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Dangerous Strategies for Eliminating Debt

When most Americans make the decision to buy a home, they are still more than year away from moving into their new dream home. That's because there's typically much work to be done before buying a home. Prospective homebuyers must first address their credit score, ensuring that they have a high enough score to qualify for a home loan; and perhaps more importantly, one must get their finances in order to ensure they can afford a home. For most Americans, this means getting rid of excess debt, an endeavor for which there's plenty of advice out there, though not all of it is good advice. Moves intended to eliminate debt can often actually increase it or even cause a new homebuyer to lose his or her home. That's because many commonly used tactics for debt elimination in fact do not get rid of debt but just shuffle it around. Following are several commonly used debt reduction strategies that most Americans should probably avoid.

One of the most dangerous debt reduction moves is to take out a loan with the equity you have built up in your home. This is especially true if the original loan was unsecured. While any failure to make payment on a credit account will hurt your credit score, failure to make payments on a home equity line of credit can also lead to losing your home. Often referred to as HELOCs, these loans are a good option for making repairs or improvements to the home, since those expenses actually increase the value of your home. Many Americans turn to HELOCs to pay off credit card debt or other mounting bills, then end up losing their home when tragedies such as losing a job or an injury impair their ability to make payments. Another commonly used debt reduction method is asking your bank to extend your line of credit, using the new borrowed money to pay off the old. While this method is better than leveraging your home, it can often make your total debt load higher and harder to pay off, since most banks increase interest rates when extending credit.

Another way many Americans pay off debt is to borrow against their 401(k) or other retirement accounts. This is inadvisable because they will end up being taxed twice on the same money. The government will tax the account holder on the loan, which they consider income, and will then tax the 401(k) when you cash it in years later. It's a much better idea to leave the retirement funds alone, allowing it to draw interest over time and only get taxed on it once. Another bad way to pay down debt is to take out so-called payday loans in order to make some other payment on time. These loans typically carry much higher interest rates than other forms of credit, leaving borrowers in more debt rather than less. Most financial advisers say that payday loans should only be used in extreme cases of emergency, and nearly all say you should never use them to pay down other debt. The final way to reduce debt, which should only be used as a last resort, is bankruptcy. This option should only be exercised when all other attempts to get debt under control have failed. Bankruptcies stay on your credit history for seven years, and most banks will not even consider extending a loan to somebody with a bankruptcy anytime in the last five years.

The common theme among these ill-advised debt reducing moves is that they're all quick fixes, but don't necessarily achieve the end result of less overall debt. The best way to reduce debt is to be patient, develop a long-term budget and stick to it. Keep track of expenses and search for ways to curb spending. If you spend three bucks a day on coffee at Starbucks, start brewing your own Starbucks coffee at home. If you go the grocery store several times a week, start going only once and bring along a list to make sure you get everything you need in one trip. Reducing debt in a financially responsible way takes time and discipline, but can be rewarding in numerous ways.

August 20, 2014