from someone who is going to be able to pull off a big turnaround.

1:20Either way, we can make him feel better, Paula. Right, exactly. So our first question comes from Knoxville. Hi, Paula. I love your podcast. You can call me Knoxville. I have a question as to whether I should use a HELOC on my primary residence to pay off a 401k loan that I took out in order to make a down payment on an investment property. And so to give you some background, I work a W-2 job making about$230 ,000 per year. And I have a flexible 1099 job where I make between$10 ,000 per year. I file as head of household. I have no credit card debt and I'm about 50 % of my target emergency fund goal.

2:04I do have a retirement account with a 7 % company match. Currently, the retirement account has$410 ,000 and I was able to take out a first loan to use as a down payment towards my primary residence. I finished paid off that loan earlier in 2022 and currently, the primary residence has an equity of$615 ,000 on a 15-year mortgage at 2 % interest rate. The HELOC is available in full at$30 ,000 with an interest rate of 8%. I have been listening to your podcast and I decided to take the plunge into real estate investment. And so I got a brand new property, two bedroom, two bath. It's out of state and will need a property manager and there's also HOA fees attached.

2:57The mortgage is a 30-year mortgage at 7 % interest rate. With HOA fees, property management and mortgage, total expenses will come up to about 1825. Our new renters will be moving in in the next two to three weeks. So my question is, should I use my HELOC with an interest rate of 8 % to pay off that 401k loan that I have with an interest rate of 5.25%. Total amount of that loan was$50 ,000. And that way I am able to maximize my return on my 401k. And then I would just slowly chip away with the payments on my HELOC. Does that make financial sense or should I use my HELOC in some other way? Thank you so much once again.

3:46And I'm just interested in hearing your insight. Thank you. Oh, we have insights. Knoxville, thank you for the question. First of all, congratulations. You've got a$410 ,000 balance in your retirement account, nearly half a million. It's actually, that's a funny because it's not quite 401k in your 401k.

4:11It's actually 410k in your 401k. Anyway, those are the kinds of things that make me happy. Is there a... But yeah, you've got a healthy, healthy retirement account. You have a great home value,$615 ,000 home on a 15-year mortgage at a 2 % rate. Wow. Wow. So you're doing so well. No credit card debt. You're halfway to your emergency fund goal. And let's talk about this loan. You've got a 401k loan at 5.25%. It's a$50 ,000 loan. Joe, and I'd love to hear what you think, Joe. I am in favor, Knoxville, of what you have suggested. I am against. I am against. Whoa. Boxing gloves are on. Here it comes.

5:02Okay, so I'll start with the devil's advocate argument, also known as Joe's argument, which is if you're paying off the 401k loan, You're paying off a loan that has a 5.25 % interest rate and keeping a loan with an 8 % interest rate. So from an interest rate arbitrage perspective, it does not make sense to pay off the 401k loan. From an interest rate arbitrage perspective, it makes sense to keep the 401k loan at 5.25 and more aggressively, you know, use that same$50 ,000, you know, chip away at that HELOC because that's the more expensive mortgage. Also, the 30-year that you have on your rental property, 7%, more expensive.

5:46So from an interest rate point of view, I get it. But I like what Knoxville said about get more money in that 401k, you know, replenish that money so it can make more money for her. Because once that loan is paid off, it isn't simply that her interest is going to go from 5.25 down to nothing. It's that an additional$50 ,000 are going to go into a tax-deferred account, which will then have compounding tax-deferred growth. And so I like the idea of beefing up the tax-deferred 401k by virtue of paying off the loan before I start tackling the HELOC. I like everything you said there. And that is a glass-half-full approach.

6:29But what I learned is that bad things happen all the time, and they happen when you least expect it. I have two issues, Paula. Number one, right now with a 401k loan, the damage is done. I really don't like 401k loans. I love paying them back. I think paying them back is awesome. I like the fact that as she puts that money back in, she's going to get more the ability now to increase that sale that's going to float with, hopefully, rising stock markets over time. but 401k loans really aren't long-term. So she'll have that paid off even on a regular schedule over a fairly short amount of time. And so I look at the types of loans that she has a 401k loan.

