Bad Decisions to Eliminate Debt

Risky Solutions to Debt Elimination
Taking short cuts can lead to compounding woes

Taken from blackenterprise.com

By Zakiyyah El-Amin
August 1, 2008 -- If you are like most people, managing your finances isn't easy in today’s volatile market. As talk of recession threatens the U.S. economy, consumers are burdened with incomes that fail to keep up with inflation and expenses that continue to mount. Desperate for alternative ways to pay down debt, many rely on quick-fix solutions that often cause more harm than good.

Harrine Freeman, founder of H.E. Freeman Enterprises, believes that most people are simply trading one form of debt for another. “If you are already irresponsible with spending money, resorting to fast ways to get money is only a band-aid over the sore.”

The Bethesda, Maryland-based firm helps clients achieve their financial goals and educates them on how to prevent from falling trap to pricey habits. Freeman highlights a few common mistakes that can lead to further debt.

Use of Home Equity Loans
Many rationalize that this is effective because most home equity loans carry lower interest rates than credit cards and have interest that’s generally tax deductable. Understand that unsecured debt, such as credit cards, becomes tied to your home once this type of loan is used to pay it off. If you experience difficulties in making payments, you could default on the loan and risk losing your home. Since the amount that you can borrow is based upon your home’s value, as the value of your home decreases, so does your equity.

“Most people get a false sense of security once the debt is paid and end up accumulating more unsecured debt and putting themselves further in the whole,” Freeman adds.

Withdrawal from Retirement Plans
Tapping into your 401(k) jeopardizes your financial future. When you take money out of your retirement plan, you no longer benefit from tax-deferred compounding on the money withdrawn. Consequently, you have less money in your account working for you, which can lead to a smaller nest egg upon retirement. In addition, if you leave your job, you’re obligated to pay back the entire borrowed amount generally within 30-60 days. If you don’t, the unpaid balance will be treated like a distribution and you’ll owe taxes on the money and be charged a penalty.

Credit Card Cash Advances
Owning plastic comes with many bells and whistles. Credit card companies entice consumers with added features such as fraud protection, rewards, even cash. However, the likelihood of falling deeper into debt when using cash advances far outweighs the convenience of fast cash. If you pay off your balance in full at the end of the cycle, there’s no problem. Few understand that payments made to the credit card will first go toward regular purchases. Since cash advances carry higher interest rates than credit cards, problems arise when balances are carried over and both interest and fees compound.

Use of Debt Consolidation Loans

Debt consolidation is usually regarded as a credit cure-all that replaces multiple loans with a single loan resulting in lower monthly payments. However, the majority of consolidation loans only extend the pay-off period and do not carry lower rates. Since interest on consolidation loans is often higher than personal loans, mortgages and home equity loans, you actually owe more in the long run.

If you consolidate your loans, Freeman advises to use caution. “Many [debt consolidation agencies] are flooded with scams, and lenders who charge exorbitant fees and offer no real solutions to your debt,” she says. Some consolidators add fees directly to your monthly debt payments, without notifying borrowers of the charges. To help deal with debt, Freeman recommends that consumers establish a budget, develop a debt management plan, and consider credit counseling. Most importantly, use common sense by not spending money you do not have.