Tuesday, April 1, 2008

How Not to Pay off Debt

I don’t like debt. I’m currently debt free except for my mortgage and I hope to be completely debt free in five years. I paid off debt by downsizing and spending less. There are plenty of good ways to pay off debt but there are also dumb ways to pay off debt.

Avoid 401(k) withdrawals. If you take money out of your 401(k) then you will pay fees. You will pay taxes on your withdrawal plus a 10% penalty. Ouch!

Don’t borrow against your 401(k). When you borrow money from your own 401(k), you usually must pay back the money with interest over five years. This sounds like a good idea because you are paying yourself the interest. There are a few drawbacks. If you leave your current employer for any reason, you will probably have to pay the loan back immediately or face the fees of an early withdrawal. The money you withdraw will also no longer be appreciating in value so you lose the impact of compounding interest. The money used to repay your loan is also not tax sheltered. A primary advantage of a 401(k) is the tax shelter. When you repay your 401(k) loan, those payments are made with after-tax dollars. Then when you take withdrawals at retirement, you pay taxes again.

Don’t borrow against your home. Don’t use a home equity loan or home equity line of credit (HELOC) to pay off debt. Your home is used as collateral with these loans. If you aren’t able to pay back your loan then the lender can force you to sell your home.

Unfortunately, these are common strategies people use to get out of debt. I personally know several people who have used these tactics. I am writing this article today to hopefully persuade others from making the same mistake.

4 comments:

JB said...

And really, the last two ways you mention are just paying debt with debt. You're taking on more debt so you can pay debt. This are dumb ways. Good post!

Kristen Zirkle said...

Yeah, you would think these would be self-explanatory but I think people feel hopeless and desperate sometimes.

MoneyBlogga said...

You are totally right about borrowing against a 401K. I have big regrets about that one and shudder to think about the money that should be mine (employer match) and isn't.

loan modification said...

Great post. your article is very informative and worth the read. keep on posting.

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