5 of the Most Foolish Ways to Pay Off Debt
When you’re trapped in debt, it can be tempting to do whatever it takes to get out from under the burden. But before you start thinking about selling a kidney on the black market to repay your student loans, take a step back. While a desire to get out of debt is commendable, there are good and bad ways to satisfy your creditors. Before you take a loan from your 401(k) or transfer the balance on your credit card, make sure you understand all the pros and cons of these get-out-of-debt strategies.
1. Cashing out your IRA
You have $10,000 in debt and $35,000 in your IRA. The solution to this problem seems easy and obvious – just take the money from your savings and you’ll be debt-free. Not so fast. Though there may be a few instances when raiding your IRA to pay off debt might be wise – such as to avoid losing your home – it should be an action of last resort, never your first move.
Cashing out your retirement account has some big financial implications. Not only will you have to pay taxes on the money you withdraw, you’ll also have to pay a 10% penalty, with a few exceptions. (Roth IRA contributions, but not earnings, can usually be withdrawn without penalty.) So to pay off $10K in debt, you’d actually need to withdraw more than $10,000 from your IRA in order to cover both the taxes and the penalty. Plus, swiping $10,000 from your IRA now could also mean tens of thousands of dollars less when you retire because of lost investment growth.
If you’re eyeing your IRA balance with the idea of using it to pay your debts, talk to a financial professional before you do anything. There may be other ways to clear your obligations, such as curtailing your spending or taking on a second job, without touching your retirement savings.
2. Borrowing from your 401(k)
Raiding your IRA may not be wise, but it’s possible. Cashing out your 401(k) is a bit more difficult. Unless you’re facing an extreme financial hardship or are changing jobs, your savings in an employer-sponsored retirement account are off-limits – sort of. Most 401(k)s do let you borrow from your balance and pay the money back a fairly low interest rate, and it can be tempting to seize this option if you need to pay down debt.
Part of the appeal of a 401(k) loan is it’s easy to get. As long as the money is in your account, you should be able to borrow against it, regardless of your credit score. Plus, the interest rate is often quite low. But a 401(k) loan comes with a big catch: If you quit or are fired, you usually need to pay back the remaining balance withing 60 days or get hit with a 10% early withdrawal penalty. If you can get money in other ways, like taking out a personal loan, consider those before borrowing from your 401(k).
“Many people don’t have enough saved for retirement in the first place, and when they take their 401(k) out of the equation and borrow the money – typically up to 50 percent of their balance – then that money is no longer working for their retirement needs,” financial planner Bob Mecca, president of Robert A. Mecca Associates, told Bankrate. “And the money is no longer growing, compounded and tax-deferred.”
It’s one thing to buy the occasional Powerball ticket with the idea that if you hit it big, you’ll pay off what you owe. But it’s another thing entirely to see gambling as a path to a debt-free lifestyle. Simply put, the odds aren’t in your favor. While a lucky (or talented) few might be able to beat the house, betting your financial future on the roll of a die just doesn’t make sense. In the worst-case scenario, you end up much deeper in debt than you were before.
Phil Goss learned the hard way about the risks of gambling to pay down debt. At first, playing online poker seemed like a smart way to pay down his student loans. But a big loss forced him to rethink his approach. Poker was “a fun hobby, but not a means of making student loan payments,” he wrote in a blog post for The Money Side of Life.
4. Loans from family or friends
A loan from the bank of mom and dad may seem like the perfect solution to your financial problems, but borrowing from loved ones to pay down debt can have some unintended consequences.
First, the pros: Loans from people you know are often cheap and easy to access. A friend or family member may lend you more money at a lower rate than you could get from a traditional financial institution. Plus, the loan won’t hurt (or help) your credit score. But those funds may come with unique strings attached. The person supporting you financially may feel they now get a say in other major financial or life decisions you make. If you struggle to pay back the loan, it can put strain on the relationship, and may damage it permanently if you default.
If you do borrow from someone you know to pay your debts, make the process as formal as possible. Put everything in writing and establish clear terms and conditions regarding interest and payback. Making sure everyone is on the same page from the get-go can avoid confusion and bad feelings later on.
5. Balance transfers
If you’re deep in credit card debt, those 0% balance transfer offers look pretty appealing. Why wouldn’t you want to move your debt from one card to another and pay less interest in the process?
The desire to cut your interest rate is smart, and a balance transfer can be a good way to do that, though you should proceed with caution. Zero-interest balance transfers aren’t free, for one, and you can expect to pay about 3% of your balance in fees. Plus, teaser interest rates don’t last forever. If the post-introductory-period interest rate on the new card is higher than what you pay now, switching may cost you more money in the end.
Balance transfers as a debt pay-down method can also mask a larger problem with spending and budgeting. (Not to mention, constantly opening new cards will ding your credit score.) If you’re in the habit of chasing down 0% card offers and are moving your balance around every few months, it may be time to take a closer look at how you’re managing your money and consider other debt payment options.
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