Many Americans are determined to pay off their debts, but they aren’t quite sure of the best way to go about doing so. After all, how you go about eliminating your debt is just as important as the end result.
Certain debt repayment strategies are riskier than others and can actually set you back farther from your financial goals than when you started. With that in mind, it’s generally best to avoid these five risky debt repayment strategies.
Using Retirement Savings
As CNBC reports, about one-fourth of Americans aged 18 to 34 report making an early withdrawal from their 401(k). The top reason for doing so was paying off credit card balances.
It makes sense that your first instinct may be to dip into your 401(k) during a debt crisis. The fund is just sitting there — and you may rationalize doing so with the thought you can just build it back up before you retire.
But the downsides are numerous: You’ll typically face a penalty for making early withdrawals and may have to pay state and federal income taxes on funds withdrawn. You’ll also miss out on the true power of compound interest, or the phenomenon in which your money grows exponentially the longer your contributions stay in the account.
Borrowing Against Your Home
Homeowners may find themselves tempted to use home equity to pay off debt through a loan or line of credit. But it’s very risky to use a secured asset like your home to pay off unsecured debt like credit card balances or medical bills. Why? Because you could lose your home if you miss payments on that home equity loan. Failing to pay unsecured debt, on the other hand, typically only results in damaged credit and annoying collection calls.
Putting your living situation and sense of security in jeopardy for unsecured debt is generally unwise.
Taking Out a High-Interest Loan
It’s generally pretty easy to get approved for a loan these days — even a bad credit loan. But there are certainly risks involved: You may end up paying higher interest rates on a consolidation loan than you were paying on your original debts. Payday loans are notorious for charging exorbitant interest rates capable of pulling people into an even deeper debt cycle. Jumping into a consolidation loan hastily may also result in you working with a less-than-scrupulous lender.
Debt consolidation has helped many people simplify their debts and reduce how much they’re paying in interest. But making the most of this strategy requires doing your research up front, avoiding loans with sky-high interest rates and working only with reputable lenders. Otherwise you may find yourself in hotter water than when you first tried to consolidate.
Keep Transferring Credit Card Balances
Transferring the balance on a high-interest credit card to a new card with no interest can provide a temporary introductory period in which to pay down your balance without accruing interest — often six months or a year. You’ll pay a low percentage of your balance per transfer. The idea here is that you’ll get some breathing room to aggressively pay down your existing balance without new interest.
However, you may have to pay full interest per the terms of the card on any new purchases you make. Read the fine print before transferring and avoid making this tactic a continual habit to outrun interest.
Make Only Minimum Payments
Making minimum payments technically keeps late fees and delinquency at bay — but it also extends the life of your credit card balance and the amount of interest you’ll pay substantially. Treat this strategy like “treading water” to stay afloat when what you really need is a strategy that’ll act more like a life raft or, better yet, a speed boat.
Some debt repayment strategies are riskier than others, meaning you should only use them as a last resort — if ever.