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How To Dig Yourself Out Of Debt

Steve Pomeranz, Debt

As you know, debt is just another term for money that you borrow and need to pay back to someone.  Typically, you have to pay back with added interest and the rate that you pay is determined by factors such as your credit rating and whether the debt can be backed by assets, such as your car or house, which are called collateral. The better your rating and the better the assets, the lower the rate.

There are times—especially when interest rates are low, as they are now—when it simply makes more sense to borrow to make a purchase, instead of paying cash. If you purchase a house and pay 3.5% for a mortgage or a car (paying next to nothing, really), then you most likely want to borrow the money rather than pay cash.

Moreover, most Americans simply do not have the spare cash laying around to make these big purchases, so they do have to resort to borrowing. Debt is essentially a reality for most of us, whether it be for a home, a car, appliances, student loans, or something else.

As a matter of fact, an analysis of the Federal Reserve and government data shows that Americans collectively owe a whopping $712 billion on their credit cards, which is about $15,400 per average household, with that average household paying $6,700 in interest on all their debt each year. That eats up 9% of the average household income.

Inevitably, most Americans find themselves in debt at some point in their lives. Ideally, if you are careful about taking on debt your monthly debt-related payments will be well within your monthly paycheck. At other times, your debt level might be just high enough to make you uncomfortable or, at worst case, might become a crushing, sleep-stealing weight that you just can’t handle anymore.

Four Ways to Get Out of Debt

I want to talk about 4 ways to get out of debt. Small or big, there are basically only 4 ways—from penny pinching on one end of the spectrum to bankruptcy on the other, and the right method will depend on your circumstances.

All of them have this first step in common, and that’s building a realistic budget. Many people don’t have a great handle on where their money goes. To free up money to pay bills, you have to first see what kind of money is available. The best way to do that is by tracking your spending for a few weeks, maybe a few months. That’s not so hard because there are plenty of online tools and mobile applications that can help you get a true picture of your finances and show you those areas where you can cut back on your spending so you can start paying your bills off steadily.

By the way, this the same for all, no matter how much money you have. With exception of the Warren Buffets or the Mark Zuckerbergs of the world, everyone has limited resources, whether it be millions, thousands, or hundreds. Each of them has to allocate their resources and spending based upon these limitations. For those with relatively small debts, the simple belt tightening might be all that is needed to free up the money to pay off the credit card balance.

Online tools such as the payoff calculator at creditcards.com can tell you how long it will take to pay off your debt under various scenarios. Try the one at creditcardfinder.com, which allows users to input information for up to 9 credit cards and then obtain a ranking of which cards to pay off first. That is pretty cool.

Some of you may have money saved in retirement or in investment accounts and may be tempted to break into those to pay off debt. But think again—not only will you lose hard won savings, but you will also miss out on any gains you might have made in the stock market, thereby compromising your retirement security.

Be aware that you’ll have to pay a tax penalty if you withdraw from a 401K or an IRA before age 59 and 1/2. I dislike this approach because it doesn’t impose any discipline or change in your behavior. I strongly urge you not to do so.

Also, know that credit card companies can raise interest rates after just one late payment. Once you are late paying one card after a 45 day’s-notice, other cards too can jack up rates for future purchases even if you are current on those payments. That is why if you have high-interest debt for multiple creditors you may be better off seeking outside help, through a financial advisor or a debt management firm or even a bankruptcy attorney.

The second step, if you are really overwhelmed, is to ask a credit counseling company for help. This is a good solution especially if you have a lot of unsecured debts such as credit card debt at high-interest rates. Credit counseling companies work with lenders to get interest rates greatly reduced. Typically, these companies help you with a basic budget and come up with a single payment which you pay them each month. They then send the newly negotiated payment to your different creditors and credit card companies. They do charge a monthly fee for this, but the negotiations involve reducing rates—for example, a 29% rate could become 7 or 8%.

With the right sort of assistance and a commitment from your end, you should be able to greatly ease your debt burden over time. Before you do this, do your research and see if your county has any non-profit firms to help you do this without paying any fees. You can find that through websites like the National Foundation for Credit Counseling.

If not, make sure that you read reviews before picking a credit counseling company. Be sure to work with one that’s legitimate, experienced, and transparent, not a rogue company that puts you deeper in the hole and takes all you’ve got. There are scammers out there, especially if they sense you are not financially savvy. Be aware and do your research well before you sign on any dotted line.