7:15Once she pays that back, she never wants to, she never wants to take that out again. And that loan will be closed. It is a fixed loan for a fixed amount of time. And to get another one, she's going to have to apply for another one. Now, she's borrowing from herself, so she's going to accept herself, but it isn't an open line of credit. And she's taking that money from an open line of credit that only has so much money available. So she's going to take money from an open line, and she's going to move it to a closed position, which means there's going to be another application process to restart it.

7:53And then, so I don't like getting rid of the flexibility that the home equity line of credit gives her in case bad stuff happens. Now, the good news about the 401k loan is the only thing that everybody tells you and I, Paula, what do people say when they say, well, I got a 401k loan? Well, I'm paying myself back the interest. Yes, you are. And at this point, that is a good thing. I mean, it is great that she's going to pay herself that interest rate and that's going to go into her account. So we know what this money is going to do. And every payment that she makes into that 401k loan puts more money into that equity sale, which you love and I love and everybody loves.

8:35I just don't like taking an open position that gives her more flexibility and locking in this closed loan. So fundamentally, Joe, what you're talking about, and to frame this into some context for everyone who's listening. You're discussing the difference between a revolving loan and an installment loan. And you don't like using a revolving loan to pay off an installment loan. Right. For the sake of everyone, so you have the framework of this, think of loans in your mental classification of different types of loans that are out there. Think of loans as either revolving or installment. A revolving loan is something like a HELOC, an open line of credit, or like a credit card, which a credit card is also an open line of credit, those type of revolving loans give you a certain maximum amount that you could potentially borrow.

9:27Like on your credit card, for example, you could potentially borrow$5 ,000,$10 ,000,$15 ,000, $20 ,000,$25 ,000, whatever you are approved for within your credit card, right? But you don't have to borrow that entire amount on the day that you get your credit card, When you receive a credit card, you don't receive$10 ,000 or$20 ,000 in cash. Instead, you receive the ability to, at whim, borrow up to that amount. And in a credit card, you do it$5 here,$15 there that slowly builds to that amount. And you also don't have a fixed monthly payment. Your minimum monthly payment varies depending on how much you've borrowed.

10:13So if in January you use your credit card a lot, your minimum monthly payment is going to be a lot higher. If in August you used it not at all and you actually haven't used it at all in several months, that minimum monthly payment is going to be a lot lower, maybe even zero if it's got a zero balance. So that's the nature of a revolving loan. An installment loan, by contrast, is a student loan, a car loan, a fixed rate mortgage payment, something where you pay a fixed amount every single month. And you borrowed a fixed amount versus also a revolving amount. So, you know, in the home equity line of credit, to your point, if I, you know, take$5 ,000 off, it's just an open loan, I can take$5 ,000.

10:53If I do that with a car loan, maybe I take an extra$5 ,000 to do something with, but now I borrowed it and I have to do that fixed payment back. And so philosophically, the reason that you don't like using a revolving to pay off an installment is largely, Joe, and tell me if this is a correct analysis of your motivation, that revolving gives you maximum flexibility and you don't like taking money from a flexible bucket and using it to pay off money from an inflexible bucket. Yeah, on the first tier, yes. Then the second tier is specifically a 401k loan. And what's going to happen if we slow play the 401k loan over the next, I don't know how many years she has left, if it's three years or four years that she has left.

11:38But in the big scheme of things, it's not going to be all that long. Yeah. The amount that she has borrowed, it's more than 10 % of her total 401k balance. And as I see it, if she can get that money back into her 401k and working for her and compounding for those additional three or four years, particularly given that it's tax deferred compounding, it can have some significant benefits over time. So that's the reason I like the idea of, you know, with a 401k or with any type of tax-advantaged account, there are limits to how much you can put in every year. And so unlike other types of accounts, your ability to shovel money into a 401k is by law limited.

