12 Dumb Mistakes People Make While Trying To Get Out of Debt

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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 […]

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. I spoke to financial experts to find out the common, dumb mistakes people make while trying to get out of debt — avoid making these same missteps.

Last updated: July 15, 2020

1. Taking Out Payday Loans

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.

What Can Happen

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% annually, according to the Consumer Federation of America.

Why This Is a Dumb Mistake

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% 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.

Do Payday Loans Ever Make Sense?

Never. Ever.

“It’s a game you’ll never win,” personal finance expert Dave Ramsey wrote on his blog. “When you consider debt as an ‘easy money’ option, the thought will linger in the back of your mind the next time money is tight. This idea of ‘robbing Peter to pay Paul’ (borrowing money to pay off your other debts) isn’t sustainable.”

2. Using Home Equity

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:

What Can Happen

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.

Compare: Here’s How Much Debt Americans Have in Every State

Why This Is a Dumb Mistake

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.

“Refinancing a home is an often overused method of getting out of debt,” said Mark Spitz, CEO at CPI Inflation Calculator. “Yes, refinancing can get you out of consumer debt, but banks prey on the idea of extending amortization rates for another decade and giving you a low rate to entice you to say yes. It’s a trick to get you to pay interest more often. The better thing to do is to apply for a straight-up consolidation loan, or offer up a consumer proposal to creditors.”

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.

Does Using Home Equity Ever Make Sense?

Save home equity loans for reinvesting in your property through major home improvements that might increase its overall resale value down the road.

3. Taking a Credit Card Cash Advance

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.

What Can Happen

You will likely pay a cash-advance fee. For example, Discover charges either $10 or 5% 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 you know that interest starts accruing the moment you take out an advance?

Why This Is a Dumb Mistake

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 annual percentage rate, 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.

Does It Ever Make Sense To Take a Credit Card Cash Advance?

“Cash advances are almost always a bad idea,” Michael Sullivan, a personal financial consultant, told The New York Times.

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.

4. Heading To the Pawnshop

Taking jewelry, electronics or other valuables to the pawnshop can get you money now so you can catch up on debt payments. The process requires no credit check and the pawnshop holds your items for collateral until you repay the loan. All you have to lose is your property if you default.

What Can Happen

The amount of money you’ll net for your items might disappoint you. Expect to get about 20% to 25% of what your item is actually worth in its present condition, according to the American Web Loan website. After all, the pawnshop 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% on some loans, according to the Texas Office of Consumer Credit Commissioner. Also, pawnshops must report every transaction to law enforcement — so be sure those bikes you picked up off Craigslist weren’t stolen before you pawn them.

Drowning in Debt? 18 Effective Ways to Tackle Your Budget

Why This Is a Dumb Mistake

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.

Does It Ever Make Sense To Pawn Your Possessions?

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.

5. Using a Debt Settlement Company

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.

What Can Happen

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 a Dumb Mistake

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% to 25% fee paid to the debt settlement agency and the income tax you’ll pay on the amount of debt forgiven.

Does It Ever Make Sense To Use a Debt Settlement Company?

Only use a debt settlement company as a last resort if you can’t consolidate debt through any other means.

“Although those with debt may feel desperate for help, it’s a mistake to pick the first debt relief company that comes up in a Google search, you see on TV or hear on the radio,” said Steve Gickling, founder and CEO of ETLrobot. “Many of these companies don’t have your best interests at heart. Instead, they are looking to grab a share of what little cash on hand you have with empty promises. Do your research with the Better Business Bureau on debt relief companies that genuinely can help you if you want to explore this path.”

6. Filing Bankruptcy

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.

What Can Happen

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 a Dumb Mistake

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.

Does It Ever Make Sense To File For Bankruptcy?

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.

7. Paying Student Loans, Mortgages and Auto Loans With Credit Cards

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.

What Can Happen

You pay a 2.5% fee on each bill you pay using a credit card with Plastiq’s bill payment service, for example. If you use a debit card, the fee drops to 1%.

That 2.5% 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.

See: 12 Ways Student Debt Hits Everyone’s Wallet

Why This Is a Dumb Mistake

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.

Does It Ever Make Sense To Pay Back Loans With a Credit Card?

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.

8. Joining a Multilevel Marketing Company

“I see a lot of people going into more debt or taking unnecessary risks in hopes of getting out of debt,” said Clay Bethune, CEO of 391 Financial. “For example, many people will attempt to join a multi-level marketing or MLM company.”

