Being stuck in debt is no picnic. Getting rid of it as quickly as possible can free up money you need to work towards other financial goals. Figuring out why you want to get out of debt is important, but how you go about doing it is what really matters most.
There’s a right and a wrong way to slay the debt monster and if you choose the wrong path, you could end up costing yourself more in the long run.
1. Drain Your Retirement
If you’ve managed to build up a tidy sum in your employer’s 401k or an IRA, it can be tempting to tap into your savings to wipe out your debt for good.
While you’ll get the benefit of being off the hook to your creditors, you’re really only creating more problems for yourself in the long run.
There are some potentially serious tax implications of withdrawing money from a retirement account. If you take out a loan from your 401k, for example, you typically have to repay it within five years but the full balance is due immediately if you change jobs.
When you can’t come up with the money to pay it off, the whole thing gets treated like a regular distribution which means you’ll income tax on it when you file.
When a withdrawal from a 401k or traditional IRA occurs before age 59 1/2, a 10 percent early withdrawal penalty applies in addition to regular income tax.
You won’t pay taxes on withdrawals of your original contributions to a Roth IRA as long as your account’s been open for five years but taxes and the penalty do still apply if you pull out your earnings before hitting age 59 1/2.
2. Use Your Home Equity
Thanks to a rebound in the housing market, homeowners are starting to get back some of the value in their homes that was lost due to the great recession.
If you’re sitting on several thousand dollars’ worth of equity, you could easily take out a home equity loan or line of credit and zap all of your high-interest credit cards or remaining student loans.
It’s convenient to be sure, but it’s not without certain drawbacks.
Using a home equity line means you’re simply exchanging one type of debt for another. While home equity loans and lines of credit tend to carry lower rates than credit cards, that doesn’t guarantee that you’re going to save any money in the transaction.
If the loan has a variable rate or you’re only required to make interest payments for a set period of time, you may not make much progress if you’re not committed to dumping it as quickly as you can.
The other possibility with a home equity loan is that it could cause you to double up on debt if you end up building big balances on your creidt cards again.
If you get so financially stretched that you can’t keep up with the payments on the home equity line, it could end up costing you your home if the lender decides to foreclose.
3. Borrow against Your Life Insurance
While term life insurance tends to be the most affordable type of coverage, many people still choose whole life policies because they allow you to build cash value.
Just like with a home equity line, you can borrow against any equity that’s accumulated in the policy as you pay your premiums.
From a repayment perspective, borrowing against your life insurance is an attractive option because you may not be required to pay anything towards the principal.
You will, however, have to continue paying the premiums to keep your coverage in place. Life insurance loans do charge interest but it’s typically less than what you’d pay to borrow from a bank.
On the flip side, you have to consider what would happen if you don’t pay the loan back before you die. In that instance, the full amount would be deducted from your death benefit. If your family ends up getting pennies because you pulled out too much equity, that could leave them in a major lurch financially.
4. Pay for Debt Settlement
Debt settlement, in and of itself, isn’t necessarily a terrible way to zero out what you owe. When you settle a debt, the creditor agrees to accept less than what’s owed and forgives the rest.
This usually requires making a lump sum payment although some creditors may be willing to let you break it down into several installments.
Settling debts can potentially impact your credit score since the account may be reported as “Settled” instead of “Paid in Full” but if you’re already behind on the payments, that may not make much of a difference.
Unless you’re insolvent, you’ll likely have to pay tax on the amount of forgiven debt that exceeds $600.
All that aside, the real problem with using debt settlement to get rid of debts occurs when you contract the help of a debt settlement company.
While there are some reputable ones out there, many of them charge exorbitant fees for their services and promise their clients more than they’re capable of delivering.
Unless you’re just extremely gun shy about talking to your creditors, you can settle debts on your own and keep more money in your pocket in the process.
With the exception of hitting the lottery or inheriting a windfall, finding a way to pay off debt usually isn’t a quick fix. If you’re contemplating any of these four options, it’s to your advantage to go back to the drawing board and see if you can’t find other ways to do it first.
Taking on a side hustle to bring in more money that you can put towards debt or transferring your balances to a 0% interest credit card, for example, are good places to start and they’re less likely to put you deeper in the red.