12:26Your ability to make new contributions is limited. And so the more money that you can just shovel into those and get working for you on a compounding tax deferred basis, the better. That's the reason I like paying it back. But I think we always have to think about what could go wrong along the way. So assuming that she does this, Paula, let's say that she does this, because if she does, what I would say if I were advising her would be, what's your contingency plan now if something goes wrong? Where's that money going to come from if she has some big need for money between the time that she puts that in and the time that that home equity loan line of credit gets paid off?

13:08Where's that money going to come from? And maybe the answer is, because I don't think we got this in the question, maybe that home equity line of credit is so big. She's got so much available that she's going to have plenty of additional money that she can still go grab if she needs it. I don't know. That would be my next question. What is your contingency plan? You know, I had a client when I was advisor who worked for the Michigan Highway Department. She was an engineer. And she told me that before they built any highway, they would always think about what could go wrong. And they would build contingencies for all of those things.

13:45This is that process. If I take money from a revolving line and pay down my installment loan, what could go wrong and how would I solve that? Once she does that, Paula, then I'm on board. All right. Then maybe the solution between both of our answers, Joe, is that her first step is to beef up that emergency fund because she said her emergency fund is 50 % of its target goal. Maybe step one, get the emergency fund to 100 % of target goal. And then only after that, pay off the 401k loan. What do you think about that? I just think this process is wonderful. I mean, the fact that you're thinking about what would be the stop gaps, this is going to make the plan far more unstoppable, far more unbreakable.

14:32And I love it. I don't know. I don't know which one's best, but certainly that is a step in the right direction. No. Excellent. All right. So Knoxville, Joe, some food for thought. Joe and I disagree on the approach, but I think we've explained sort of the principles that underpin both of our lines of thinking as well as, you know, what needs to be done before you take the next step. And I think it's generally in our nature as well. Paula's glass half full. Glass could be full, but it also could be empty. We never know. I'm definitely not glass half empty. I will tell you the glass is half full all the time too, but I do think it's in our nature.

15:17Yeah. Yeah, exactly. I am a little bit more. Let's do it. Yeah. Yeah. Optimistic. Yes. Let's go. Awesome. Well, Knoxville, I hope that was helpful. I hope it gave you a couple of different considerations as you decide which course of action is best for you. So as always on the Afford Anything podcast, we don't tell you what to do. We give you a framework for thinking about how to arrive at the solution. We should have an episode though, where we just tell people what to do. Put$32 on red, you know? The fourth horse in the fifth race. What? My question was about real estate. Who cares? Well, Knoxville, thank you for the question.

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20:03Our next question comes from Joelle, who is interested in rent to own. Let's hear from Joelle.

20:15Hi, Paula and Jo. Joelle here. I own a home free and clear that I essentially inherited and I would rather deploy its value in other ways. In other words, I didn't choose the home's location, its characteristics, but I have been renting it and I have a great tenant who may be interested in buying my home and having it for the long term. But before I approach him or offer it as an option, I need to understand it better for myself. In episode 409, Kyle mentioned rent to own, but he had a mortgage on his property and I was left still wondering about the details of that kind of agreement. Like Kyle, I have heard it also described as quote ideal, but I don't understand why or for who.

21:10I just want to know, how does it work? I know there are two forms, a lease option and a lease purchase. So my tenant pays X amount currently. If we enter into a rent to own agreement, does he pay X amount plus some that counts towards his down payment? And how long do we decide to do this until he reaches a certain down payment? Or do we just arbitrarily choose a timeframe like three years? So once we reach that point, the end point, then what happens? Does he march off to the bank and apply for a traditional mortgage for the remainder of what he hadn't paid towards the house? In other words, why would property owners enter into these kinds of agreements?

21:55I have looked and tried to do research, but I really just see the pros and cons from the tenant's perspective. I'm asking here because you and Joe know how to unpack a question, convey the pros and cons clearly, and debate them. I really hope that this discussion will benefit someone else who may be in a similar situation as me or just want to educate themselves. Thanks so much for all that you do for the community. I really have learned so much over the years. Thank you. Joelle, thank you for such a sweet message. That was very kind. It's clear Joelle cares about the this show and about the entire community.