Joining an MLM company involves selling products to family and friends and recruiting other people to do the same. Most MLM companies allow you to make money two ways — by selling products directly to customers and by recruiting new people to sell and earning commissions off the products they buy and sell.

What Can Happen

By joining what seems like a legitimate MLM, you might actually be signing up to be a part of an illegal pyramid scheme. Legitimate MLMs will pay you based on the products you sell, not on recruiting other members.

Even if an MLM is legitimate, it usually doesn’t lead to the riches that the recruiter will say are possible to make with the company. You might end up buying more product than you can sell, which can leave you with more debt than you started off with.

Why This Is a Dumb Mistake

“[MLMs] typically require an investment and a large time commitment, with little odds of achieving meaningful success,” Bethune said.

According to the Federal Trade Commission, “Most people who join legitimate MLMs make little or no money. Some of them lose money. People who become involved in an illegal pyramid scheme may not realize they’ve joined a fraudulent venture, and typically lose everything they invest. Some also end up deeply in debt.”

Does Joining an MLM Company Ever Make Sense?

If you have a knack for sales, a solid sales plan and can afford to lose money and time if the MLM venture doesn’t work out, you might consider it — but there are definitely better alternatives to make some extra cash to pay down debt.

“Instead, I would recommend taking advantage of the gig economy,” Bethune said. “There are companies like Uber, Lyft and Doordash that you can sign up with in just a few minutes and start making money on a part-time basis to pay down your debt. If you have a particular skill, try offering your services as a freelancer on sites like Upwork.com or Fiverr.com. If you have a product that people may want, try Gumroad.com or Etsy.com. There are many ways to earn additional income in order to start getting out of debt. Do your research, and pick what works best for you and your schedule.”

9. Continuing To Make Credit Card Charges

You might have made a commitment to yourself to focus on paying down your debt by spending less and saving more, but many people continue to put charges on their credit cards during this time.

What Can Happen

When you continue to buy things with your credit card, you continue to rack up high-interest debt — which could cost you hundreds or even thousands of extra dollars over time. The more debt you rack up, the harder it is to pay down.

Read: Mark Cuban Says the Best Investment Is Paying Off Your Debt — Is He Right?

Why This Is a Dumb Mistake

“When you continue to use credit cards, your mountain of debt will not get any smaller,” serial entrepreneur John Rampton said.

Though it might be easy to continue swiping your credit card, this behavior is not doing you any favors.

“If you’re in the hole, the first rule is to stop digging,” said James Lenhoff, CFP, life coach and president of Wealthquest. “The truth is that a lot of people are medicating a negative emotion, like inadequacy, with their spending. They don’t want to experience it, so they live a lifestyle they can’t afford to try to feel better.”

However, if you end up with more debt, you could just end up feeling worse.

Does It Ever Make Sense To Continue Using Credit Cards While Paying Down Debt?

If you’re dealing with long-term debt, such as a mortgage or student loans, it’s OK to keep using a credit card. But if you are specifically dealing with credit card debt, it’s time to stop swiping. Make payments with cash or a debit card to prevent yourself from spending more than you have and racking up even more debt.

10. Stopping Your Contributions to Retirement and Emergency Funds

If you’ve decided to make paying off debt your priority, you might be tempted to funnel all your income toward necessary expenses and debt repayment and put a pause on contributions to your retirement savings and emergency savings.

What Can Happen

Not contributing to your retirement savings now, especially if you are young, might not seem like a big deal. But you’re robbing your future self of financial security.

And not contributing to an emergency fund can negatively impact your not-so-distant-future self. If you don’t have three to six months’ worth of living expenses saved up “just in case,” you might be in even worse financial shape than your current debt situation if an unexpected event occurs.

Why This Is a Dumb Mistake

“It’s a mistake to stop contributing to your retirement fund just to pay down debt,” said Brian Burke, founder of Sell Your Mac. “The money you set aside for your future can continue to grow as you regularly contribute to it. Look for other areas where you can cut back so you can divert that money to paying down debt instead.”

If you do need to lower your retirement contribution amount while focusing on debt repayment, you should at least contribute enough to your 401(k) to get your employer match.

“Perhaps the worst financial mistake anyone can make is turning down free money,” said Robert Johnson, professor of finance at Heider College of Business, Creighton University. “If one doesn’t contribute enough in a 401(k) plan that has a company match to earn that match, one is basically turning down free money.”

