One of the biggest divorce-related questions is: “Should we pay off our joint debt before the divorce?”
The answer might seem pretty straightforward for a divorcing couple in many situations. However, there are times when the answer might not be so clear.
This article contains five things you should consider about divorce and debt.
Debt Consideration #1: 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 may not have enough money to pay everything off.
If that’s the case, you might want to prioritize the debt, in terms of what gets paid off first. To do this, you might want to consider the following factors:
What is the interest rate?
Generally speaking, paying off higher interest rate debt will give you a bigger benefit.
For example, you might be better off paying off a credit card balance at 22% interest than paying off the 3% car loan. Of course, this is only true if you can keep the credit card paid off.
Is it secured debt or unsecured debt?
Secured debt, like a mortgage or car loan, will usually have a lower interest rate than unsecured debt. Personal loans or credit cards are considered unsecured debt, and will charge higher interest rates.
If it’s secured debt, then you’ll want to know which spouse’s assets are securing the debt.
For example, let’s imagine that a husband wants to pay off his car using the couple’s joint accounts. If he decides to leave the wife’s car loan in place, there might be a valid reason. Perhaps her loan interest was much lower than his. Or maybe he’s trying to take advantage of a situation.
The best way to proceed is to document the debt and the asset that is being secured by the debt. And to make note of it in the equitable distribution worksheet.
Is it revolving debt or is it installment debt?
Revolving debt, like joint credit cards, have flexible, open-ended payment options. Same goes with a home equity line of credit (also known as a HELOC).
Conversely, installment debt, like a home equity loan, mortgage, or car loan, will usually have a fixed loan amount, regular monthly payment, 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). Perhaps you’re concerned about your spouse running up a ton of debt on your HELOC. In that case, you might decide that you’d rather pay off the HELOC and freeze the credit.
While your car loan might have a higher interest rate, you have fixed loan payments. As a result, it’s hard to increase the balance.
Debt Consideration #2: Whose debt is it?
This can be pretty tricky, since there are two things to consider.
Is it marital debt or separate debt?
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 various factors, such as:
- What state do you live in? Marital property definitions can differ, depending on which state you live in. Debt incurred in community property states might be treated differently from debt in an equitable distribution state. Your family law or divorce attorney should give you legal advice and help you understand how your state laws might apply to your particular situation.
- Did you obtain the debt during your marriage? If you have an old student loan from before you were married, that’s probably separate debt. A credit card opened up during your marriage is joint debt.
- 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 determine that you received a benefit from the debt. In that case, the judge may decide to hold you responsible for part of your spouse’s separately held debt.
Be careful about jointly held debt.
If you are responsible to a lender for a joint obligation, you are still on the hook. Even if your (now) ex-spouse fails to make timely 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 marital home.
Also, marital vs. separate debt is a determination that only a judge can make 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.
Finally, 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.
Which debt is under your name?
Maybe you don’t know what debt is currently outstanding in your own name. If that’s the case, you should obtain a free credit report from www.annualcreditreport.com.
Each of the three credit bureaus (Equifax, Transunion, and Experian) must 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.
Debt Consideration #3: Can you pay off the debt before your divorce is final?
Many times, there are enough assets to pay off revolving debt, such as joint credit card debt or lines of credit. If that’s the case, you might consider paying off those joint 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?
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 plan or 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, you’ll pay taxes on any capital gains at preferred tax rates.
What type of debt are you looking to pay off?
Most people should pay down their debt 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. Student loans usually belong 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.
Debt Consideration #4: 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.
Why you might want to pay off the balances.
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. If they never focused on correcting the behaviors that got them into trouble in the first place, they’ll have a hard time in the future.
This is especially true for people who wipe out their debt responsibility with a windfall, like a bonus or tax refund. So keeping a clean slate helps the responsible spouse identify where he or she is no longer involved.
Limiting the ability for one spouse to engage in destructive spending. Many marriages end on negative terms. In some cases, a spouse might want to do destructive things out of spite. Sometimes, that might include hiding assets, or spending a lot of money.
Why you might NOT want to pay off the balances.
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 good credit on their own.
Loss of financial flexibility. This is particularly important, since both former 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. For example, if someone isn’t receiving spousal support, then not having access to credit could put them in a more difficult situation.
Debt Consideration #5: How does this match up with dividing your marital assets?
The decision to pay off debt should make sense when put next to your plan to separate property. You would do this on your equitable distribution worksheet, which shows all of your assets, and all of your financial obligations.
That way, you can agree to a fair division of property and a fair division of debts. From there, you would jointly decide what debt to pay off, if there’s too much debt to completely eliminate.
If there is enough liquidity to pay off the ‘bad debt,’ such as credit cards and signature loans, it might be a good idea to pay it down. However, if you have to sell stocks or mutual funds to pay off the debt, it might not be the best way. Here are some things to consider:
Personal property vs. real property
Personal property, like cars or furniture, usually go down in value over time. Real estate usually will go up over time. But if the house comes with a huge mortgage, then you might be better off selling it instead of keeping it in the name of the spouse. That way, you also get rid of the mortgage payment.
Do you have a prenuptial agreement?
If so, then you might have most everything covered. But things might be different at the time of divorce than they were when you first got married. So make sure to talk with your divorce attorney about how your prenup impacts your situation.
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 proceedings will make it easier for both spouses to move forward.