If your income and other assets aren’t enough to cover your regular living expenses—including your mortgage payment, car note, and at least the minimum payments on your credit cards—you will likely never pay off your debt without taking significant action. In fact, according to the National Foundation for Credit Counseling, it takes an average of 20 to 30 years to pay off a credit card account balance. So if you’re having a problem making a dent in your outstanding debt, it’s time to consider other strategies.
Understanding Your Financial Situation
Before you decide how to take control of your financial future, you should have a firm grasp of your present financial condition. To start, you’ll want to gather information about your income and other resources, like bank accounts, whole life insurance policies, and retirement savings. You’ll also need to inventory your debts.
Once you have all your paperwork together, you’ll be ready to set up a budget. You’ll be better able to distinguish between needs and wants when it’s all in front of you, as well as put together a plan that will free up resources and reduce or eliminate debt.
(The article I’m Drowning in Debt, What Should I Do? gives suggestions on taking a financial snapshot.)
Things to Consider Before Using Your Resources
If, when evaluating your financial picture, you realize that there’s equity in your house, or that you have a nest egg in your 401k or IRA, the impulse might be to use the funds to pay down debt. But that might not be such a good idea in the long run. Many financial planners advise against raiding your resources for the following reasons:
- Penalties. Most retirement accounts will impose a stiff penalty when you withdraw your funds early—as much as 20% of your balance. You’ll also have to pay any taxes that you would otherwise defer until you reached retirement age. Instead, consider borrowing from your 401k account if you can do so without the penalty or the tax consequences.
- Wasted assets. If you’re using the money to pay credit cards and other unsecured accounts, you might be wasting valuable funds if you later decide to file bankruptcy. (You put up property to guarantee a secured account, such as a car loan or a mortgage.) In a bankruptcy case, you will likely discharge the unsecured debt while still protecting most, if not all of your retirement funds and the equity in your house. There’s no need to deplete your retirement account or pillage your home equity mortgage if you’re going to file for bankruptcy later.
If you’ve cut your spending by eliminating unnecessary expenses, and you still can’t find enough to pay more than the minimum payment, you’ll need to consider other options.
- Increase your income. If getting a new job with a higher wage isn’t in the cards, try finding a part time job or start a business in your spare time. Of course, you’ll want to earmark that income to pay down your debt. The more you pay on the principal, the faster your debt will vanish.
- Ask your bank to modify account terms temporarily. Many banks and credit card issuers have programs to change the terms of your repayment—at least in the short run. A lender might be prepared to reduce your payments, forgive past due balances, reduce the interest rate, or forgive fees for late payment and over the limit charges. Even if altering the terms will not ultimately reduce what you owe, the accommodations could allow you to direct your resources to more immediate concerns, like preventing foreclosure or repossession. Many of these accommodations won’t be available until you’re at least two months behind on your payments.
- Take out a consolidation loan. A consolidation loan is attractive because it might allow you to pay off most of your unsecured accounts—such as credit card balances—and replace them with one monthly payment. Look for a loan that carries a lower interest rate than the accounts you pay off. Close the old accounts to reduce the temptation to charge them up again, which would defeat the purpose of the consolidation loan and dig you even deeper into debt.
- Offer to Settle. If you have credit cards that are seriously past due or charged off, many lenders and collectors will settle with you for less than what you owe. The settlement amount is almost always negotiable, but the creditor will likely expect payment of the settlement amount in a lump sum. Be aware that settling for less might have tax consequences because the lender is likely to report the forgiveness to the IRS (and you might have to pay tax on the forgiven amount).
- Discharge your debts in a bankruptcy case. When other options seem ineffective, it might be time to consider filing for bankruptcy. Depending on your income and expenses, you would file either a Chapter 7 liquidation bankruptcy or a Chapter 13 reorganization bankruptcy. Either way, most of your unsecured debt can be eliminated and your property preserved (including most retirement accounts—another reason you’ll want to think twice before dipping into your IRA). Bankruptcy has the added benefit of stopping most repossessions, foreclosures, lawsuits and creditor harassment while you reorganize your debt.
Consider Getting Professional Help
A credit counselor can help you design a strategy to tackle your debt. A good place to start is with your local Consumer Credit Counseling Service. These offices, which are affiliates of the National Foundation for Credit Counseling, provide one-on-one counseling and classes. Also, CCCS offers a debt management plan that will allow you to consolidate your unsecured accounts into one convenient monthly payment. CCCS charges a small monthly fee to administer the debt management plan, but many of the counseling and educational services are free.
If you are behind on your home mortgage or car loan, or if you’ve been sued, time is of the essence. You should consult with a qualified consumer or bankruptcy attorney as soon as possible. The attorney might be able to offer you solutions that will protect your property while you work to settle or manage your debts—and many offer free or low-cost initial consultations.
Questions for Your Attorney
- Can you help me negotiate a lump sum settlement with my creditors?
- If I settle a debt, how much tax will I owe?
- Should I file for bankruptcy instead, and if so, a Chapter 7 or Chapter 13 bankruptcy?