How debt 'solutions' could dig you in deeper

Americans are slipping ever deeper into hock. To cope, many people turn to debt-consolidation loans, cash-out mortgage refinancing and retirement-plan loans that promise relief but could leave them worse off.

Paying off high-rate debt such as credit cards with lower-rate loans may seem like a no-brainer. Unfortunately, many of these loans have hidden costs and drawbacks.

And consolidation by itself can't fix the problems that led to the debt in the first place. In fact, such loans can make matters worse if borrowers feel freed up to spend more.

"Consolidating debt seems to create the psychological effect of making you feel like you've zeroed it out," says Moira Somers, financial psychologist and author of "Advice That Sticks." "Then [borrowers] just start spending up again, until there is no more wiggle room."

Statistics show U.S. households are taking on record levels of debt.

Overall household debt, including mortgages, student loans and credit cards, hit a new high of $13.54 trillion at the end of 2018, according to the Federal Reserve Bank of New York.

Credit card balances have returned to their 2008 peak, and serious delinquencies — accounts at least 90 days overdue — are on the rise.

Cash-out mortgage refinancing has also made a comeback.

With this type of loan, borrowers pay off their existing mortgage with a larger one and get the difference in cash. Mortgage buyer Freddie Mac reports that cash-out borrowers represented 83% of all conventional refinance loans made in the fourth quarter of last year, the highest share since the third quarter of 2007.

Forty percent of those who cashed out their equity used the money to pay bills or other debts.

Cash-out refinancing and other home-equity borrowing are often aggressively marketed as good ways to cope with debt, but the drawbacks can be significant, says Diane Standaert, an executive vice president with the Center for Responsible Lending, a nonprofit that fights predatory lending. The loans drain away equity that otherwise could be used to build wealth or cover emergencies.

Relief is often temporary, since many continue to rack up debt. And the loans turn unsecured debt, which could be wiped out in bankruptcy, into secured debt that not only can't be erased but could cost borrowers their homes.

Retirement-plan loans pose hazards as well. If you don't pay the money back on time, the balance turns into a withdrawal that triggers penalties and taxes — plus you lose all the future tax-deferred returns that money could have earned.

One study found 86% of the people who left their jobs with outstanding 401(k) loans wound up defaulting on the debt.

An unsecured personal loan could be a better option if borrowers are offered lower interest rates and can get out of debt faster. Unfortunately, scams and deceptive marketing abound, Standaert says.

Unwary borrowers could wind up paying high fees or higher interest rates and end up owing more in the long run.

Often, the best solution isn't a loan at all, said financial literacy expert Barbara O'Neill, a professor at Rutgers University. Cutting expenses and boosting income, perhaps with a side job, can help people make extra payments to reduce their debts.

Nonprofit credit counselors, such as those affiliated with the National Foundation for Credit Counseling, have debt management plans that can lower interest rates on burdensome credit card debt. Truly overwhelmed borrowers should consult with a bankruptcy attorney, preferably before they start skipping payments, O'Neill says.

"That's a sign of distress, and you need to take action before you get to that point," O'Neill says.