TAMPA, Fla. - It is 2021, and you resolved in the New Year to get yourself out of debt, and if things work out, maybe even save a little bit of money. But you've been down this road before and you know how much effort it takes to become debt-free, especially if you have a sizable chunk that you owe to creditors.
I've witnessed firsthand those that were eager, almost desperate to get out of the debt trap, but despite how hard they tried, they never could get free. Today, I’m breaking some of the obstacles that throw people off their debt payoff game.
Before we talk about the mistakes to avoid, it's helpful to remember what are the benefits of becoming debt-free:
Increase credit score - Increasing your credit score can help you save a ton of money and also make your financial life more enjoyable. Having a high credit score can lower your interest rates on credit cards and personal loans, give you more negotiating power when you're looking to purchase, say, a new car, and can also help you save on your auto insurance rates. There really is no downside to increasing your credit score.
Lower your interest payments - The average U.S. consumer has just over $145,000 in total debt, with the U.S. racking up a total of $14.35 trillion. This was a 2.85% increase from 2019 and 2020, according to a NerdWallet study. Assuming a modest 3% interest rate, that means Americans on average are shelling out $4,350 per year on interest charges.
The pandemic has only made people's financial situation more dire. We've seen credit card balances increase, where the average balance is $7,027.
With an average APR of 16.43%, the average consumer is paying $1,155 on interest charges. For small business owners, that's even higher with around $1,539 being paid on interest per year.
Increase your happiness - You can't put a price on is happiness. A study done by the American Psychological Association showed that 72% of Americans feel stressed about money and the level of debt that they were carrying.
Even worse, 22% felt extremely stressed over their finances. And the scary thing is this study was done well before the pandemic. We can only assume that stress has only gotten worse.
Mistakes to avoid when paying off debt
Now that we remember some of the benefits of taking charge of our debt situation, let's look at the four mistakes to avoid.
Taking money out of your retirement accounts - It seems like the logical answer: pull money from your 401(k) and use that to pay off a good chunk of your debt or even all of it. This is one of those situations where you really have to measure the short-term win versus the long-term impact.
Now, the good news is that the IRS added a special rule, section 2202 of the CARES Act, that allowed up to a $100,000 distribution from all eligible retirement plans. This included 401(k)s, 403(b)s, and IRAs. And as long as you met certain requirements regarding the pandemic and COVID-19 portion, you wouldn't have to pay the typical 10% early withdrawal penalty by taking a distribution before the age of 59 and a half.
While the CARES Act special rule expired, Congress did pass new legislation, creating a similar and permanent retirement plan distribution. This is called the "qualified disaster distribution," and it's very similar to the CARES Act special rule. But even though you can still avoid the 10% penalty, it doesn't necessarily mean that taking money out of your 401(k) is the best option.
The way that I've always looked at it is for every dollar that you are taking out, you are potentially giving up four to 10 times that, depending on how long your time horizon is. Say for example, you were in your younger 30s and you withdrew $10,000 from your 401(k). Over time, that $10,000 could grow to be between 40 and $100,000 depending on how aggressively it was invested. It's always important to outweigh the short-term gains versus the long-term impact.
Not reviewing your interest saving options: It might feel good to finally have a plan to pay off all your debt. And after making several payments, you may feel good about your progress. But one thing that you may be missing out on is investigating ways to reduce how much the interest is that you're paying.
It's important to look for interest saving opportunities, such as using a balance transfer credit card, or transferring the debt that you owe to a lower interest personal loan.
Let's say, for example, that the average interest rate on all your debt is at 19%. If you're able to refinance and lower that interest rate down to 15%, that means that more of your payment will go towards the principal and pay off that debt that much faster.
Refinancing without getting the details: As we mentioned above, refinancing your debt could save a ton on interest and help you pay off your debt that much faster, but there are some instances where you might get yourself in trouble and not realize it. Refinancing can increase your monthly payments in some situations, which if your goal is to pay off your debt that much faster, this is a win. But if you can't afford the increase in payment, then you could find yourself right back where you started in a financial hole.
The other issue to be aware of is if you execute a balance transfer of your credit card. The new card issuer may not grant you the same amount on your credit limit as your previous card. This may not sound like a big deal, but it could factor in with your credit utilization ratio, which looks at how much debt you have compared to how much you have available.
Increasing your credit utilization ratio could also affect your credit score, but not in a positive way. This is just another important thing to look at before you make any financial move.
Forgetting what's important: Coming from somebody who found himself in a debt-hole before he even started his career, I completely understand how exciting it can be working on a plan to pay off all of your debt. And even though high-yield savings accounts are paying next to nothing because of the low-interest-rate environment, this doesn't mean it's not important to have an emergency fund.
Financial experts typically recommend at least $1,000, preferably more, socked away in a savings account at your local bank. This is money put away for one purpose and one purpose only, to take care of any financial emergencies that may occur.
If you are highly motivated to finally say goodbye to all of your debt, then make a plan and stick to it. Avoiding these four mistakes can hopefully make your debt-free reality happen that much sooner.
Jeff Rose is a combat veteran, certified financial planner and founder of GoodFinancialCents.com