Why You Should Not Use Home Equity to Pay Off Debt
Getting out of debt is a major financial goal for many people. While it’s important to reduce your debt load and try to begin creating wealth it’s also important that you take the right steps toward repaying your debt. In fact, there are a few common methods people use to help them get out of debt that can end up doing even more harm than good. Here are a few things you may want to think twice about in your quest to become debt free.
Don’t Use Home Equity to Pay Off Credit Cards
Not long ago using the equity in your home to finance everything from vacations to consolidating debt was all the rage. On paper, it often seems like a good idea because you’re able to tap into some hidden money at an affordable low-interest rate. And when it comes to consolidating credit card debt this seems like a no-brainer. If you can get rid of all the high-interest cards and make one single payment that has a nice low rate that would be a good thing, right?
Not so fast. The big problem with this method has to do with the difference between secured and unsecured debt. Credit cards are unsecured meaning there is no collateral backing the card. If you fail to pay off your credit card you might have to put up with collection calls and damage to your credit score, but that’s about the extent of it.
If we’re talking about a mortgage or car loan we’re dealing with secured debt. This just means that the underlying asset is used as collateral for the loan. Now if you fail to make payments the bank is going to take your house away. If you can’t repay the home equity loan or line of credit you might be forced to sell the house so the bank can recover the money. As you can see, if you use a home equity loan to pay off your credit cards you just traded in that unsecured debt for secured debt and you could lose your home if you can’t keep up with payments.
Don’t Tap Into Your 401(k)
If you have a 401(k) plan at work there’s a good chance that you’re allowed to borrow from it with a loan. These loans often seem like a good idea because you’re just borrowing some of your own money and paying it back over time. So, you can essentially borrow money with attractive terms, pay off your high-interest debt, and then in a few years have your 401(k) replenished. Again, it seems like a good strategy at first, but there are plenty of problems with this idea.
First of all, this money is meant for retirement and it needs time to grow. If you borrow money from your retirement plan you’re essentially taking it out of whatever it was invested in and missing out on any potential interest or growth it might have otherwise seen. Even if it doesn’t seem like a big deal at the time it can have significant consequences in the long run.
The other things to consider are the consequences if you leave or lose your job. Most of the time these loans will need to be repaid in full within 60 to 90 days after termination. If the loan is not paid in full it will be treated as a distribution. Distributions are taxable and if you’re under age 59.5 they are subject to an additional 10% early withdrawal penalty. This could leave you owing the IRS 30% or more on your loan. Ouch! This could result in an unexpected tax bill totaling thousands of dollars.
If you have an old 401(k) from a past job it’s tempting to cash it out and use the money to pay off debt. Again, by doing this you’re putting your retirement in jeopardy by reducing how much money you have invested and working to grow. Not only that, but the same taxes and penalties would apply so you could be throwing 30% of your money away.
Better Ways to Pay Off Debt
While using the equity in your home and raiding your retirement nest egg aren’t the best ways to pay off debt there are still plenty of good alternatives.
First, create a budget. The single best thing you can do to help you pay down your debt is to create a realistic budget that frees up some extra cash that can be applied to your credit card payments. There is more free money in your budget than you think, so look for ways to find some of that hidden cash.
Next, you need to make more than the minimum payment each month. When you make just the minimum payment on your credit card you’re doing little more than paying finance charges. This means you’ll be repaying this debt for many years.
Finally, you should be living below your means. If you find yourself in credit card debt there’s a good chance that you were living beyond what you could afford. By adopting a lifestyle that requires spending less money than you make you’ll be well on your way to financial security.