How Not to Pay Off Your Debt
Paying off your debt is an admirable goal and a smart move for your financial health, right? Yes—if you do it the right way, because there are wrong ways of doing it that might actually hurt you more than they help.
Withdrawing from your 401(k), draining your emergency fund or ignoring your monthly bills in the name of paying off your credit card debt may seem like good ideas in the moment, but they can have adverse consequences in the long run.
Here is why you shouldn’t…
1. Dip into your 401(k):
There are plenty of reasons not to use your 401(k) to pay off debt, but let’s start with the potential financial ramifications. If you take money out early—that is, before age 59½—not only will that money be taxed at your current income tax rate, but you’ll also pay a 10 percent penalty.
If your 401(k) has a loan provision, it is a more affordable way of paying off your debt. However, 401(k) loans also have downsides. For one thing, any money you borrow won’t be earning a return until you repay it. If you quit or lose your job before repaying the loan, the entire balance will come due soon after. And if you can’t pay it off in full, it will be treated as a distribution—meaning you’ll incur the taxes and penalties of an early withdrawal. It’s a risky move.
Finally, by using your retirement funds to pay off your credit card debt, you’re potentially setting a dangerous precedent. You’re making tapping into your retirement fund an option for sticky financial situations, which could help you justify withdrawals in the future, even if they aren’t absolutely necessary. Unless you’ve exhausted all other legal options, try to leave your retirement savings alone for Future You.
2. Drain your emergency fund:
Because of high interest rates on credit cards and low interest on savings accounts, it isn’t wise to keep a large cash reserve while carrying credit card debt from month to month. However, it’s also not a good idea to drain your cash reserves completely to wipe out your debt. Emergencies happen, and you need to have some savings in place to deal with them, because a credit card isn’t an emergency fund.
The amount of emergency savings you should keep depends on your personal situation. As a starting point, everyone should have $1,000. Some people—like small-business owners, custodial parents or sole breadwinners—may need more, while a single young professional without a mortgage will probably be fine with a small fund. Any savings greater than what you need for emergencies can be put toward debt, but don’t drain your entire rainy-day fund.
3. Neglect your current bills:
When you’re anxious to get rid of your debt for good, it may be tempting to cut corners elsewhere to pay it off as soon as possible. But ignoring your monthly payment obligations to pay down debt isn’t a sound approach. You’ll likely get hit with fees, and your late payments may be reported to the credit bureaus and remain on your credit reports for seven years.
Instead, pay your bills and minimum debt payments first. Then, provided you have a small emergency fund already, put the excess toward extra debt payments.
So, pay down your credit card debt aggressively, but don’t hurt yourself financially to do it. Instead, aim to bring down your debt by making more or spending less, and allocating the extra funds to your credit card bills.
This article originally appeared on NerdWallet. Erin El Issa is a staff writer covering personal finance for NerdWallet.
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