22:34So yeah, thank you. Thank you for that message. I love her question. In this case, Joelle, I think your question is the answer. I think that you go, it's not the whole answer. And obviously there's going to be a lot of this, but when Joelle goes to an attorney, she says, is this going to be a long-term agreement or is this for, let's say, three years? Because you can do it either way, which is awesome. And then she goes, so what happens at the end of three years? Is there a balloon payment or is it, and I go, the cool thing is, is you get to decide that too.

23:13I am tweeting this out. The question is often the answer. Okay. That's very nice. Thank you. I'll attribute it to you. But isn't it in this case, When you sit down with an attorney to draw it up, you and the tenant and the attorney answer these questions legally. And what's neat is you can do it however you want. You can structure the deal however you want it to go, which is part of why this can be cool. Again, Jolene, though, for the tenant, right? It can be cool for both parties. So let's take a step back and kind of go over the big picture of what's going on here. A lease option, as the name implies, it gives the tenant the option to purchase the property after a predetermined specified period of time.

24:07And so you set the, you know, some of the terms in advance, but the renter isn't locked into needing to purchase the property. They just have the option to be able to do so. Essentially, they have the right of first refusal is another way of looking at it. Technically, legally, those are different things. But effectively, what you're saying is, renter, I can't sell this to anybody other than you within the specified time period. You kind of have locked down the exclusivity to have the choice to buy this. And it's your decision whether you want to exercise that choice or not. And this is the time period in which that happens.

24:44And these are the terms under which that happens. And so what you get from the perspective of a seller is some type of a premium because of the fact that you are effectively taking the home off the market for anybody else. You're removing the competition. You're locking in certain terms in advance. Because you are guaranteeing so much for the renter, you get a premium for that. So that's the advantage to both parties, right? The renter gets that option. They get that certainty. They get to kind of tie it down for a little while, and then you get the premium for exactly what the renter gets. By contrast, a lease purchase is an agreement in which the tenant commits to purchasing the property, barring some type of extreme situation like barring the tenant isn't able to secure a long-term mortgage If you put that into the contract, some kind of other situation, the tenant really has agreed to purchase the property.

25:49You can think of this, Paula, more like an option, right? It's like an option on the stock. I can buy it. I can't buy it. But I almost, you know, because I have this piece of paper in my hand, I get first right toward this during these specific conditions. Right. But, Joelle, in your case, because you own this home free and clear, you don't have to worry about lenders. You're in a prime position to be able to offer this as either a lease option or a lease purchase. And the advantage that you get if you decide to do this is that you can charge the interest rate that you and the renter decide on.

26:29You can charge the advance premium that you and the renter decide on. Basically, you get to not only receive the profits from selling the home, but you also get to receive the profits by virtue of being the bank, being the lender. And so, you know, if you think about kind of who makes money in a real estate transaction, right? Who makes money when a home is sold? The seller makes money. They make money on the sale of the home. And the bank makes money because it makes money on the loan that they issue. for the sale of the home. You get to be both. And so you get to make money in two ways. And that is the advantage that you have.

27:12Now, the disadvantage that you have is that necessarily it means that equity is going to be tied up, right? The money that you are using to be the bank is money that you're not using in some alternate way. So that lack of liquidity is part of the disadvantage to you, there's also the risk that the tenant might default and walk away, right? And typically, what people will say is, you know, that's not that much of a risk because if the tenant defaults, you can foreclose on the house and then you just get the house back, right? So you still retain ownership of the house, just like any other normal foreclosure.

27:55You've received all of the payments that they've made already, and now you have the house back again. That's true in an up market. But in a down market, if, and I don't think this is going to happen, but just hypothetically, if the home were to decline in value, and then the tenant were to walk away, you'd be left holding the bag on an underwater property, or a property that would be underwater from the tenant's perspective. So that is part of the risk of being the entity that holds the securitized asset. Yeah. I have a friend, Paula, who sold a house three times. And because it's an up market, it ended up being financially very, very good for them.