Wrong Ways Consumers Choose to Pay off Credit Card Debt

NEW YORK (MainStreet) — Paying down mounting credit card debt is not an easy task, but consumers should avoid taking on additional debt or other risky schemes where they could lose their collateral.

With the Federal Reserve planning to raise interest rates later this year, consumers should take stock of their current debt and consider paying down credit cards.

While the impact on monthly credit card payments is “pretty minimal,” it is more advantageous for consumers to pay down debt when rates are low, rather than when they are rising, says Greg McBride, CFA, Bankrate.com’s chief financial analyst.

Balance transfer offers

Many credit card companies are offering 0% balance transfers, but the number of offers will dwindle as the Fed raises rates.

“Grab those rates now while you still can,” McBride says. “As the Fed eventually moves away from a 0%, credit card issuers will do the same. Over time those offers will dissipate.”

If you decide to use a balance transfer offer, ensure that you have a plan to pay it off by the time the lower rate ends, which ranges from 12 to 18 months. Consumers who are still left with a balance could wind up shelling out more money “than if the balance had been left where it was in the first place," says Bruce McClary, spokesman for the National Foundation for Credit Counseling, a Washington, D.C.-based nonprofit organization.

“Low ‘teaser’ rates can be tempting as a way to lure a high balance from one credit card to another, but if the window on the low-interest offer is too short, the strategy may backfire if the transferred balance remains after the rate adjusts,” he says.

Car title loans

These loans are often advertised as a method for consumers to combine all of their high interest debt, but McClary warns that the trade-off might be disastrous. The interest rate you get is often akin to those found from payday lenders.

When you agree to a car title loan, the lender has the ability to place a lien on the vehicle of the borrower to have collateral on the loan. If the consumer defaults, lenders can seize the collateral to pay off the debt.

Depending on your agreement, missing more than a payment or two means your car could be repossessed, “which is a far more serious consequence than what might happen after missing a credit card payment,” he says.

Using your house as collateral

Do not get a home equity line of credit to pay down your credit card debt. Homeowners could wind up having a home where it is negative in equity, which means you owe more of the property than it is worth,” says Paul Kuzmickas, a bankruptcy attorney with Luftman, Heck & Associates, a Cleveland law firm.

Once you reach the end of the draw period, which is often 10 years, the outstanding balance converts to the repayment term, where both principal and interest payments are made, typically over a 20-year period. Your monthly payments could easily double.

“Some homeowners used the proceeds to purchase other items,” McBride says. “If they have made little progress in paying it down, then they are in for a rude awakening when the line of credit converts into an installment loan.”

Refinancing your mortgage and receiving cash at the closing is an equally poor idea, says Kevin Gallegos, vice president of Phoenix, Ariz., operations for Freedom Financial Network, a consumer debt resolution company.

“If any possibility of missing a payment ever arises, you may face foreclosure because you transferred too much unsecured debt to secured debt,” he says.

Other ideas to avoid

Some consumers turn to payday lenders because of the appeal of getting cash instantly, but they can trap people into more debt. Although some states have passed laws limiting the amount of the interest rate, in 27 states the payday loan interest rates can still exceed 300% APR, McClary says.

“With such high rates, borrowers can feel the pinch more than once,” he says. “It is not uncommon that borrowers roll over their loan at the end of the term in order to give themselves extra time to pay off the debt, but these extensions come with additional fees.”

Once the fees start accruing, it is not uncommon for consumers to wind up paying more than the amount they borrowed initially. A study by the Pew Charitable Trust revealed that borrowers paid $520 in fees for a loan of $375 after rolling it over an average of seven times, McClary says.

“The higher the fees pile up, the harder it is to break the cycle of debt,” he says. “If a payday loan is the only option, it is better to look for alternative short-term loans offered by some credit unions. Their rates and fees are typically much lower than traditional payday lenders and they are usually designed to help consumers avoid further debt.”

Borrowing money from your retirement savings to pay off debt could cost you more money. If you lose your job and borrowed from your 401(k), the entire amount could be due in a short period.

“The IRS could collect taxes from your withdrawn tax-deferred money, and you could own additional money as a penalty for withdrawing your savings too early,” Kuzmickas says.

Turning to a debt consolidation service is not as simple as it appears. These companies ask consumers to make one monthly payment that is used to pay creditors. Consumers pay back 100% of the debt, plus interest.

“This actually can be helpful if the problem is too many accounts with too high minimum payments at crippling interest rates,” Gallegos says.

If you chose this method, proceed cautiously, because the loan is often secured by the borrower's property, such as a home or car.

“Many services have poor histories and reputations and the fees can be high,” he says. “Those working with a debt consolidator will likely sacrifice the freedom to open and use additional credit lines.”

— Written by Ellen Chang for MainStreet

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