Financial stress and pressure from debt collectors can create a sense of urgency that isn’t always productive. The urge to get a creditor off the phone, stop the threatening phone calls, eliminate the possibility of a lawsuit and otherwise dial down the pressure makes many people reach for the first available release valve. Too often, that means a dangerous financial decision that will ultimately do more harm than good.
Most working Americans have only one or two significant assets: their homes and their retirement accounts. That means these assets can be the first place people look when they’re searching for a way to pay off debt. But, tapping into either is usually a mistake.
Protecting Your Key Assets
What is Home Equity?
The equity in your home is the amount by which the value of your home exceeds the amount you owe on your mortgage. If your home is worth $175,000 and you owe $125,000, your equity is $50,000. The equity represents the true value of the asset to you.
Equity varies significantly, and not every homeowner has equity. As of the spring of 2020, about 3.6 million U.S. homeowners had negative equity, meaning that they owed more than their homes were worth. Mississippi has the second higher percentage of homeowners who are seriously underwater in the country.
Using Home Equity to Pay off Debt
For those who have equity in their homes and still have relatively good credit, a refinance, home equity loan, or home equity line of credit (HELOC) can look like the perfect solution. Paying off all of your other outstanding debt by drawing on the equity in your home can mean one monthly payment instead of several with different due dates. And, the interest rate may be significantly lower on the new debt.
But, borrowing against your home is risky, for at least two reasons.
First, it’s your home. If you don’t pay your credit card debt or a payday loan, you’ll rack up interest and fees. You may even get sued, and eventually the creditor may secure a judgment and request a wage garnishment order or attach your bank account. Obviously, you want to avoid those outcomes.
But if you’ve paid off those debts with home equity, you’ve given the lender a lien on your home. If circumstances change and you can’t keep up the payments on that loan, you could find yourself facing foreclosure.
Second, real property can be an asset or a trap, depending on equity. And, equity fluctuates with the housing market–you lose equity when property values drop. If you have little or no equity in your home, it can be impossible to sell the house unless you have money to make up the difference. That means if you lose your job or otherwise fall on hard times and can’t keep up the mortgage, you may end up in foreclosure and walk away with nothing rather than being able to sell your home and reinvest in something more affordable.
Retirement savings are critical for most Americans. In 2020, the average Social Security benefit is $1503/month. That’s less than half the amount one recent study said you’d need to pay for rent and other necessities in Alabama, Tennessee and Mississippi. That’s assuming Social Security benefits are available when today’s workers reach retirement age, which is far from settled at this point.
Still, nearly half (46%) of Americans aged 32-61 have no 401(k) or other retirement plan. While the percentage with retirement savings increases slightly with age, more than a third of those aged 56-61 are without retirement plans. If you have a 401(k) or other retirement savings plan, you’re off to a better start than many of your peers. If you don’t, you should look to correct that, but that’s a topic for another day.
Using Retirement Accounts to Pay Debt
If you’re relatively young, in debt, and have funds sitting in a retirement plan that you don’t expect to need for many years, pulling out some of those funds or taking a loan against your 401(k) may seem like a painless way to pay down debt, reduce stress, and improve your credit. In the moment, that may all be true. But in the long run, taking money out of a retirement account to pay off debt can be very painful.
At 5% compound interest, the $10,000 you take out of your retirement account to pay your credit card bill at age 27 would have been worth more than $55,000 at age 62, when you’re looking to draw income from that retirement account. But, retirement account growth depends on funds gathering interest over time. If you put that $10,000 back in a lump sum 10 years later, you’ll only end up with about $33,000. In this scenario, paying off your $10,000 credit card debt with retirement funds cost you $22,000 in interest–far more than you would likely have paid by paying off that balance over time.
Many retirement accounts are also exempt assets, meaning that they are protected from creditors. If you’re sued over that credit card debt, most retirement accounts remain off limits. You can usually even keep your full retirement account if you file for bankruptcy.
Weigh Your Options for Managing Debt
In a crunch, it’s natural to want to reach for the quickest solution and put the stress behind you. But, the easiest answer isn’t always the best. When you’re deciding how best to take charge of your finances, it’s important to remember that you’re not just making a short-term decision. The fix you apply now could have a lasting impact on your financial security.
At Bond & Botes, we’ve been helping people with debt and creditor harassment issues for decades. We know your best first step is to gather accurate information. So, we offer free consultations to help you make the right decision for you and your family. You can schedule yours right now by calling 877-581-3396 or filling out the contact form on this page.
Brad Botes is a principal of each of the Bond & Botes Law Offices throughout Alabama, Mississippi, and Tennessee. He holds a Bachelor of Science from the University of North Alabama, and a Juris Doctorate from Cumberland School of Law at Samford University. He and his team of bankruptcy lawyers have spent over 30 years guiding people through financial challenges. Read his full bio here.