Although carrying around debt is almost as American as apple pie, you shouldn't hold onto it forever.
Eventually, you'll want to pay off those debts to help free yourself from the financial burden that debts can cause.
There are both good ways and bad ways to pay off debts, but sometimes the bad advice gets pushed more heavily than it should. Before you start attempting to whittle away your debts, make sure you avoid these eight wrong ways to pay off debt.
1. Using Payday Loans
In the world of debt, payday loans can make credit cards look like a good value. These loans, which are usually unsecured cash advances for small amounts of money, are so bad that they've been outlawed in six U.S. states and the District of Columbia. Most other states heavily regulate how much payday lenders can offer, limit the length of the loan period and limit the finance charges allowed.
Payday loans are considered predatory in most places, even where they aren't banned. Lenders tend to target individuals who have limited or fixed incomes, including the elderly drawing Social Security.
Even still, where they are legal, the average payday loan interest rate is nearly 400% of the loaned amount. In several states, including Texas, the average interest rate is over 650%.
It's tempting to take out a payday loan, especially since the money is easy to acquire. But if you're living on a fixed or limited income, the high interest rates and the added risk of owing four to six times the amount you borrowed is riskier than your debt.
2. Borrowing Too Much From a Home Equity Loan
A home equity loan can be an excellent, low-interest way to access money quickly. However, it's never a good idea to borrow too much from your home equity. This type of loan uses your home's value as collateral. Failure to pay the loan could not only lower your credit score, but could also give your lender room to take your home.
If you do plan to use a home equity loan, focus primarily on using it toward something that will increase in value over time or pay dividends. One common example of a use for a home equity loan is if you need cash for home improvement projects, which can increase your home's resale value. Even then, make sure you avoid borrowing more than your home is worth, or you may still owe on the loan even after you sell the house.
3. Taking Out a Title Loan
Title loans work like home equity loans, but you use your car as collateral in exchange for money. If you fail to pay, you could lose that property. Unlike home equity loans, however, title loans have a much higher interest rate. You may pay 300% or more in interest, which increases the risk your vehicle will be repossessed.
4. Consolidating Debt Into a High-Interest Loan
Debt consolidate can make sense in some situations. For older Americans who still carry thousands of dollars in non-mortgage debt, consolidation can make it easier to manage where payments are going. Yet similarly to credit card debt, this is not a good practice if you're just shifting the debt to a loan with high interest.
Debt consolidation can offer the convenience of reducing the number of lenders you're paying each month, but it could result in overall higher payments. Make sure you read the interest rate details and compare them to your other debts. Look at the total long-term cost of paying the consolidated debt. If it's higher than keeping your debts where they are, you may want to avoid consolidating.
5. Using a Debt Settlement Firm
Debt consolidation firms can be good, especially if you're having trouble with crippling debts. But using these companies may be expensive, and it could destroy your credit score.
Debt consolidation companies will usually tell you to stop paying your debts, which will cripple your credit score. And they may not be successful in settling your debts. If that happens, you'll still have your debts, with the added bonus of a lower credit score, the fee you still have to pay the consolidation company, and the continued risk of bankruptcy.
6. Borrowing From a 401(k)
When you hit retirement, your 401(k) should be one of your income lifelines. Although the money in your 401(k) is technically yours, borrowing from it isn't free. All 401(k) loans incur a fee and a repayment interest rate. You also lose the value that the money would have accrued had it remained invested in the portfolio. The lost compound interest potential could make borrowing from the loan more expensive than it's worth.
7. Be Cautious Using a Credit Card to Pay Debts
There are some situations where it's OK to pay off debts using another form of debt. Credit cards aren't one of them.
Of the many types of debt you might accumulate, credit cards are among the worst. In fact, credit cards are often listed at or near the top in the "bad debt" category. According to the Federal Reserve, the average credit card interest rate was more than 15% in the first quarter of 2020 but often shifts above that. Few other debts have a higher interest rate, so if you're using a credit card to pay down other debts, you may end up paying more on that debt and end up kicking the can down the road.
The only caveat here is if you pay off your credit card balances at the end of each month before they accumulate any debt or have an APR term that eliminates interest. If you only pay the minimums, you only increase your debt burden with a credit card.
8. Transferring Credit Card Balances
An overwhelmingly common, but often bad practice for paying off overdue credit cards is to transfer that balance from one card to another. The new card may have a lower interest rate at first, but that rate could increase down the road.
Don't transfer a credit card balance without reading the fine print. You may have to pay a 3% to 5% fee just to transfer the amount. And if you don't pay off the debt soon enough, the interest rate may jump to a level that's higher than what you had with the previous card.
Carrying debt can be a problem, but trying to pay off debt the wrong way can make matters worse. Avoid predatory lending, and when possible, don't pay your debts with borrowed money. Instead, speak to a certified debt counselor (which is different from a debt settlement company), or use well-regarded debt payment methods to help work through what you owe.
Maxime Rieman is Product Manager at ValuePenguin. Educating and assisting shoppers about financial products has been Rieman's focus, which led her to joining ValuePenguin, a consumer research and advice company based in New York. Previously, she was product marketing director at CoverWallet and launched the personal insurance team at NerdWallet.
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