If worrying about how to pay off debt leaves you awake some nights, late-night television abounds with alleged solutions. Some ads promise to get rid of your debt for "pennies on the dollar," while others try to persuade you to take out new loans to pay off old obligations.
Fall victim to these "deals" and you might be left with worse financial troubles than before. But these aren't the only foolish ways of paying off debt. Some common debt-elimination strategies also leave much to be desired. Learn about these mistakes so you can avoid them and find the right way to get out of debt.
The strategy: If your car or house payment is due before your next paycheck, a payday loan can seem tempting. You don't need good credit, just a steady source of income and a valid ID. The lender gives you the cash you need, and you write a check for the amount you're borrowing, plus a finance fee.
The check is not cashed right away. Instead, you pay it off in full at your next paycheck. Supposedly, this allows you to avoid late fees and dings on your credit.
The reality: As payday approaches, you might run into worse financial trouble. Not only are other bills due, but you've also got a high-interest loan on your back. Suddenly, you're tempted to take on a second payday loan to pay off the first. And if you can't pay, you might roll over to a higher-interest installment plan that can exceed 400 percent annually, according to the Consumer Federation of America.
Why it's incredibly stupid: It's a debt trap, as the CFA has noted. It's too easy to find yourself in deeper debt than when you started. Payday loans aren't based on your ability to repay the loan, but on the lender's ability to collect.
You might have authorized the loan company to take money out of your bank account to pay the loan. As the lender extracts fees, you'll likely end up defaulting on your other financial obligations from lack of cash. If your account gets sucked dry, the lender might also take you to court and attempt to garnish your wages.
About 20 percent of payday loan borrowers default, according to the CFA. Even worse, more than half of online payday installment loan sequences default. That means the odds definitely aren't in your favor.
When this might make sense: Never. Ever.
Using Home Equity
The strategy: Finding yourself cash poor and equity wealthy makes it tempting to use your home's appraised value to pay off debt or other financial obligations. The debt gets wrapped into a loan or line of credit for which you pay less interest than you would on a credit card. That frees up more money each month.
Ways to use your home's equity to pay off debt include:
- Mortgage refinance
- Home equity line of credit (HELOC)
- Home equity loan
- Reverse mortgage
The reality: Paying down credit cards using your equity frees up money each month, and creates more room to spend on your credit cards. That seems like a good thing at first glance. But if you haven't corrected the spending, budget and income issues that got you in debt in the first place, you'll wind up in the same boat — and in much deeper water. This time, you won't have the equity to bail you out.
Why it's incredibly stupid: Credit card debt is unsecured. Fail to pay the debt, and the lender has relatively few options to collect. But paying off debt with your home equity means the debt is now backed by your home. Fail to pay, and your home could be at risk.
Higher monthly mortgage payments make it more likely you'll lose your house to foreclosure if you suffer financial setbacks such as job loss. Some of these home equity options come with adjustable rates or balloon payments that can add to your burden.
When this might make sense: Don't risk it. Save options such as home equity loans to reinvest in your property through major home improvements that might increase its overall resale value down the road.
Taking a Credit Card Cash Advance
The strategy: When you're short on your mortgage, car or automatically debited payments, you might be tempted to make up the difference with a cash advance. That's especially true if it means avoiding late fees, bank returned-item fees and bad reports on your credit history.
The reality: You will likely pay a cash-advance fee. For example, Discover charges either $10 or 5 percent of the cash advance amount, whichever is higher. Expect to pay a higher interest rate on the amount of your cash advance. Discover charges 25.24% on a cash advance, instead of 11.24% to 23.24% for regular purchases. Oh, and did we mention that interest starts accruing the moment you take out an advance?
Why it's incredibly stupid: A cash advance is one of the most expensive types of credit transactions. Credit card companies are in the business of making money, so they often apply your monthly payments toward your lower interest debt first. Any money you apply over the minimum payment is then credited to the debt with the highest APR, such as a cash advance. So if you only pay the monthly minimum, you'll continue paying the high interest rate on the cash advance amount until the entirety of lower-interest purchase amounts gets paid off.
When this might make sense: Again, never. Taking on more high-interest debt isn't a good idea for any reason. And next month, you'll have a harder time paying off debt when the larger payment comes due.
