While you might think all debt is bad, some can actually improve your finances.
Laura answers a listener’s question about the best way to pay off a large credit card balance. You’ll learn eight of the best methods to eliminate any debt you owe and stay debt-free.
Money Girl is hosted by Laura Adams. A transcript is available at Simplecast.
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Kerri H. asks, "I have about $20,000 in credit card debt and want to know if it's better to pay it off using a home equity line of credit or a loan from my 401(k)?"
I appreciate your question, Kerri! This show will answer it by reviewing eight of the best methods to pay off debt and their pros and cons. You'll learn how to evaluate different options and know which one is best for you in the long run.
Hello, friends, and thanks for joining me this week! I'm Laura Adams, a money expert and author who's been hosting the Money Girl podcast since 2008, with over 40 million downloads. My mission is to help you get the knowledge and motivation to prioritize your finances, build wealth, and have more security and less stress.
If you're not already subscribed to the podcast, that's the best way to ensure you never miss a weekly episode. Also, I love getting your questions on our voicemail line at 302-364-0308. You can also email me using my contact page at LauraDAdams.com.
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What's the difference between good and bad debt?
Before I cover ways to pay off debt, I want to review the differences between good and bad debt. While you might think all debt is bad, some can actually improve your finances. So, identifying your good and bad debt should help you know which ones to tackle first. Then we'll review various debt payoff methods.
One way to know if a debt is good or bad is whether it pays for something likely to appreciate or depreciate. If you use debt to finance an asset that increases in value and boosts your net worth, it's typically good. But going into debt for something that loses value or deflates your net worth is terrible.
For instance, a home mortgage allows you to buy real estate that typically appreciates over the long term. While there's no guarantee that a home will be worth more in five years than today, real estate generally appreciates about 3% to 5% per year and could be higher in desirable areas.
QUICK TIP: Use a Mortgage Affordability Calculator to know how much home you can afford before shopping.
Another example of a good debt is an education loan. While a student loan isn't backed by an asset, such as a home, it can help you earn more over your lifetime. A college degree is required for many jobs and industries, such as health care, law, and computer engineering. So, depending on the career you want, taking out a reasonable amount of education debt can make you more employable.
As I mentioned, bad debt finances something that loses value over time. For example, an auto loan allows you to buy a new vehicle, which typically depreciates by 50% within a few years. Of course, the depreciation rate depends on a vehicle's age, make and model, and how well you maintain it.
While a car loan is technically bad debt, many people need vehicles for their businesses, jobs, or everyday chores. So it's wise to borrow as little as possible or finance cars that hold their value over time.
Credit cards are one of the worst debts because they charge some of the highest interest rates and typically get used for consumer goods. Kerri owes $20,000 and didn't mention the card's interest rate—but let's say it's 18% APR. If you only paid the monthly minimum, it would take over fifteen years to pay off, and you'd fork over an additional $12,000 in interest! And the stuff you charged would likely be worth pennies on the dollar.
LEARN MORE: Get Out of Debt Fast–A Proven Plan to Stay Debt-Free Forever
3 methods to pay off your debt
Now that you know the difference between good and bad debt, what's the best way to pay off your top-priority debts? There are three popular methods I'll review.
But first, I recommend making a list of your debts, their interest rates, and balances. You might jot them down on paper or create a spreadsheet or Google sheet. Identify your good debts, such as mortgages and student loans, and your bad debts, like high-rate credit cards, personal loans, and auto loans.
Then you can prioritize them according to one of the following methods.
ALSO LISTEN: How Consolidating Credit Card Debt Affects Your Credit Scores
While these are common elimination strategies, there isn't a right or wrong way to pay off debt. Any method you can stick with and make steady progress will be a good one.
Once you get rid of bad debts, you can consider tackling the good ones—unless you have a better use for your money. For instance, if you can invest money for a higher rate of return than a debt's interest rate, you're usually better off investing.
RELATED: How to Know When to Invest or Prepay Debt
5 debt consolidation strategies
Using a consolidation strategy can save money if you have one or more unsecured debts, such as medical bills, personal loans, student loans, or credit cards, you want to pay off faster. Debt consolidation doesn't reduce the debt you owe, but transferring or reorganizing it can reduce your interest rate and make it easier to pay off.
Here are five ways you may be able to consolidate debt and pay less interest.
1. Balance transfer credit card: You move unsecured debt to a new or existing credit card with a 0% APR promotion that may last up to 18 months. Every transfer is subject to a fee, such as 3% or 4%, which gets added to your balance.
Once a transfer promotion ends, your interest rate increases and could be very high. Therefore, it works best when you're sure you can pay off the entire balance before the promotion expires.
Avoiding interest during a balance transfer promotion can save a chunk of change. However, the amount you can transfer to a card depends on the credit line the issuer offers you. If you don't have good credit, you may not get approved for a balance transfer or be able to only put a small amount of your debt on a card.
Use a comparison site like Finder to shop for the best balance transfer cards with the lowest interest, transfer, and annual fees. Choose an offer where you come out ahead, even accounting for the transfer fee.
