It's practically a commandment of sound financial management that you should never throw good money after bad. And that means never taking out a loan to pay down debts, because in so doing you just create a cycle of more debt, more stress, and less control over your own finances.
Like all rules, though, this one is not carved in stone. Sometimes your debt nightmare is so bad that you need to get out of it, no matter what it takes. Other times a loan can actually be a financial windfall. The following circumstances warrant considering a loan to pay down debt.
Balance Transfers and Low Interest Rates
If you can transfer a high-interest balance to a low-interest loan or credit card with an introductory interest rate, you should absolutely do it. This stops the debt snowball of escalating interest, and can also encourage you to quickly pay down your debt, before the introductory rate expires.
If you owe back taxes to the IRS or to your state Department of Revenue, the consequences can be dire. Talk to your accountant about the specifics of your situation, but remember that if you don't have a payment plan, that debt can be an endless source of stress. It can also lead to liens and even criminal prosecutions. Consider taking out a low-interest loan to pay down the debt, then paying down the loan as quickly as you are able.
Debt from Lawsuits
If you owe money on a lawsuit, you may not be able to discharge it in bankruptcy, and can accrue additional charges if you fail to pay. Pay these debts down as quickly as possible, even if it means taking out a loan. Just make sure you opt for a low-interest loan, so you don't find yourself later getting sued by the company from which you received the loan!
If you're over 62 and own your own home, a reverse mortgage is a low-risk way to get reliable income from the equity in your home. This option can dig you out of a financial hole, offer you a low-interest loan you might not otherwise be eligible for, and help you get some financial breathing room. Reverse mortgages do come with some downsides such as high upfront costs, affecting your ability to qualify for other loans, and reducing the value of your estate that will be left to heirs.
When Not to Take Out a Loan
You may encounter other circumstances that necessitate pursuing a loan, but you should never go into debt to pay down other debt in the following circumstances:
- When the interest rate on the new debt is higher than the interest rate on the loan you are paying down.
- To get luxury items, go on vacation, or buy a new car. A used car is almost always the most financially savvy decision.
- When you know you cannot afford to pay back the loan.
- When your home is in foreclosure.
- When you do not owe the money claimed; you have a right to dispute debts, and you are not responsible for paying debts that all outside of your state's statute of limitations.
- If you have so much debt you don't know where to begin. Bankruptcy might be the best option, but talk to a financial planner before making the decision.
- When taking out the loan will not enable you to pay down the full balance of the other debt.
The bottom line is that you never want to take on more debt than you can comfortably manage. Taking out a new loan should ultimately allow you to pay down your debt faster and at a lower overall cost.