Heading to the Pawn Shop
The strategy: Taking jewelry, electronics or other valuables to the pawn shop can get you money now so you can catch up on debt payments. The process requires no credit check and the pawn shop holds your items for collateral until you repay the loan. All you have to lose is your property if you default.
The reality: The amount of money you'll net for your items might disappoint you. Expect to get about 20 percent to 25 percent of what your item is actually worth in its present condition, according to the American Web Loan website. After all, the pawn shop has to cover its costs should you default.
In addition, loan interest rates can be high. For example, Texas pawn shops can charge up to 240 percent on some loans, according to the Texas Office of Consumer Credit Commissioner. Also, pawn shops must report every transaction to law enforcement — so be sure those bikes you picked up off Craigslist weren't stolen before you pawn them.
Why it's incredibly stupid: If you're not able to come up with the money by the loan's due date, you risk losing valuables at a small fraction of their cost. You'd be better off selling items online or at a garage sale.
When this might make sense: If your only other options include a payday or auto title loan, this is your best bet. All you have to lose is the property you're pawning, not your wages or car.
Using a Debt Settlement Company
The strategy: Using a debt settlement company theoretically allows you to negotiate the amount of your debt with your creditors with the hope of paying just a fraction of what you originally owed. In addition, you'll simply make one easy monthly payment to the debt settlement company.
The reality: Lenders aren't under any obligation to accept less than they're owed, and some won't work with debt settlement companies. If they do let you pay less, your credit report will show that you didn't pay in full for the next seven years. That makes it harder to get your financial act together.
Why this is incredibly stupid: Debt settlement companies might encourage you to withhold payment from creditors during the negotiation process. But such a process can take up to 36 months, according to Debt.org. During that time, you'll rack up late fees and penalties on top of what you already owe. Add in a 20 percent to 25 percent fee paid to the debt settlement agency and the income tax you'll pay on the amount of debt forgiven.
When this might make sense: Only use a debt settlement company as a last resort if you can't consolidate debt through any other means.
The strategy: When you have far more debt than money to pay it, bankruptcy gives you a chance to start over. You might wipe out unsecured debt completely and even stop or delay foreclosure on your home, or repossession of your automobile.
The reality: Filing bankruptcy is a long and stressful process that takes six months or more to complete. You must attend credit counseling and compile all your financial records before you can even file. Complicated laws surrounding bankruptcy are best faced with an attorney at your side. Even if you "win" your petition, you still lose: The bankruptcy stays on your record for up to 10 years and can make establishing new credit — or even renting an apartment — difficult.
Why this is incredibly stupid: In addition to being a financial pariah for the next decade, you'll lose nonexempt assets you own, such as bank accounts, a second car, a vacation home, coin collections and stock investments.
When this might make sense: If you've tried debt consolidation and debt settlement but still can't eliminate your debt in five years or less, bankruptcy might be your best option, according to Debt.org. If you take this step, make sure you learn how to rebuild your credit.
Paying Student Loans, Mortgages and Auto Loans With Credit Cards
The strategy: The notion here is to rack up credit card reward points by paying your student loans, mortgage or other large loan payments with a credit card. Even if your lender won't take credit card payments, you can employ the services of an intermediary payment service to convert a credit card charge to currency the lender will accept.
The reality: You pay a 2.5 percent fee on each bill you pay using a credit card with Plastiq's bill payment service. If you use a debit card, the fee drops to 1 percent.
That 2.5 percent credit-card fee doesn't sound like much. However, if your monthly debts include a $500 car payment, $1,120 for your mortgage and $280 toward your student loan, you'll shell out an extra $47.50 monthly. That's $570 per year that you could use to lower your consumer debt instead of adding to it. If you use payment intermediaries to pay your utility bills and other payments, you could create debt far faster than you're getting out of it.
Why this is incredibly stupid: Paying more interest than you need to is never a clever decision when you're trying to get out of debt. In addition, Plastiq notes some transactions might be treated as a cash advance if Plastiq does not have an existing relationship with a merchant you're trying to pay. Plastiq also notes that temporary authorizations on your credit card might reduce your available credit for anywhere from a few days to a few weeks.
When this might make sense: Never. Using your bank's bill-pay function to have checks sent to your mortgage company or student loan servicer is a much better move than racking up extra interest and more debt.
Keep Reading: Smart Strategies to Get Out of Debt in 2017