ALSO LISTEN: Dealing with Debt: Expert Tips for Using a Balance Transfer Credit Card
2. Personal loan: You use a new fixed-rate personal loan to pay off higher-rate unsecured debt. You make monthly payments during a set repayment term, such as three or five years. The rate and terms a personal loan lender offers usually depend on factors like your income and credit.
Remember that even though a personal loan may cut your interest, the shorter your repayment schedule, the higher your monthly payments will be. You risk hurting your credit if you can't repay a personal loan as agreed.
You can enter basic information at LendingPoint to see your loan options without hurting your credit. It’s a good option when you have a larger balance to consolidate and want a structured repayment term.
3. Home equity line of credit (HELOC): If you're a homeowner with at least 20% equity, you may qualify for a home equity line of credit (HELOC). Equity is the value of your property, less what you owe for it.
For example, if your home's market value is $400,000 and your outstanding mortgage balance is $300,000, you have $100,000 in equity or 25% ($100,000 / $400,000 = 0.25).
A HELOC is a revolving line of credit that allows you to borrow an amount up to your credit line, using your home as collateral, without needing to refinance an existing mortgage.
Since a HELOC is a secured debt, it typically has a much lower interest rate than a credit card or personal loan. You can use it in any way, such as for home renovations or paying off higher-rate debt. However, if you use HELOC funds to buy, build, or improve your home, a portion of the interest paid is tax-deductible—but that's not the case for other uses like debt consolidation.
Like a credit card, you must make minimum monthly payments on a HELOC. Most have a variable rate, which means your payments can increase if interest rates rise. Another downside is that the lender can foreclose on your home if you can't repay a HELOC.
Shop around for the best HELOC rate with the lowest fees. Your current mortgage lender may be able to expedite your application using paperwork from your original loan, depending on how long ago you got your first mortgage.
4. Home equity loan: Homeowners with at least 20% equity may qualify for a home equity loan. Like a HELOC, it uses your home as collateral without having to refinance an existing mortgage. But instead of a variable-rate credit line, it gives you a lump-sum amount to be repaid over a set term, such as from 5 to 30 years, at a fixed interest rate.
Like a HELOC, home equity loans generally have lower interest rates than unsecured debt. And you can use it any way you like, but a portion of interest is tax-deductible when you spend it to buy, build, or improve your home.
The main downside of tapping your home equity with a line of credit or loan is that if you default, you risk losing your home to foreclosure. Plus, there are closing costs, similar to a primary mortgage, which add to the cost of borrowing. Again, consider getting multiple quotes, including from your current mortgage lender.
5. Retirement plan loan: If you have a workplace retirement account or are self-employed with a solo 401(k), most plans allow you to take out loans with a five-year repayment term. Note that loans are never an option with any type of IRA.
While you must repay retirement loans with interest, it's typically relatively low and goes back into your account. In addition, there's no credit check, underwriting requirement, or fees since you're borrowing your own money. You can borrow 50% of your vested balance or $50,000, whichever is less.
You can use a 401(k) loan for any reason, including paying off high-interest debt. But remember that borrowed funds won't get invested in the market during repayment, which could jeopardize your retirement.
Another consideration is that a retirement loan must be repaid in full within 60 days if you leave your job or get terminated. If you didn't repay it on time, it would be considered an early withdrawal, subject to income taxes plus a 10% penalty if you're younger than 59.5.
ALSO LISTEN: Taking 401(k) Loans–11 Pros and Cons You Should Know
Should I consolidate debt using a HELOC or 401(k) loan?
Now that we reviewed the most common strategies for paying off and consolidating debt, let's get back to Kerri's question: Is it better to pay off $20,000 in credit card debt using a HELOC or a 401(k) loan?
Kerri, as always, there are pros and cons for both. On the one hand, a HELOC gives you much flexibility to spend any way you like but requires a lender application, origination fee, credit check, and sometimes, an appraisal to verify your home's market value.
On the other hand, a 401(k) loan has no formal application or fees but leaves you with less invested, and it could be costly if you separate from your employer for any reason and can't repay the entire balance right away.
My top recommendation is buckling down and paying off your card debt without borrowing any money. Ideally, you'd stop making charges you can't pay in full monthly and create a $20,000 payoff plan. For instance, you could pay $3,333 monthly for six months or $1,666 for 12 months and wipe it out. If you have multiple cards, you could attack them using a snowball, avalanche, or landslide approach.
However, consolidating is likely worthwhile if you genuinely believe you can't pay off your card(s) within a year. The danger is that after wiping out your balance, you'd continue racking up more card debt. So, be sure you're committed to staying out of credit card debt.
Kerri, without knowing more about your financial situation, I'd lean toward the HELOC if I had to choose between a HELOC and a 401(k) loan. I believe a retirement account should only be tapped as a last resort. Your retirement funds are too precious to squander, and the potential penalties are too costly.
That's all for now. I'll talk to you next week. Until then, here's to living a richer life.