Money Essentials

How to avoid borrowing to pay debts

A home equity loan or line of credit is smart in some instances to handle your personal debt

Besides life's big-ticket items - home, car and college - you may be tempted to borrow money to pay for an assortment of other expenses such as furniture, appliances and home remodeling.

Generally speaking, it's best to pay up front for furniture and appliances since they don't add value to your home and are depreciating assets. If you do finance such purchases, however, read the fine print.

Retail stores often charge high interest rates. And even if they offer a low-interest or no-payment period for several months on a purchase, you may be required to pay for the item in full at the end of that period or risk being charged a high interest rate dating back to the day of sale.

Taking a home equity loan or home equity line of credit makes sense if you're making home improvements that increase the value of your house, such as adding a family room or renovating your kitchen. The interest you pay in many cases is deductible, and you increase your equity.

If, however, a home project doesn't boost your house value, consider paying cash or taking out a short-term, low-interest loan that will be paid off in five years or less.

If you're saddled with a lot of high-interest credit-card debt, you might be tempted to pay it off quickly by borrowing from your 401(k) or taking out a home equity loan.

There are two primary advantages to home equity loans: They typically charge interest rates that are less than half what most credit cards charge. Plus, the interest you pay may be deductible. (Note, however, that when you use a home equity loan for nonhousing expenses, you may only deduct the interest paid on the first $100,000 of the loan, according to the National Association of Tax Practitioners.)

But there is one potential and very significant drawback when you borrow against your house to pay off credit cards: If you default on your home equity loan payments, you may lose your home.

Borrowing from your 401(k) is even less advisable. That's because you lose out on two of the biggest advantages to workplace retirement plans: tax-deferred compounding of your money and tax-deductible contributions. Sure, you pay yourself back with interest, but that interest is paid with after-tax dollars, and it will be harder for you to make new contributions while you're repaying your old loan.

Also, if you quit or lose your job, you'll probably have to repay the entire borrowed amount within three months. If you aren't able to do that, you'll owe income taxes on the money, plus a 10% penalty if you're under 59-1/2.

One other word of caution if you take any kind of loan to pay off your credit cards: Once your credit-card debt is paid off, you have to be vigilant about not running up your balance again because you still will have big loan payments to make.

If you're having chronic trouble paying off your credit-card debt, it may be time to consult a debt counseling service for help managing your finances in the future.

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