4 Mistakes to Avoid When Paying Off Debt
If you’re paying down your debt, then you know it’s a challenging undertaking. And if you’ve got a lot of debt to work through, it can also be a lengthy one, which is why it’s tempting to look for ways to speed up the process. However, in doing so you will encounter options that seem to be a shortcut to dumping your debt, but in the end, could cost you both money and time.
As you make your way to debt-freedom, beware of these four mistakes that could set you back:
1. Not Having an Emergency Fund
In an attempt to put as much money as possible towards your debt, you may be inclined to forgo having an emergency fund.
This decision could hurt you. An emergency of some kind — whether it’s unexpected car repair or a medical expense — is likely to occur while you are paying off your debt. If you’re not prepared, you may end up going deeper into debt. A Bankrate survey showed that 36 percent of Americans would either borrow from friends or family, take out a loan, or use credit cards to handle a $1,000 emergency.
Avoid this mistake by maintaining a small cash cushion while you are paying down your debt.
2. Taking Out a Home Equity Loan
The lure of taking out a home equity loan or line of credit to pay off your consumer debt can be quite appealing — you can “wipe out” your credit card debt and other payments in one fell swoop, in exchange for a single payment at one interest rate. This can make your debt situation feel more organized and less overwhelming.
But this can turn out to be a mistake, on many levels. For starters, you are clearing your unsecured debt but increasing what you owe on your secured debt. Should you have trouble paying your home equity loan, your home could be in jeopardy.
Additionally, you could be increasing what you pay in interest if you use the home equity loan to pay off medical and other bills that had zero interest, or a lower rate than the new loan.
Most importantly, it’s a mistake because you aren’t actually reducing your debt — you’re just moving it around. If you wipe out your credit card debt and other payments without addressing what caused you to go into debt, it’s likely just a matter of time before you run up those balances again.
3. Borrowing From Your 401(k)
Another tempting debt solution is to borrow from your 401(k). It goes without saying that doing this goes against the very reason you contributed to your 401(k) in the first place: To provide a secure financial future for yourself. Borrowing from it unplugs money from that goal and causes you to miss out on the benefit of compound interest.
Even though you will be required to pay the loan back with interest, the interest is coming from you, so there is no actual gain there. Plus, the money you use to pay the interest is subject to double taxation since you’re paying the loan back with after-tax dollars and will be taxed again when you take distributions.
Furthermore, should you be fired from your job or resign, you will have to pay the loan back within a specific amount of time, usually 60 to 90 days; otherwise, the loan balance will be considered a taxable distribution and will be subject to a 10 percent penalty if you are under age 59 1/2. This scenario will only make your debt situation worse.
4. Falling for a Debt Relief Scam
Many companies tout their ability to reduce your debt. And the promises they make can seem like the answer you're looking for.
But beware. While some reputable businesses do offer credit counseling and related services, there are several companies whose primary purpose is to take your money. Others do attempt to reduce your debt but use questionable practices like holding your payments aside for several months, thus putting you in a position where you are so behind on your bills that your creditors are willing to negotiate. This can reduce the amount you ultimately pay on your bills, but potentially endanger your credit.
One way to spot a scam is to see when they ask you to pay: If a company requires payment upfront, you are likely being conned. Another red flag is if they promise a specific outcome, as no one can guarantee what concessions your creditors will be willing to make. Let conventional wisdom guide you here — if it sounds too good to be true, it probably is.
When you’re overwhelmed by debt, it’s understandable to want a quick or immediate solution. But keep in mind that you did not go into debt overnight, so it’s not likely that you’ll be able to get it out of it so quickly, either. If you want to make sure you get out of debt for good, you might want to skip the shortcuts.