Tapping into your home equity or your retirement account to pay off credit card or other unsecured debt is always a bad idea. It seems like more and more lenders and other financial services companies are encouraging you to do both. Don’t do it and here’s why:
Home Equity Loans to pay off credit card and other unsecured debt –
Sure, it’s advertised that using a home equity loan or line of credit is an easy way to get out of those “high interest rate” credit card debts. The logic is that the home equity line of credit or refinance loan (debt consolidation loan) interest rate is lower than the interest rates you would be currently paying on your credit cards. You save money. Great! The second rational is that the interest rates on the line of credit or home equity loan is usually tax deductible. Greater still! You save more money.
Based upon the above, many Americans have taken advantage of these types of loans to pay off their credit card bills. Actually, by the end of 2004, the Federal Reserve reported that Americans borrowed a total of $826 billion dollars against the equity in their homes. To put that into perspective, in 1997 (just 7 years earlier), Americans borrowed $416 billion dollars. That’s about a 50% increase in borrowing.
So, why are so many Americans still in debt? And if this is such a great idea, why am I against it? Because so many Americans are still in debt, that’s why.
You see, if you do the numbers, about two-thirds of the people who use this “great tool” to eliminate their unsecured debt, usually go back out and run up more unsecured debt. This usually wipes out the tax benefits of getting the “rational” loan in the first place.
This type of program not only leaves the consumer with less equity in their home to use in case of real emergencies but exchanges unsecured debt for secured. What you may have been able to eliminate through debt settlement, credit counseling or even bankruptcy, has now been exchanged with the security of your home.
With a major real-estate market correction, many homeowners may find themselves actually owing more on their property that it is worth. It’s happened before and not too long ago.
If you have borrowed against your home to pay off credit card debt, pay it back as quickly as possible and make sure that you do not use your credit cards anymore. Tear them up. Don’t cancel them (unless there is some stupid usage fee attached for the privilege of using their card). Cancelling them can hurt your FICO score. Just keep one card for emergencies and cut the others up.
Now, let’s move onto Borrowing from your 401(k) –
About 80% of all companies out there offer their workers the ability to borrow against their 401k plans. Unless it is a dire emergency, don’t do it. Get a home equity loan before you do this. Of course look at debt settlement, credit counseling or bankruptcy before you do either.
According to the Investment Company Institute about 1 in 5 workers have borrowed against their 401k. $6,800 was the average amount borrowed.
The logic behind this type of borrowing is that people think that they are actually borrowing against themselves. They are earning interest off of their retirement plan so what’s the harm? At least the money is going back to them right? Yes and no.
If you pay it all back and don’t lose your job during the process you are fine. Of course, leaving that money sitting there at 8% interest could have grown to more than $75,000 but I am sure the $6,800 was more important at the time.
Now let’s say that you do lose your job, what then? Well, in addition to the $6,800 that you borrowed “from yourself”; the loan must be repaid sooner than later, usually in about a couple of weeks. As you know, most people don’t have $6,800 lying around so, the outstanding loan is now taxed and penalized as a premature distribution. Remember, that money is tax free as long as you wait until retirement. If you don’t pay it back right away, you’ve taped in and the IRS will be taping you for their cut. This could end up costing you thousands of dollars more, as the tax and penalties are pretty steep.
So to recap, if you have credit card or other unsecured debt that you need help with, look into debt settlement, credit counseling and bankruptcy as options before you even think about putting your home or future retirement at risk…