There’s nothing fun about debt. Depending on how much you owe, the impact can be disastrous to your FICO score and monthly payments can eat at your extra income.
If you’ve been paying on debt year after year with no end in sight, you might be eager to give your creditors the boot. But being desperate doesn’t mean you should consider any and every possible solution. Here are six worst ways to pay off debt.
1. Pawning your valuables.
If you have items of value, such as jewelry, musical instruments or electronics, you may view a pawnshop loan as your ticket out of debt. This approach might get you closer to a zero balance but it can also create problems for you.
Your personal items are nothing more than collateral for a loan, and you’re given a specific length of time to pay back the pawnshop. If you don’t repay the loan, you lose your items.
It’s a dangerous, risky plan because in all likelihood you won’t have cash to pay back the shop. For quick cash for debt repayment, you’re better off selling items you don’t need to a pawnshop.
2. Hitting up friends or family for a loan.
If you have family or friends with money, what you owe might be a drop in the bucket for them. You may be tempted to ask someone for a low or no-interest loan to get creditors off your back and enjoy some breathing room. But things can get rocky when you mix money and friendship.
If you have difficulty paying your creditors, who’s to say you won’t have similar problems paying back a relative or friend. This person may outline specific terms, and you may mistakenly agree to these terms without fully considering whether they’re doable. Failing to fulfill your end of the agreement might create an irreparable rift between you and the other party.
3. Thinking of your 401(k) as easy money.
It’s tempting to dip into your retirement account to pay off debt, but while the money is readily available, this might not be the best move for your personal finances. A 401(k) loan isn’t a freebie. You have to repay the loan plus interest within five years and there’s the loan origination fee.
Your take-home pay will be less while you’re repaying the loan, and if you leave your job before paying back a 401(k) loan, you must immediately repay any remaining balance. If you can’t repay the funds, the loan becomes a distribution, at which time you’re hit with a penalty and the withdrawal is subject to income taxes.
4. Gambling with your home’s equity.
If you’re sitting on a mountain of equity and you don’t plan on selling your house, borrowing against your equity or a cash-out refinance can put extra cash in your hands. And with this cash, you can pay off debt. This is an effective approach, but extremely risky if you don’t know how to control your spending.
Using your home’s equity to pay off debt increases how much you owe the mortgage lender, which subsequently increases your monthly payments. Not the worst thing in the world if you can afford the higher payment. But too often when people use home equity to pay off debt, they re-accumulate the debt in just a few short years. This puts them back in the same situation, but only this time, they’re also dealing with a higher mortgage payment. For those who can’t keep up, there’s a greater risk for foreclosure.
5. Using a debt management company.
They promise to negotiate better rates with your creditors, which lowers your monthly payments, and sometimes, they deliver. But while a debt management company can get your finances on track, using a third-party can have a negative impact on your credit.
Working with a debt management company won’t lower your credit score per se. But if your existing creditors agree to modify your terms, they may report “third-party assistance” to the credit bureaus. Any potential creditor checking your report will see that you sought help to manage your accounts, and based on this revelation, they may decide not to approve your application for a loan or credit card.
Additionally, a debt management company is only as good as the person handling your account. You may submit your payment to the company each month, trusting that the company will pay your creditors on time. But there are no guarantees, and if the company pays your creditors late, this can damage your credit score.
Also, debt management can be costly, with some for-profit services charging upfront fees and monthly service fees. But the truth is, you might be able to get a better rate by calling creditors yourself. If your account is in good standing, there’s a good chance that your creditors will comply with this request.
6. Not paying off a balance transfer within the introductory rate period.
A zero percent rate on a balance transfer is an effective way to get rid of existing credit card debt, but only if you’re able to pay off the card within the introductory rate period.
Balance transfers can be iffy for two reasons. First, there’s a balance transfer fee, about 3% of the amount of each transfer. Second, there is no way to guarantee the cards interest rate after the introductory rate period. The credit card application provides a interest rate range, but it’s all subject to creditworthiness. And if you don’t pay off the balance transfer within the introductory rate period, you could end up with a rate higher than the rate on your previous cards, which pretty much nullifies any potential savings.