It's a noble financial goal to aggressively pay down your debts, especially high-interest debt like credit cards. However, as with everything else in finance, there are right and wrong ways to do it. In the interest of avoiding costly mistakes, here are three ways of paying down debt that our contributors think you should avoid.
Often, when people have a lot of debt, they'll choose to go after the largest debt first. Unfortunately, that may be an unwise choice. The most important debts to pay off soonest are the most expensive ones, not necessarily the ones with the highest balances.
"What's the difference?" you may be wondering. It's simple: The debts with the highest interest rates are the ones you should focus on paying down the quickest. Here's an example.
Let's say you have $15,000 in credit card debt, with $10,000 of it at a 12% interest rate and $5,000 at a 20% interest rate. Because of the much higher interest rate on the smaller balance, that $5,000 debt will cost nearly as much interest as the bigger balance. As a matter of fact, you'd pay more interest on $5,000 in debt with a 20% interest rate than you would on $8,000 of debt at 12%.
Plain and simple: In almost every case, you should prioritize paying off debt with the highest interest rate and work your way down. You'll end up spending less money on interest, and you'll get out of debt sooner.
One frequently used way to pay off personal debts is with a 401(k) loan. Although this may sound like a good idea at first, I have a good reason not to use this method.
Generally, 401(k) plans allow participants to borrow up to half of the money in their accounts and then pay the money back to themselves with interest over a specified time period. Understandably, this sounds like a good deal, especially since many 401(k) plans charge a low interest rate of prime plus 1%, which currently translates to 4.25% -- much better than you're likely to get from any other personal loan.
However, consider the time value you're giving up by doing this. That money is supposed to be invested for your retirement, and the stock market has historically averaged a 9.5% rate of return -- much better than the 4.25% you'll pay yourself back. Over time, this lost compounding can really cost you.
To illustrate this, consider an example of someone who has a $100,000 401(k) balance and is 30 years away from retirement. Let's say they want to borrow $30,000 to pay off other debts, which will be paid back over a five-year period. According to a 401(k) loan calculator, by the time they're ready to retire, the act of taking out the loan will have cost them nearly $46,000 in investment returns. That's a big price to pay for borrowing money, and that's why I would personally prefer to pay a little extra for a personal loan.
Many financial advisers tout the advantages of using a home equity loan to pay down personal debt, and under the right circumstances, it doesn't have to be an unwise move. The question is whether you have the discipline for the strategy to work.
The reason using home equity to pay off personal debt is appealing is that you can often get much lower interest rates on a home equity loan than you'd pay on an auto loan or on credit card debt, which in turn will let you pay the debt off faster and with less in total interest charges along the way. Moreover, home equity loan interest is typically tax-deductible, further reducing your after-tax cost.
The trap, though, is that many people pay off other debt using a home equity loan and then go right back out and run up their credit cards again, ending up with a double helping of debt. That's where the strategy is unwise; suddenly you've not only dug yourself a deeper hole, but also put your home at risk. If you're not sure you can resist the temptation to incur more debt, then using the home equity loan strategy is a risky move.