One of the biggest divorce-related questions is: “Should we pay off our debt before the divorce?” While it seems pretty straightforward in many situations, there are times when the answer might not be so clear. This article contains five things you should consider about paying off your debt.
What kind of debt is it?
Both spouses should have a decent understanding of their outstanding debt. However, this isn’t always the case. If you have multiple debts, you might want to consider the following factors in determining your options:
- Interest rate: Generally speaking, paying off higher interest rate debt will give you a bigger benefit, since your interest payments will be lower.
- Unsecured debt vs. secured debt: Secured debt, such as a mortgage or car loan, will usually be a lower interest payment than unsecured debt, like credit cards or signature loans.
- Revolving debt vs. installment debt: Revolving debt, like credit cards, have flexible, open-ended payment options. Conversely, installment debt, like a home equity loan (not to be confused with a home equity line of credit or HELOC) will usually have a fixed loan amount, regular payments, and a scheduled payoff date.
Knowing how much, and the type of debt you have will help you decide what the best option is. For example, while interest rate is an important consideration, it might not always be the primary factor.
Let’s say that you have a car loan at 8% interest and a HELOC at 5% interest (floating rate). If you’re concerned about your spouse running up a ton of debt on your HELOC, you might decide that you’d rather pay off the HELOC and freeze the credit. While your car loan might be at a higher interest rate, the payments are fixed, and it’s hard to increase the balance.
Whose debt is it?
This can be pretty tricky, since there are two things to consider.
First, is the debt considered to be marital debt or separate? This is a legal question. The answer to this question differs from case to case. In each case, the judge has the ultimate discretion because it depends on a couple of factors, such as:
- What state do you live in? Marital property definitions can differ, depending on which state you live in. However, your family law attorney should be able to help you understand how your state laws might apply to your particular situation.
- Was the debt was incurred during your marriage? An old student loan from before you were married is more likely to be considered separate debt than a credit card that was opened up during your marriage.
- Are you legally liable for the debt? In other words, are you a cosigner, like for a mortgage, or is this a credit card in your spouse’s name only?
- Did you benefit from the debt? Even if you’re not responsible to a lender, a judge might decide that you could be held responsible for part of your spouse’s separately held debt if it’s determined that you received a benefit from goods or services purchased with that debt.
There is a second point, which is just as important to understand. If you are responsible to a lender for a jointly held debt, you can still be held responsible for that debt if your (now) ex-spouse fails to make payments. This is true, even if the divorce decree holds your ex responsible for payments.
A common example is a divorce in which one spouse receives the primary residence.
- Marital vs. separate debt is a determination that can only be made by the judge when finalizing your divorce. Even if the debt is only in your spouse’s name, a judge might determine that you’re responsible based upon other factors in the case.
- Even if the divorce settlement determines that you’re not responsible for paying the debt, the lenders are not bound by the terms of the settlement. In other words, if your name is still on the mortgage, and your ex-spouse stops making the mortgage payments, the lender can come after YOU for payments.
If you’re not sure as to what debt is currently outstanding in your name, you should obtain a free credit report from www.annualcreditreport.com. Each of the three credit bureaus (Equifax, Transunion, and Experian) are required to give each consumer a free annual credit report. Each credit report should contain the following:
- Credit accounts: This should include the type of account, date you opened the account, credit limit, account balance, payment history.
- List of credit inquiries: This would include any inquiries that you initiated, as well as any inquiries a lender might have made in order to offer you credit.
- Public record information: This might include efforts from collection agencies, as well as bankruptcies or lawsuits.
You may want to ask for a credit report just to better understand what debt you’re responsible to lenders for, in addition to anything the divorce decree might state.
Are you able to pay off the debt before your divorce is final?
Many times, there are enough assets to pay off revolving debt, such as credit cards or lines of credit. If that’s the case, you might consider paying off those debts and moving on. Here are some things to take into account when trying to decide whether you can pay off the debt:
- How much do you have in liquid assets (cash, short-term CDs, etc.)? Ideally, there should be enough left over AFTER paying off the debt for each spouse to have an emergency fund.
- If you have to sell securities to raise the cash, what type of account are they in? If possible, you should refrain from having to dip into a retirement account. Withdrawals from most retirement accounts (except for Roth accounts) will increase your taxable income. If you aren’t aware of the tax consequences, this could be a bad decision. If you’re selling securities from an after-tax account, any capital gains are taxed at preferred tax rates.
- What type of debt are you looking to pay off? For most people, debt should be paid off in the following order:
- Unsecured debt: This includes credit card debt and consumer loans. This could also include payday loans or other types of predatory debt with ridiculously high interest rates.
- Revolving debt: This would include things like home equity lines of credit, where there isn’t a fixed payment schedule. Shutting down revolving debt accounts reduces the chance that one spouse might charge a lot of debt without the other’s knowledge.
- Car loans: This might be a consideration if one spouse will receive the car, and the other spouse knows they might still be liable for the payments. However, car loans usually have fixed payment schedules, which means the payments are predictable.
You probably would not include mortgages or student loan debts in the list of debt to pay off. Mortgages are usually too large to consider paying off, and student loans are usually attributed to one spouse or the other. However, they might require some analysis, such as whether the mortgage can be refinanced in one spouse’s name.
Do we shut down the accounts as we pay off the balances?
There are pros and cons to shutting down accounts as you pay off balances, particularly with credit cards.
- Sense of accomplishment. This is usually true for couples with a history of high credit card debt.
- Curbing careless spending habits. Many people who pay off credit card debt end up relapsing, because they never focused on correcting the behaviors that got them into trouble in the first place. This is especially true for people who pay off debt with a windfall, like a bonus or tax refund.
- Limiting the ability for one spouse to engage in destructive spending. Many marriages end on negative terms, with some spouses wanting to do destructive things out of spite. Sometimes, that might include hiding assets, or spending a lot of money.
- Impact to credit score. This is particularly important if one spouse has significantly less credit history than the other. This can happen a lot in gray divorces, where a significant amount of the credit card and car loan history is in the primary breadwinner’s name only. People with only one joint credit card should pay particularly close attention to ensure that closing that card doesn’t impact either spouse’s ability to obtain credit on their own.
- Loss of financial flexibility. This is particularly important, since both spouses will experience some financial uncertainty in the first year after a divorce. While you shouldn’t use credit to finance your lifestyle, there could be unforeseeable circumstances where having access to credit makes a big difference. Not having access to credit, as indicated above, places a double-whammy on the spouse who might not have many other options in an emergency.
How does this work with relation to dividing your assets?
The decision to pay off debt should coincide with how assets are divided. If there is enough liquidity to pay off the ‘bad debt,’ such as credit cards and signature loans, this might be an easy case. However, if you have to sell stocks or mutual funds to pay off the debt, it might not make sense at the time.
Also, it’s easy to go a little too far without realizing it. If you focus too much on trying to make your divorce debt-free, you and your ex might make decisions that hurt you in the long run.
Managing debt while you are getting divorced can be difficult. It’s especially hard since there are so many other factors that become more pressing during the divorce process. However, correctly addressing any debt-related issues during the divorce process will make it easier for both spouses to move forward.
If you're looking to make sense of your financial life after divorce, contact us. At Lawrence Financial Planning, we would be happy to schedule a complimentary phone call to see how we might be of service to you.