Making sure you can maintain control of your money.
When you’re struggling to make ends meet because of debt, you need to find a solution that allows you to get back on track as quickly as possible. Of course, if your payments are too big and interest is making it impossible to make a dent in what you owe with a simple budgeting strategy, then it’s going to take more aggressive action to get ahead.
What you don’t want to do is make your situation worse – and if you’re not careful, that’s exactly what you can do. You can also hurt your financial future by taking steps that help you now, but hurt you in the future. It’s like robbing Peter to pay Paul.
So while you want to do everything possible to get ahead of debt, you don’t want to take any actions that are going to do more harm than good in your financial outlook. With that in mind, here are six things you should avoid as you seek debt relief.
True or False: If you have to go through an accredited debt elimination program to reduce your debt, it always damages your credit.
A debt management program through a credit counseling agency may not damage your credit. In fact, consumers with bad credit have actually seen their credit improve by completing a DMP.
Bad Idea No. 1: Cash out your savings
This is almost always a bad way to solve debt problems, because you are destroying the savings you’ve worked so hard to build. The only time you should ever touch any savings to pay off debt is if you have an actual financial safety net to draw from. This is where you have at least 12 months of budgeted expenses saved in reserve for unemployment or expensive life events.
If you have money in savings (not retirement accounts, which we’ll get to later) then you can use it, but by and large most people do not have that kind of money just set aside in a regular savings account.
Fact: Cashing out savings/investments almost ALWAYS causes you to lose growth with compound interest.
Even if you do have 12 months squirreled away in a regular savings account, you should still be cautious. That money is supposed to be your emergency fund in case there’s a change in your financial situation. If you spend the money to reduce debt and then get laid off, there won’t be anything left to help you get by until you find another job. In a best-case scenario if you do have the 12 months saved, don’t take out more than six months of that savings to pay off debt so you at least have some protection.
Bad Idea No. 2: Cash out your investments
Keep in mind there is a difference between stopping your current investing and cashing out your existing investments. The latter is a bad idea when it comes to debt relief, while the former may provide a means to reduce your debt safely.
Consider if you make regular contributions to investments, such as $100 per month to an IRA. If you stop investing that money temporarily and use it to pay off $100 extra of debt each month, you could pay off over $15,000 in just 3 years. At the same time, the investments you’ve already made are left intact so they can continue to grow.
Bad Idea No. 3: Cash out your 401(k)
Although you can borrow up to 50 percent of the value of your 401(k) or up to $50,000 if you have a sizeable 401(k) established, you should leave your retirement money alone. First, you usually have to pay the money back within five years or face paying taxes for an early withdrawal. You also lose the growth for all the years the money was gone.
Removing money from your 401(k) is effectively stealing money from yourself — just a future version of yourself. After you reach retirement age, you’re probably not going to be happy if you have to keep working or maintain a part-time job because you don’t have enough money available.
Bad Idea No. 4: Borrow against a life insurance policy
If you have a policy that has cash value, you may be able to borrow against it, but that doesn’t mean you should. Effectively, you are creating another debt to pay off the debts you’re having problems with now.
In addition, if you don’t pay it back or die before the loan is paid off, the amount still owed plus interest will be taken out of the money your family receives on the policy. This can make it harder for your family to pay for hospital and funeral costs, as well as finding stability without you there.
Bad Idea No. 5: Borrow from friends / family
Unless you want to lose your friend or never want to speak with that family member again, don’t ever borrow money from someone you know personally. You should always keep your finances separate from friends and family, because money tends to ruin relationships.
If you take out a debt consolidation from a bank to pay your debt back and then can’t pay the bank, there will be financial fallout. However, if you don’t pay back your brother or best friend, you could lose that relationship in the process. It can also cost everyone extra time and money in court.
Bad Idea No. 6: Borrow against your home
Credit card debt is unsecured. That means that as much as collectors might threaten about it, they can’t take your home or assets to pay off what you owe without a court order. So unless the creditor sues you over the debt or you have a bankruptcy judgment ordering you to sell, then your property is yours and can’t be touched.
This is why it’s crazy to take out a home equity loan just to pay off your credit cards. You’re putting your own home at risk of foreclosure!
A home equity loan means you borrow against the value of your home to get money. If you don’t pay back the loan, the bank takes your property. So it’s almost never worth it to use this kind of loan to eliminate credit card debt. You should only take out unsecured debt consolidation loans to pay off debt.