On the surface, getting debt-free sounds like a simple process. Make your minimum payments each month and get your balances to zero, then you’re across the finish line. But with interest rates steadily on the rise, this isn’t much of a strategy. It’s a surefire — and expensive — way to keep yourself chained to debt for much longer than you need to be.
The truth is that saving the most money and getting out from under debt as quickly as possible comes down to learning the basics.
Here’s a rundown of the top mistakes to avoid while on the road to debt-free living.
1. Continuing to accumulate new debt
Deciding to take charge of your debt once and for all is an empowering move, especially when you start seeing those balances go down. But accelerating your payments on one account while continuing to rack up new debt is hardly a solution.
“You may feel better because you’re sending an extra $500 to your credit card every month to pay it down, but if you’re using a different credit card to buy groceries, you’re just cycling the debt around,” Michaela Harper, director of community education at the Credit Advisors Foundation, told MagnifyMoney.
This all-too-common scenario underscores how important it is to have an effective budget in place, which requires a firm grasp on your monthly income and expenses. If you’re spending more than you’re earning, you’ll never break the debt cycle.
Vid Ponnapalli, a New Jersey-based certified financial planner, recommends looking back and tracking your spending over the past six months. This should highlight any gaps between your spending and your income.
“If you’re bringing in $4,000 each month but spending an average of $4,500, you need to remedy that deficit,” he told MagnifyMoney. “This means either reducing your expenses or increasing your income.”
Crafting a solid budget is your best defense.
2. Focusing on the wrong debt
Not all debt is created equal. When you’re in over your head, Harper said to focus first on “people who can mess with you — [anyone who has] a judgment against you or has the ability to put liens on you.” Having your wages garnished or your car repossessed are never scenarios in which you want to find yourself.
From there, high-interest balances should be front and center because you’re paying the most to keep them around. This is precisely why it makes sense to roll these balances over to accounts that have lower interest rates. This process is called debt consolidation.
Let’s say your debt looks like this and you’re paying $150 a month on each account:
- Credit card No. 1: $5,000 at 19% interest
- Credit card No. 2: $2,000 at 14% interest
- Credit card No. 3: $1,000 at 10% interest
Going that route will take you four years to pay everything off, and you’ll dole out $2,383 in interest alone (if you stick to $150 payments even after certain cards are paid off). But if you take all that debt and pay it off with a two-year debt consolidation loan at 8%, you’ll cut your interest payments by almost $1,700, lower your monthly payment by about $100 — and be debt-free in half the time.
Many debt consolidation loans come with an origination fee of up to 6%, but your savings could very well make up for it. To explore your loan options, consider using this debt consolidation loan tool from LendingTree, MagnifyMoney’s parent company. The tool could match you with up to five different lenders offering competitive loan options.
3. Tapping your 401(k) to pay off debt
Let’s talk 401(k) loans, which let you borrow from your future self and then gradually pay it back with interest, usually via automatic payroll deductions. You have five years to repay these loans, and the interest rate is generally the current prime rate plus 1%.
When face to face with a mountain of debt, it can be very tempting to use your retirement nest egg to wipe out your balances and start over, but think very carefully before doing so.
First, there can be significant tax implications. You’re putting pretax money into a 401(k). But when you’re paying back a 401(k) loan, you’re using after-tax dollars, Ponnapalli said. Then you have to pay taxes again when you withdraw the money during retirement.
What’s more, Ponnapalli said if you fail to make good on your loan terms, the loan is then considered a distribution. If you’re younger than 59 ½, you’ll also pay a 10% penalty.
“And if you leave your job for any reason, the balance will be due, in full, much sooner than originally planned,” he added. (Check your individual plan for details.)
By taking your money out of the market, you’re robbing yourself of future gains as well. Where retirement savings are concerned, your No. 1 weapon is time. The longer you’re invested, the more money you’ll have waiting for you come retirement.
4. Falling for a debt relief scam
When you’re overwhelmed by debt, navigating the situation on your own can feel impossible. Credit counseling is a legitimate option if you go with a reputable company that has your best interests at heart. American Consumer Credit Counseling and the National Foundation for Credit Counseling have strong reputations.
Through these groups, you can connect with professionals who’ll review your financial situation, educate you on personal finance basics and — hopefully — empower you to get back on the right track. Credit counselors also help clients create a plan of attack for addressing their outstanding debt.
But consumers are wise to beware of shady debt relief organizations. For-profit credit counseling groups are generally a red flag, as are companies that make too-good-to-be-true promises or guarantees about debt relief.
Harper said initial counseling sessions should be free and have no strings attached. He recommended going with one of the nationally recognized groups. “You’ll have assurance that you’re dealing with a reputable organization and staff that knows what they’re doing,” Harper said.
5. Neglecting your other financial goals
There’s nothing wrong with being laser-focused on paying down debt as long as it doesn’t impact your ability to move the needle on your other financial goals. Whether it’s saving for retirement or building up your emergency fund, you don’t have to ignore your other goals in the name of debt repayment.
Speaking of emergency funds, Ponnapalli recommends building yours up to at least three months’ worth of expenses, but this can be a tall order for those at war with debt. An alternative strategy is to gradually fund a mini-savings account of $1,000 until you’re debt-free. This should be enough to cover most pop-up expenses. After that, you can top off your emergency fund to that three-month mark, then start saving more aggressively for other financial goals.
No matter what, kicking into a 401(k) that offers an employer match should always be a top priority, even while you’re paying off debt. (It’s free money, after all.) As for the big things, Harper suggests breaking down these goals into bite-sized pieces. If you want to save $5,000 to put a down payment on a house in three years, how much do you need to save every month to get there? Is it possible to do this while still making progress on your debt payments? It doesn’t have to be an all-or-nothing situation.
6. Putting all your eggs in the bankruptcy basket
It isn’t all that surprising that money is America’s leading cause of stress, according to a 2018 Northwestern Mutual study. When you’re buried under tremendous debt, bankruptcy can feel like a gift that wipes the slate clean. In the face of financial catastrophe, it might make sense, but it’s a last-resort option.
Any reputable counselor will guide you toward bankruptcy if it is your best path forward, but Harper warns that it isn’t without consequences. While many of your debts might be forgiven, you could lose other assets, such as your home or car, in the process. Your credit score will take a hit as well. Chapter 7 bankruptcy stays on your credit report for 10 years, while it’s seven years for Chapter 13. The silver lining is that, according to a study put out by LendingTree, roughly 75% of those with a bankruptcy on their record end up restoring their credit after five years.
“I’m a big believer that if it’s the right thing to do for your family in order to move forward, and it’s truly an insurmountable situation or amount of debt, then by all means grab it with both hands, do it and focus on rebuilding behaviors,” Harper said.
For folks who are overwhelmed by debt, Harper said credit counseling is often the best medicine for understanding what you’re up against and making a plan to get out of it.
The most important things to remember
The road to getting debt-free isn’t always straight and narrow — sometimes life gets in the way — but knowing the basics can make course-correcting a whole lot easier. Pushing pause on accumulating new debt is crucial. From there, put out the biggest fire first. Tapping your 401(k) to pay off debt or ignoring your other financial goals, while tempting, could also come back to bite you.
It’s about prioritizing debt repayment without putting your future self at risk.