Jon Bradshaw, president of Appointment, also advises against failing to contribute to an emergency fund.

“The unexpected is bound to happen, and you will end up having to use a credit card to cover that car repair or medical bill,” he said. “Then, you are deeper in debt. By putting money aside for these unexpected events, you won’t create more debt.”

Does It Ever Make Sense To Stop Contributing To Retirement or Emergency Funds?

If you already have a good financial safety net saved up in an emergency fund, it’s OK to funnel your usual savings contribution toward debt repayment.

“Once you have three to five months of basic living expenses put away in a high-interest savings account, you can pause your emergency savings while you repay your debts more aggressively,” said Liam Hunt, a financial writer at CPI Inflation Calculator.

On his blog, Ramsey said it’s OK to pause retirement contributions until you have a healthy emergency fund and have paid off your debt, aside from your mortgage.

11. Not Having a Reasonable Debt Repayment Strategy

When sitting down to tackle your debt, the first step should be to see how much total debt you actually have. Add up any debt you have accrued from student loans, car loans, credit cards, medical debt, home equity loans, payday loans, personal loans, and IRS and government debt. If you’ve been dealing with debt for a while, this might add up to a scary number that could leave you feeling overwhelmed, and you might feel like you don’t know how to even begin paying it back.

What Can Happen

When you don’t have a clear debt repayment plan, your instinct might be to try to cut back on spending, save more and earn extra money until you’ve saved enough to pay back your debt all at once. However, if you are just making the minimum payments throughout this time, you’ll be accruing more interest all along.

Why This Is a Dumb Mistake

“The biggest mistake people make when they’re in a hole is trying to take it out in one swing,” said Cory Klippsten, CEO of Bitcoin savings app SwanBitcoin.com. “Get on a program where you’re consistently paying down your debt every month. Your positive momentum will feed on itself and is likely to open doors for making more money so you can pay down even faster, and get back to saving and investing for your future.”

Chalmers Brown, co-founder and CEO at Due, agrees.

“Don’t try to attack every debt you have at one time,” he said. “It’s like multitasking: you are doing a lot of things but not necessarily making any headway. Instead, it’s good to use a debt payoff method like the snowball method or avalanche method. Both have you focusing on one debt — whether it be the one with the largest interest rate or the [lowest] balance. Once that is done, you move on to the next debt on your list.”

Does It Ever Make Sense To Pay Down All Your Debt at Once?

In many cases, paying off all your debt at once is impossible, so having this as your goal will only set you up for failure. However, if you’ve recently received a bonus, tax refund or another cash windfall that can eliminate — or at least pay off most of — your debt, this is a great way to use that money.

Paying off debt as quickly as possible will lower the interest you have to pay and also will improve your credit score.

12. Closing a Credit Account as Soon as You Pay It Off

Whether you choose to pay off debts from highest to lowest interest rate or smallest to largest amount, you might be tempted to close each account as soon as you are done paying it off.

What Can Happen

Especially with credit cards, it’s true that having fewer credit cards open can make it less easy for you to spend above your means — but this seemingly smart move can end up raising your credit utilization rate. This is measured by the total amount of your balances divided by the total amount of credit you have available, so the fewer cards you have open the higher your utilization rate will be. Your credit utilization rate is one of the factors that is used to calculate your credit score.

Why This Is a Dumb Mistake

“While you may have the best intentions in mind and think it helps your financial position, it’s a big mistake to close a credit account when you pay it off,” said Jason Powell, real estate and securities attorney with EstateInvesting.com. “You end up further harming the very credit score you are trying to fix by doing so. Your credit report is not only based on how much you owe, but it is also about how much credit is available to you. Closing accounts means you show you have less credit available to you.”

Instead, “keep it open, stay disciplined on what you use it for, and pay off monthly balances,” Powell said.

Does It Ever Make Sense To Close a Line of Credit?

If you know you won’t be able to stop yourself from adding new debt to a credit card you’ve paid off, closing it could be worth the ding to your credit score.

Before you close a card, make sure you have paid off all outstanding balances and fees, redeem any remaining awards, remove the card as a saved method of payment for any recurring payments and call your provider to formally close the account.

More From GOBankingRates

Gabrielle Olya and Jodi Thornton-O’Connell contributed to the reporting for this article.

This article originally appeared on GOBankingRates.com: 12 Dumb Mistakes People Make While Trying To Get Out of Debt

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