Debt is an important tool in your personal finance toolkit. But just as a hammer can be incredibly destructive if incorrectly used, debt can be misused and abused — to devastating results.
Are you guilty of any of the top five worse debt decisions?
1. Using your 401(k) to pay off a loan
There are a number of reasons why this is a bad idea. First, any money you take from your 401(k) prior to reaching age 59½ will be hit with a 10% early-withdrawal penalty, as well as income tax. In addition, the money you take from your 401(k) will be considered earned income, which means that you’ll likely be pushed into a higher tax bracket when you make your withdrawal.
And all that’s before you even get to the lost growth on your retirement fund. Every dollar you take from your 401(k) is a dollar that can no longer earn compound interest.
No matter how big of a fix you’re in debt-wise, tapping your 401(k) should absolutely be a last resort.
2. Co-signing a loan to help out a friend or family member
It seems like a generous thing to do: you sign off on a loan for a struggling friend while they get back on their feet. But the thing is, banks require co-signers for people who couldn’t otherwise qualify on their own credit.
The bank knows that these individuals are bad credit risks — so you should recognize that truth, as well. Unless you’re able and willing to pay the entire loan yourself, and you don’t mind having a strained relationship (at best) with the borrower, then just say no to co-signing.
3. Signing up for a store credit card
The lenders behind store credit cards have your number. They know a discount and zero-percent interest window will seduce you into signing up for a card you neither need nor want.
But unless you can go straight home and immediately pay off the amount you’ve charged, you’re likely to get stuck with a ridiculously high interest rate when the zero percent window closes. The cost in interest, which is often as high as 22% on these types of cards, far outweighs the discount you received for signing up.
4. Taking a payday loan
These loans are cancerous: they tend to grow and grow until they destroy your life. Taking a payday loan to survive until your next paycheck may seem like a simple solution — but if you don’t have the cash this week to pay for your unexpected expense, what makes you think next week will be better?
Instead of going to a payday lender, see if you can generate the needed cash by selling something, taking on extra work, or borrowing from a friend. And then start building an emergency fund, so you don’t find yourself in this position again.
5. Not having a credit card
If you struggle with credit, it may seem smarter to simply live without a credit card. Then you know there’s no way for you to get in over your head.
While those individuals who really can’t trust themselves with credit cards probably ought to live without one, it’s important to remember that lenders need to see that you can responsibly handle credit. If you ever want to buy a house or a car, it will be much more difficult to qualify for a good loan if your credit history doesn’t include responsible credit card use.
That doesn’t mean you shouldn’t be smart about your credit card use. Sign up for a card with no annual fees, and use it to make regular, automatic purchases, such as your utility bill. If you know you can’t trust yourself with the card itself, then freeze the card in a block of ice, and pay off your monthly automatic purchases to build your credit without tempting yourself.
The Bottom Line
Using debt responsibly is a skill you can learn, even if you’ve made big mistakes in the past. Avoiding these five bad decisions will get you on the right path.
Have you made any of these mistakes before? Which do you think is the worst?