Carrying around high interest debt is like living in a financial black hole. You throw money at credit card bills each month but the balances never seem to go down. You want to sock away extra money for retirement and other financial goals but there just never seems to be any cash left once you’re done feeding the debt monster.
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To successfully pay off debt, you must have determination, patience and a solid plan. What seems like a quick fix could actually end up costing you more in the long run, so you need to be on the lookout for potential money missteps. Here’s a look at four of the worst ways to try and dump your debt:
1. Tapping Your Retirement Account
If you’ve got a healthy balance in your 401(k) it can be tempting to withdraw part of the money to pay off debt. After all, you’re borrowing from yourself so it can’t really hurt, right? Not so fast.
Borrowing against your retirement is a surefire way to sabotage your long-term savings strategy. While it’s true that you’re putting the money back into your own account, you’re also missing out on any growth you could have potentially seen if you’d just left your nest egg alone. If you’re borrowing a sizable chunk of cash, you run the risk of coming up short when it’s time to leave the 9 to 5 behind.
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You also can’t afford to overlook the fees, interest and penalties you may have to pay when you take borrow from a 401(k). Typically, there’s a loan origination fee and you’ll have to pay back the interest within five years. If you leave your job, you’ll have to cough up the remaining loan amount in full. And you shouldn’t forget about Uncle Sam. If the money becomes a distribution you’ll have to pay taxes on what you took out, plus a 10 percent early withdrawal penalty if you’re under 55.
2. Borrowing Against Your Home Equity
Prior to the housing collapse, home equity loans and lines of credit were heavily marketed by banks as a way to finance renovations, pay off debt with high interest and fund other expenses. While these loans tend to offer much lower interest rates than other types of personal loans, cashing out your home’s equity to pay down debt could have you feeling the pinch later on.
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When you take out a home equity loan or do a cash-out refinance, you’re essentially trading in all your smaller debt payments for one larger payment, albeit at a lower rate. That might be fine for now but what happens if you lose your job or an unexpected illness keeps you out of work? You end up running up your credit cards again to pay the bills because you can’t keep up with the higher mortgage payments. Before you know it, foreclosure is looming. When it comes to your home equity, a hands-off approach is best.
3. Taking Out High Interest Loans
Consolidating your credit cards or other debts into a single loan can potentially help you save money but only if you get a low rate. Taking cash advances from your credit card, borrowing against your car title or taking out a payday loan are all big no-no’s when you’re trying to consolidate debt.
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In fact, using a payday loan to pay for anything is one of the worst money moves you can make. Even though these loans promise quick cash, the interest rates you’ll pay far exceed anything you might have to pay for a credit card. Rates can be as high as 400 percent and many borrowers find themselves trapped in a vicious cycle when they start rolling the loans over. This is not a smart long term move to pay off debt.
4. Hiring a Debt Settlement Company
Turn on the TV and you’ll see plenty of commercials for companies that promise to help you pay off debt for just pennies on the dollar. Debt settlement ads offer a quick way out of the debt hole but they tend to gloss over the potential drawbacks of working with one of these companies.
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For one thing, debt settlement companies typically charge hefty fees for their services and there’s no guarantee that you’ll get the settlement you want. The commercials also typically don’t mention the damage that you’ll be doing to your credit score in the long run. As a general rule, creditors won’t settle until you’re significantly past due which means your credit is likely to drop pretty drastically. You should also keep in mind that you may have to pay taxes on the part of the debt that’s forgiven.
If you need help getting a handle on your debt, you’re better off contacting a nonprofit credit counseling agency for advice. These agencies can go over your budget and help you figure out the best strategy for repaying what you owe.
Being mired in debt can make you desperate to get out. But you need to tread carefully when it comes to paying it down. There are plenty of wrong ways to pay off debt and being able to recognize some of the worst culprits can go a long way towards helping you achieve debt freedom.
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