Mistake #4: Paying Off the Debt With the Highest Interest Rate First
Paying off the debt with the highest interest rate is a common mistake among those paying off debt. At first glance, it seems like a smart idea. Think of all the interest you will save! However, sometimes your largest debt balance is an account with the highest interest rate, commonly the situation with student loan debt. When trying to pay off the larger balances first, it can feel like you aren’t making any progress. This can be discouraging and depressing. To keep your momentum going, begin paying off your smallest debt first. Continue to make the minimum payments on all other debts, but apply all of your surplus to the smallest debt. You will be surprised at how quickly this small debt is paid off. Once that happens, you are now able to put your normal surplus plus the extra amount you were paying toward the smallest debt onto the next smallest debt. This is referred to as a “debt snowball” and is the quickest way to get out of debt. By using the debt snowball method, you will be debt free much quicker and the savings in interest will have been minimal.
Mistake #5: Cashing Out Your 401(k)
When you feel like you are swimming in debt, it can be tempting to cash out your 401(k) plan to speed up the pay-off timeline. This is a short-term fix with negative short-term and long-term consequences. You will experience immediate consequences from this decision, as taxes and penalties will be imposed for cashing out your 401(k) early. More importantly, you will experience the long-term consequence of tapping into your retirement savings. Retirement wealth builds tremendously over time, as your principle balance grows and interest is compounded. Time value of money calculations prove that substantial wealth can be built by saving even just a small amount, provided this amount is saved beginning at an early age. Cashing out your 401(k) reduces not only the principle balance, but years of compound interest growth. This option should be considered only as a last resort to avoid bankruptcy.
Mistake #6: Expecting Quick Results
Most likely, you did not get into debt overnight. Your debt grew over a number of years, whether it was the student loans you took out after high school to pay for college or from a few too many nights on the town over the years that your income just couldn’t support. Likewise, you should not expect to get out of debt overnight. This desire can lead to poor financial decisions that will have long-term consequences, such as the 401(k) example mentioned previously. While techniques such as debt consolidation might help you pay off your debt a little quicker, if the underlying behavior does not change, no progress will ultimately be made. There’s no time like the present to begin changing your behavior and tackling your debt.
Photo courtesy of frankieleon