Solutions That Are Not Solutions
Some of the most commonly prescribed fixes for credit problems such as home equity loans; debt consolidation loans and withdrawals from retirement plans actually make the credit crisis worse. That’s because these solutions, once they are applied, often make your credit score and your debt load heavier to handle in the long run!
Home equity loans, lines of credit and cash-out mortgage refinance are particularly tempting to access during a financial crisis because they offer low rates and tax deductible interest to those who take advantage of them.
However keep in mind that taking out these types of loans come with three big problems…
1. Most people who use home equity to pay off credit card and other unsecured loans ultimately end up deeper in debt with in a few years. That is because the fundamental problem of overspending that got them in this fix in the first place was never addressed.
2. Such loans transform short-term debt into long-term debt. Often you end up paying more in interest and wind up even more in debt than if you had simply paid the credit cards off with your current income.
3. Using home equity, lines of credit and cash-out mortgages to pay off credit cards, medical bills or personal loans transforms unsecured debt that could be erased in bankruptcy court, into secured debt that can’t be wiped out…dealing with your credit crisis in this way also puts your home and other assets at risk as well.
Most retirement plans are also protected from creditors claims in bankruptcy court and typically shouldn’t be used to pay off any unsecured debt. In addition, a 401 (k) or IRA (an RRSP in Canada) means you are losing out on the tax-deferred returns that your money could earn in the plan if you had not withdrawn from it all.
As an example of how much early withdrawal from a retirement fund could cost you—for every $10,000 you take out of a 401K could cost you $100,000 or more in retirement income (assuming it had been left alone to grow at an 8 percent average annual rate for 30 years.)
Some lenders are miffed that you would choose to hoard our retirement income or home equity instead of cashing things out to pay debt. However that doesn’t matter considering the long- term cost of early withdrawal. When your taxes are due you will also have to pay 25 to 50% in taxes to what you took out.
Loans from 402 (k)s and 403 (k) s also come with fraught perils. If you lose your job you typically must repay the loan within a few weeks or else you incur penalties and taxes on the balance.
Of course all of this said there are some exceptions to the rule. For instance it might be necessary to borrow from your 401 K to pay the mortgage for a month or two to avoid foreclosure. However if you cant make your house payment any other way then by tapping into your retirement funds you are probably better of selling the place then continuing to struggle with the basics. At least if you sell the home you can preserve what is left of your credit score and your equity so that you will be in the position to buy another home when your finances improve. That is a far better solution then trying to put a band-aid on a credit crisis that is a like gushing wound.
You are also best advised to steer clear of debt consolidation loans simply because there is a lot of consumer fraud and abuse in this industry. These places offer to settle your debt for pennies on the dollar, supposedly without hurting your credit. In reality these debt settlement outfits often disappear with your upfront fee and leaves your credit score in shreds.
Another scam to avoid is the so called “debt elimination†firms which use weird arguments from “natural law†and the Declaration of Independence to help you try and argue that you don’t owe what you owe. These firms offer to teach you how to talk your way out of debt with a lender or how to use eloquence and facts from law to convince a credit bureau to remove negative things from your report. Needless to say anything like this falls on deaf ears when it comes to creditors, lenders and credit bureaus.
If you really can’t pay all of your unsecured debts your best bet is usually to file for bankruptcy. You can get a fresh start and you will still retain all of that money that you would have wasted on solutions that are no solutions at all.