Under these debt management programs, debtors typically pay off their debts in full over a period of 5 years. Most debt management programs do, however, require participants to be employed because a regular income is key to making those monthly payments. Agencies charge a modest monthly fee, usually somewhere between $15 and $50 for their services.

I also recommend moving to cash payments in lieu of plastic. Cash payments help you feel the spending as real, but you will need a system to track your spending, perhaps utilizing features on your smartphone or carrying a small pocket-sized notebook.

The third way to get out of debt is to use a debt settlement company. Debt settlement companies are very different from credit counseling companies. The process is not for the faint of heart, and here is why. First of all, debt settlement firms are for-profit operations, so you need to know that up front. The process is essentially a high-stakes game of chicken. Debt settlement programs generally require consumers to stop paying their bills and allow their debts to go into delinquency and then eventually default. You stop making any payments and let the late fees, interest, and penalties continue to build. Instead of paying their creditors, consumers then pay the debt settlement firm a monthly amount that gets put into an escrow account. The idea is to make creditors think they will wind up with nothing so that when the debt settlement firm offers them something they are more likely to accept. It’s kind of a scheme to make the credit card companies think they are never going to get paid, which gives you leverage to have them negotiate.

When enough is accumulated, the debt settlement company will contact your creditors and attempt to get them to accept a much smaller amount, maybe 10 or 50% of the total you owe and then write off the rest as bad debt. If you can brave that process, you might get to pay off your debt and be rid of that burden for far less than you owe. Keep in mind, however, that this won’t save your credit. Creditors don’t always accept the lower offer, and there could be tax consequences.

Also be aware that the Federal Trade Commission warns consumers to be wary when selecting one of these companies. Some debt settlement firms will ask for upfront fees before settling any debts, a practice that is against the law.

I’m going to repeat that. Paying upfront fees for these services is against the law. Don’t fall for that. What’s more, many consumers chicken out. They don’t like these programs and, ultimately, don’t have the nerve to go through with them, and so they end up paying fees without reaping any rewards.

One final note on this subject is that the IRS considers forgiven, canceled, and discharged debt to be taxable income. In the event that you go through with this form of debt settlement, you will receive a form in the mail from the IRS requiring you to report the amount of the discharged debt in your gross income subject to certain exceptions.

The final and most serious way to settle your debt is bankruptcy. It may be the last option, but it’s probably not the end of the world. In fact, businesses use this all the time for all sorts of accounting shenanigans. The key to deciding if bankruptcy is right for you is to consult a bankruptcy lawyer and to know what kinds of debts are—are not— discharged through bankruptcy. Not all debt can be forgiven through bankruptcy.

(And, by the way, not all companies go bankrupt because they are trying to fool the government. There certainly are valid reasons well outside the boundaries of shenanigans, as I mentioned above.)

Generally, 401K and IRA assets are protected in bankruptcy, so those who have dipped into or depleted their accounts have unnecessarily compromised their future security since the creditors can’t get to that money. The lesson is to think before you act. Do your research and understand the situation before you take any action. You don’t want to make crucial mistakes like this.

One good thing about filing for bankruptcy is that it stops all the collection calls. It stops the lawsuits and all those kinds of annoyances. The process, in effect, is a way to provide for debtors to get a handle on an overwhelming situation. That said, filing for bankruptcy should not be taken lightly. Bankruptcy stays on filer’s credit reports for up to 10 years, and this black mark can hinder your ability to secure a home, get a lease on a car, or a job. On the upside, your credit score can recover more quickly than that 10-year period, often in just a few years. Why? You no longer have debt, and creditors can’t worry about something that doesn’t exist.

The bankruptcy process itself can cost thousands of dollars in attorney’s fees and hundreds of dollars in court filing fees. But practical and financial costs aside, sometimes bankruptcy represents the best way for strapped consumers to achieve a fresh start after years of stress and struggle.

Starting over is no shame. Second chances are the American way.

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I've been an investment strategist and adviser for over 35 years, leading with a mission of unbiased advice to educate and protect listeners on my weekly radio show on NPR affiliates nationwide. I have been named a “Top 100 Wealth Advisor” by Worth Magazine and “Top Advisor” by Reuters.