Considering taking out a home equity loan or borrowing against your 401K to pay off debt?  Maybe someone recommended you get a bill consolidation loan to move all your credit card and consumer debt to one payment?  If any of this sounds like a smart move to get out of debt, it really isn’t.

Most folks believe consolidating loans makes the most sense, primarily because consolidation gets down to a single payment.  This sounds good but herein lies the problem, most folks haven’t changed the behavior that got them into debt in the first place.  So, instead of consolidating all debt and paying it off, they tend to use their new found available credit on the cards or loans that they included in the consolidation loan and continue to spend.  In the end, they have just accumulated more debt and find themselves in a worse situation.

Other concerns are a home equity loan, home equity line of credit (HELOC) or borrowing against a 401K:

  1. A home equity loan is borrowing against fake equity; why, because a home is only worth what someone else is willing to pay for it. Using an appraisal, normally done by someone hired by the loan company, only tells one what their market value is of said property.  Then the loan company will let them borrow 70-80% of that equity value in the property and now they have two payments, mortgage and second mortgage (home equity loan or HELOC).
  1. The HELOC can be even worse as it’s a line of credit and as one pays it down they have more credit again.  Remember credit debt is what got a person in this position in the first place.
  1. A 401K is supposed to be an investment, a person loses a portion of their investment if they take out a loan against it.  The loss is greater than one might think as it not only loses the actual funds in the account, it also loses the compound interest that would have occurred if the money had stayed in the 401K.  So, borrowing from a 401K is really a bad idea all around.

The best option is to stop spending, establish a $1000.00 emergency fund for life’s little incidents, then organize the debts smallest to largest and attack the smallest one first while making minimum payments on the others.  Once the first debt is paid off, add the funds to the next smallest debt along with the current payment to attack it while making the minimums on the others.  This process should be motivation to paying off debt using the debt snowball effect.

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Avoiding the Debt Trap

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