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.

Dave Ramsey’s Debt Snowball

I’m a fan of Dave Ramsey’s debt payment approach called the debt snowball. The approach is simple. Pay off your smallest debt first. Then once that debt is paid off, move to your next smallest debt. Mathematically, I agree the debt snowball approach often does not work in your favor. Paying off your highest interest rate first will ultimately save you more in interest payments. But Dave Ramsey’s debt snowball is all about momentum and psychology.

"The math seems to lean more toward paying the highest interest debts first, but what I have learned is that personal finance is 20% head knowledge and 80% behavior. You need some quick wins in order to stay pumped enough to get out of debt completely. When you start knocking off the easier debts, you will start to see results and you will start to win in debt reduction.”
- Dave Ramsey

Do you agree with the debt snowball approach? What approach do you prefer to pay off debt?