Should you get a loan to pay off your debt?

"Do Not Paint" signPhoto courtesy of Jacob

Paying off debt is hard. It can feel like you’re not even making progress.

Sometimes this is actually true. If you make minimum payments on your credit cards, you’re basically never going to pay anything off. And if you’ve got an income-based repayment plan on your student loans, your loans may actually be growing each month. Now that’s a scary thought.

I wish I could tell you that there is a “secret method” that allows you to pay off your loans much more quickly and costing you less.

Unfortunately, such a method doesn’t exist. But that doesn’t stop people from claiming there is.

So here are a few ideas that people claim are a way to pay off your debt faster. And why they are all terrible ideas.

Use a home equity line of credit (and go directly to HEL)

If you own a home, you have the opportunity to get what is known as a Home Equity Loan (HEL or HELOC). This allows you to convert the equity you have in your home to a line of credit.

People often use this to pay for home upgrades. Some people use this for times of hardship. The interest rate can be very favorable because it is tied to your home,  which makes it enticing.

Unfortunately, this is a terrible idea. Say you want to pay off your student loans. Student loans are what is known as an unsecured loan. An unsecured loan means there’s nothing they can take away from you if you don’t pay. Sure, collection agencies can make your life miserable, but they can’t reach in and take away your knowledge out of your head. (Yet.)

However, a HEL is a secured loan, which means that it’s backed by collateral: in this case, your home. And the thing about secured loans is that if you don’t pay, the lender can resort to repossession. In other words, you could lose your home.

Never trade an unsecured loan for a secured loan. It’s just as simple as that. No interest rate change is worth that.

Use a personal line of credit (but if you could do this you wouldn’t need to)

Banks offer an option to extend to you a personal line of credit. This can sometimes be at favorable interest rates, and can either be secured or unsecured, depending on the type of loan.

Now, we already know that a secured loan is a terrible idea. So what if we were to go with an unsecured personal line of credit?

Well, the short answer is: you probably can’t get a truly unsecured personal line of credit.

Few banks are going to lend unsecured money to people without knowing that they are going to come out ahead. And if there’s nothing securing the loan, why would they lend, knowing that you could take the money and run?

So most of the time, even an unsecured loan is going to require that you have a certain amount of assets. And let me ask you: if you have $100,000 in non-mortgage assets (which is what SunTrust Bank requires, for example), why would you need a $25,000 loan?

And even if you did qualify, your rates are not going to be any better than a credit card. If you’re a reliable borrower, you can get an 8-10% credit card. I can’t see you You won’t get a personal unsecured loan for any less than that.

I actually tried to get a personal loan once. When I was going to a non-accredited school, I tried to get a “personal” loan from my bank, in lieu of private loans. The rates they quoted me were credit card sized rates. I opted for private loans, which at least offered some more favorable terms.

Take a loan from your retirement account (and destroy the future)

Remember that 401(k)? It’s the thing that you set up when you first landed your job. You put money into it, wherever it goes.

You just checked, and it has $40,000 in it. You could get a loan from it and pay off your debts right now! Free money!

Unfortunately, it doesn’t work like that.

It’s true that interest rates from a 401(k) loan can be very low. But all that money you take out is now not growing tax free anymore. Yes, you could pay off your debt now, but you miss the opportunity cost of what your money could be doing if left to grow in a retirement account.

(Remember, $1,000 left unchecked in a retirement account could grow to between 5 times and 17 times its original size over 30 years. How much are you taking out?)

It gets worse. If you lose your job where you have your 401(k), you have to pay back your entire loan almost immediately. A student loan or credit card, no matter how odious, will never ask for that.

Take out a payday loan

No. Just no.

Didn’t anyone catch the irony?

I didn’t think I needed to write a post like this. People: a loan is debt. Taking out a loan to pay off your loans doesn’t make sense. You can consolidate loans to better manage them, but you’re just putting the rocks in a different pile.

Trying to be sophisticated is almost always a recipe for disaster.I could take out a loan, use it to front-load my debts in advance of my paycheck, then use my paycheck to pay off my loan, thus saving me some interest, allowing me to pay off my loans a little faster.” There are so many ways that could go wrong in very bad ways.

I mean, I like irony as much as the next person, but not when it comes to one’s financial well-being.

Here’s my secret method

If you’ve read this far, I have a surprise for you. Here is my secret method for paying off debt:

Shhh, don’t tell anyone.

But enough about me: have you ever used a loan to pay off your debt?

Mike Pumphrey

Mike Pumphrey

I'm the founder and author of Unlikely Radical, a site to help people succeed with money, achieve their goals, and live intentionally.

I offer a free phone consultation to anyone who is interested in changing their financial narrative. Are you ready? Click here for details.
Mike Pumphrey
Posted on November 17, 2016