Get Out of Hock

By Daniel Kadlec

Whiffs of inflation are in the air, and a dead-tired stock market is sending the message that economic troubles lurk. It hardly seems possible that prosperous times will soon fade. Profits are up, and record numbers of Americans are at work. Yet the paradox of a market economy is that stock investors get scorched near the end of a robust expansion, while good times still roar. The reverse is true at the trough of a recession, when times are toughest.

Is the nose-diving NASDAQ forecasting a recession? No one knows. But the Federal Reserve will raise short-term interest rates this week, possibly by a hefty 0.5 percentage point. I'm not suggesting anyone hit the panic button. But a steady rise in interest rates is how good times often end. Given that the Fed has been boosting rates since last June--mortgages are the costliest in five years--why not use today's prosperity to pay off debt?

On a grand scale, that's what the Federal Government is doing--using windfall tax receipts to cut the national debt by a record $185 billion this quarter. The interest savings, in effect, provide a reserve for bumpy times--notably when baby boomers start drawing heavily from the Social Security system in about 15 years. The government doesn't often shine when it comes to budget matters. But in this case, Congress's lead is worth emulating.

Do Americans have a debt problem? Big time. Nearly 14% of our disposable income goes to repay loans, the highest level since 1986, according to economist Cynthia Latta at Standard & Poor's. Credit-card debt and total household debt are at record highs relative to personal income. Even if you sweep aside thoughts of recession, it still makes sense to pay down debt as rates rise. Most debt, including credit cards, home-equity lines and many mortgages, carries variable rates, so your costs will be increasing.

What to do? First, stop that exuberant spending. Then add all your minimum monthly payments and figure out how much more you can put toward debt repayment. That total should remain constant. List your nondeductible debts in order, with the highest rate on top. Pay that one off first, and pay the minimum on the others. Move down the list until all nondeductible debts are gone. Then start on deductible debts. Target loans with floating, not fixed, rates when the rates are similar.

Avoid new debt if you can, and explore alternatives if you can't. For instance, you may be able to find a moderate fixed-rate credit card. That beats transferring your balance to a new card with a low teaser rate every few months. Most people fail to stay on top of that strategy, and many teaser rates don't apply to an old balance anyway. Home-equity lines of credit are easy to get, but the rate usually floats. Consider instead a fixed-rate home-equity loan for a one-time consolidation of debt. Beware though. Some lenders let you borrow 150% of your house's value. That puts you in jeopardy of losing the house if you can't make payments, and interest on amounts exceeding the home's value are not deductible.

Finally, you may want to sell some of your stocks to pay down debt. After all, if you have credit-card debt at 18%, your stocks must rise faster than that because of taxes just to break even. And those days are numbered.

See time.com/personal for more on paying off debts. E-mail Dan at [email protected] See him Tuesday, on CNNfn at 12:45 p.m. E.T.