The Two Dumbest Ways to Pay Down Your Credit Card Debt

If you've been reading Free Money Finance for any time now, you know that I'm not a big fan of credit cards. Oh, I don't suggest that you shouldn't have any (like Dave Ramsey does), but I'm not pro-credit card because many people simply can't handle them. In the end, this is more of a problem with the people themselves than with the cards, but that post is for another day.

Today I wanted to talk to those of you who are working to pay down your credit card debt. First of all, congratulations. You're on the way to increasing your net worth. Second, be sure you pay down your cards in a smart way. In The Two Dumbest Ways to Pay Down Your Credit Card Debt, Suze Orman talks about two ways that are BAD for people to decrease credit card debt. She says:

"Whatever you do, don’t you ever use a Home Equity Line of Credit (HELOC) or a loan from your 401(k) to pay off your credit card debt!"

Why? Here's why to avoid a HELOC:

"Your credit card debt is what is known as “unsecured.” What that means is that if you default on paying this debt, the credit card issuer can’t take possession of any asset of yours as a way of getting their money. A HELOC, on the other hand, is what is known as a secured loan; there is collateral on the loan so if you default, the lender can indeed grab that collateral as a way to get paid. And guess what? The collateral on a HELOC is your home. If you get behind on that loan—say you lose your job, or become too ill to work—and miss too many payments, the lender has every right to force you to sell the home to pay off the debt."

And here's why borrowing from your 401(k) is a bad idea:

"When you contribute to a 401(k) you use money that has not yet been taxed. But if you borrow against your 401(k), you will repay it with after-tax money. Then that money you have used to “repay” your 401(k) loan will be taxed again when you eventually make a withdrawal in retirement. I think being taxed once is plenty."

So keep paying off those credit cards. Just do it the right way.

Comments

[ncnblog]

Love your site, thanks for the link! I remember waking up a few years ago, and noticing that my credit cards were taking over my financial life. I was buying and buying and buying...they are addictive. I think that the reason that I go with Dave's plan over Suze's is that I know that I am a credit "junkie." I cannot give myself any leeway when it comes to credit card use. It's either all or nothing. Some may think that this is crazy or "weak," but I think that this is a sensible response to a real problem I had (have). Thanks again for your great site.
ncnblog.blogspot.com

[S. G. Sanderson]

I'm new to blogging, but came across your site in the WSJ Sunday Edition. I am retired and have reached my financial goals thru never going into debt (aside from mortgage). I recently grew so tired of offers for interest free loans from my credit card issuers that I signed one of their "free" blank checks into my MM account in the amount of $10,000.00. I then bought 10K worth of an exchange traded stock that I,ve had for several years which pays 12.5% dividend. I only have 6 months of "no interest" on the loan, but for the last three months I've been getting $80.00 plus a month and the stock has risen $1200.00 in value. I love the idea of making money on the bank's money. There are a few things you should know before trying this. Mail me for details.

[Steve Mertz]

I admire his ingenuity and just pray that the dividend is secure!

[sixpack]

401(k) loans are such a bad idea, I'm surprised it's offered. Plus if you leave your job while still paying your loan off, you need to pay it immediately or face IRS penalties. OUCH!

[pfadvice]

The problem most of the time is that when people use home equity to pay off credit card debt, they have never addressed the problem of why they have the credit card debt in the first place - that's what makes it so terrible. Since the source of the problem never has to be addressed the likelihood of credit card debt coming back is extremely high.

The "correct" ways to pay it off addresses this problem by forcing you to figure out how you got there in the first place. I'm not against using a home equity loan to pay of credit card debt IF you have solved the problem that got you there in the first place corrected before doing so. That is a big "if" for most people.