If you're dealing with your debt the wrong way, you're compounding the problem.
Multiple credit card bills each month, with balances that are growing, not shrinking. Student loans. Plus a car payment. Do you feel buried by a mountain of debt?
There are smart ways to dig your way out. Pick the wrong way and you’ll make a bad situation much worse, adding years and thousands of dollars to your burden.
In the video below, Money Talks News founder Stacy Johnson explains the wrong ways to pay off debt and offers some tips on how to get the job done right. Check it out, then read on for more details.
Do you have a debt problem?
First, let’s look at some telltale signs that your debt is getting the best of you. Do you:
- Choose to pay some bills and not pay others because there’s not enough money in your account?
- Max out your credit cards, even though you know that’s damaging your credit scores (and making you feel ill when you get the bills)?
- Keep using your credit cards even though you swore you’d leave them in the sock drawer?
Do any of these sound familiar? Then you need to take some steps to pay down that debt. Here are the worst possible strategies:
Making minimum payments
While paying the minimum payment each month will keep the card companies happy, it’s a counterproductive way to pay off debt. Do you need proof? Check the little chart on your next credit card bill. The Credit CARD Act of 2009 requires credit card companies to show how long it would take you to pay off your debt by paying only the minimum.
Bankrate provided an example:
For example, say you have $5,000 in debt on one credit card. Your interest rate is 15 percent, and your minimum payment is calculated by adding interest to 1 percent of the balance. So if you pay the $112.50 minimum required each month, it will take 266 months, more than 22 years, to pay it off. And you’ll end up paying $5,729.21 in interest on top of the original balance.
Pillaging your retirement plan
The money in your retirement savings may be a tempting fix for your current financial woes, but you’ll be shortchanging yourself in the long run. Take the money out and it’s no longer being invested and growing for your retirement. And, other than a few limited circumstances, withdrawing the money early means you’ll pay not only taxes on it but also a 10 percent penalty.
If you borrow from your 401(k) at work, you may be charged hefty fees, and you must repay the loan plus interest within five years. If you quit or lose your job, you’ll have to pay the money back right away.
It could also hurt in other ways. Jeanne Thompson, vice president at Fidelity Investments, told USA Today that many who’ve borrowed from their 401(k) had to reduce their contributions to their retirement so they could afford to pay it back. On average, it took them two years to get back to their initial contribution rate. That’s not the way to save for your golden years.
Other bad ideas
As you can see, it usually makes no sense to pay off debt with borrowed money — particularly loans that carry exorbitant interest rates and fees. Among them:
- Cash advances from credit cards. You’ll pay a fee of 3 percent to 5 percent, plus an interest rate that’s higher than the rate for using your card. There’s no grace period, so the interest begins to accumulate right away.
- Bank direct deposit advances. Your bank may be willing to offer you a loan that will be repaid when your next paycheck is direct deposited. Huge drawback: The Center for Responsible Lending says the average bank direct deposit advance carries an annual interest rate of 365 percent.
- Payday loans. Each year 12 million Americans use payday loans, according to a Pew Charitable Trusts report. The vast majority of borrowers are using payday loans to cover expenses like rent, food and credit card bills. And it costs them dearly. Pew says the average borrower took out eight loans of $375 each per year and paid $520 in interest.
- Title loans. You’ll pay fees and a high interest rate — and lose your car if you can’t pay the money back.
What about debt settlement?
Using a debt settlement company can mean paying a huge fee to a company to do what you can do yourself: Ask your creditors to settle the debt for less than you owe. Also, as Money Talks News founder Stacy Johnson said:
The debt settlement industry, unlike the credit counseling industry, is largely unregulated. That means there are more than a few bad apples. Some agencies take major fees up front before they even begin to settle your debt. Some have been charged with flat-out stealing people’s money.
How to do it right
One of the most effective ways to destroy debt is called the debt snowball. Let’s apply it to credit card debt in our example. Basically it works like this:
- Make a list of all of your debts. You can order them from smallest to largest or from highest interest rate to lowest rate. Paying off the credit card bill with the highest interest rate first is the smartest way from a purely financial point of view. But paying off the smallest debt first may give you the confidence boost you need. Think how good you’ll feel when you cross that first debt off your list.
- While you continue to pay the minimum due on your other credit card bills, throw every extra cent you have at the first debt on your list. Where can you find extra money?
- Review your spending plan (if you don’t have one, it’s essential you create one now) and reduce your discretionary spending. Brown-bag your lunch more often. Ditch the cable TV. (You can do so and still enjoy the TV shows you love.) Switch to generic brands at the grocery store.
- Sell stuff. There are plenty of ways to turn your unwanted possessions into cash: Sell on eBay, piggyback on a neighbor’s garage sale, take your items to a consignment shop.
- Make more money. Are you long overdue for a raise? Can you find a part-time job? Websites like Fiverr, TaskRabbit and Zaarly can connect you with people who are willing to pay for your help with a wide variety of tasks.
- Once the first bill on your list is paid off, apply the money you used to make those payments to the next credit card debt on your list.
- Repeat the process until your debt is gone.
What if your debt has spiraled out of control and the collection companies won’t stop calling? Your best bet may be a reputable credit counseling agency. Stacy has explained how to find one and what to expect from them. This can work if you have income. If not, bankruptcy is worth a look.
As Stacy has advised before, “If you don’t have enough income left after eating and putting a roof over your head to make even minimum payments on your debts, it’s time to talk to a lawyer.”
What have you done to destroy debt? Let us know on our Facebook page.
Karen Datko contributed to this report.