Getting out of debt is a major financial goal that may be on your radar. Eliminating debt can make it easier to pursue other financial goals, such as saving for retirement and building wealth.
While it’s important to reduce your debt load, it’s also crucial that you take the right steps to do so. There are certain methods you may consider for paying off debt that could do more harm than good. Tapping into your home equity, for example, might be at the top of the list.
As you embark on the quest to become debt-free, here are some things to consider before using home equity—or other financial assets—to pay off your balances.
Option #1: Use Home Equity to Pay off Debt
Home equity refers to your ownership stake in your home. It’s the difference between what your home is worth and what you owe on the mortgage.
There are two primary ways to access the equity in your home to pay the debt: home equity loans or a home equity line of credit. A home equity loan can offer a lump sum of funding you could use to pay off or consolidate credit cards or other debts. A home equity line of credit is a revolving line of credit you can borrow against as needed. To consolidate and pay off debt, a home equity loan is likely more appropriate.
Under the Tax Cuts and Jobs Act, the interest paid on home equity loans or home equity lines of credit is only deductible if the funds are used to make substantial improvements to the home.
On paper, using home equity to pay off debt seems like a good idea since you’re able to tap into funding at an affordable, low-interest rate and streamline your monthly payments. If you can get rid of all the high-interest cards and make one single payment that has a nice low rate, that would be a good thing.
The big problem with using home equity to pay off debt has to do with the difference between secured and unsecured debt. Credit cards are unsecured, meaning there is no collateral backing the card. If you fail to pay off your credit card, you might have to put up with collection calls and damage to your credit score, but that’s about the extent of it.
If we’re talking about a mortgage or car loan, we’re dealing with secured debt. Secured means that the underlying asset is used as collateral for the loan. What that means is that if you fail to make the payments on a home equity loan, the bank could initiate foreclosure proceedings against you. In other words, you could lose your home, which is a poor trade-off for wiping out your credit card debt.
Option #2: Use Your Retirement Account to Pay off Debt
Aside from your home equity, you may have another tangible asset you could use to pay off the debt in the form of your retirement account. If you have a 401(k) plan at work, for example, you may be able to borrow from it with a loan.
These loans often seem like a good idea because you’re just borrowing some of your own money and paying it back over time. So, you can essentially borrow money with attractive terms, pay off your high-interest debt—and then in a few years—have your 401(k) replenished. But like using home equity to pay off debt, there are problems with this strategy.
You can borrow up to $10,000 or half (whichever is more), or $50,000 of your vested account balance from your 401(k), whichever is less.
First of all, this money is meant for retirement, and it needs time to grow. If you borrow money from your retirement plan, you’re essentially taking it out of whatever it was invested in and missing out on any potential interest or growth it might have otherwise seen. That could leave you with a savings shortfall when you retire.
Something else to consider is the impact if you leave or lose your job before the loan is paid off. Typically, 401(k) loans must be repaid in full the due date for filing a federal income tax return for that year after termination. If the loan is not paid in full, it will be treated as a distribution. Distributions are taxable, and if you’re under the age of 59½, they’re subject to an additional 10% early withdrawal penalty. That could result in an unexpected tax bill when you file your return.
An exception is if you have a Roth IRA. With this type of retirement account, you can withdraw your original contributions at any time, with no tax penalty. But again, you could end up sacrificing returns on your investment dollars for the sake of paying off debt.
There Are Better Ways to Pay off Debt
Using the equity in your home and raiding your retirement nest egg may be convenient, but they’re not the best ways to pay off debt. Consider other strategies you can try and keep these two on the backburner as a last resort. These tips can help you get a better grip on your finances:
Create a budget. The single best thing you can do to help you pay down your debt is to create a realistic budget that frees up some extra cash that can be applied to your credit card payments. There is more free money in your budget than you think, so look for ways to find some of that hidden cash.
Make more than the minimum payment each month. When you make just the minimum payment on your credit card, you’re doing little more than paying finance charges. This minimum principal payment means you’ll be repaying this debt for many years.
Look for ways to reduce interest on your debt. Consolidating credit cards or transferring the balance to a 0% APR card, for example, can reduce the amount of interest paid. You can also try consolidating or refinancing federal and private student loans.
The Bottom Line
Ideally, you should be living below your means to avoid taking on debt. If you find yourself in credit card debt or other debt, consider what strategies will work best for paying it off. Then, focus on what you can do going forward to adopt a lifestyle that requires spending less money than you make. This budgeting can put you on the path to long-term financial security.