Barbara O’Neill, Ph.D., CFP®, Rutgers Cooperative Extension, oneill@aesop.rutgers.edu
Got outstanding loan balances and credit card debt? Do monthly payments seem overwhelming? You are not alone. The ability to “buy now and pay later,” coupled with slick advertising, has made living beyond one’s means very tempting. As a result, many Americans, at all income levels, went on a credit-fueled “spending spree” during the late 1990s and early 2000s. Now it’s time to pay back what we owe and get out of debt as quickly as possible.
With the exception of large medical bills that are paid with a credit card, debt problems usually do not just “happen.” They grow slowly over time as spending exceeds available income. “Perma-debt,” a permanent balance on credit cards and other non-mortgage, non-installment loan (e.g., car loan) accounts, is a big contributor. As soon as a payment is made, most of it (or more!) comes back the following month in the form of new purchases, interest, and/or fees. Debt does not have to be a permanent condition, however. Below is a description of five strategies to get out of debt. A sixth debt reduction strategy, bankruptcy, is discussed in the fact sheet Bankruptcy: A Last Resort. You’ll also learn about the only way to repair a credit history marred by debt problems (i.e., time) and telltale signs of credit repair fraud.
Credit Counseling
Both non-profit and for-profit entities provide credit counseling services. Many are supported by contributions from creditors as well as by client fees. Services typically begin with some type of intake process (e.g., by phone, mail, or a secure online questionnaire) where information is gathered about a consumer’s income and outstanding debt obligations. With this information, credit counselors can examine debtors’ cash flow patterns and help them establish a spending plan (budget). If consumers decide to enter a debt management program, or DMP, they send the credit counseling agency a specific amount each week or month, which is pro-rated among their creditors. Some type of administrative fee, which should be a nominal amount, is generally charged as well. Creditors sometimes make concessions to DMP clients, such as reduced interest rates and waived fees, at the request of credit counselors. Clients, in turn, must generally surrender their credit cards and agree to incur no further debt during the duration of the program.
Make sure that the agency you deal with is accredited and preferably a member of the National Foundation for Credit Counseling (NFCC). Some states license credit counseling agencies, so inquire about this also. A state attorney general’s office, banking department, and/or consumer affairs department are good places to make these inquiries through. To find a NFCC-accredited agency, call 1-800-388-2227 or visit the NFCC Web site at www.nfcc.org. Many of these agencies have the words “Consumer Credit Counseling Service” or “CCCS” in their title.
Debt-Consolidation Loans
This strategy involves taking out a new loan and closing old credit accounts after using debt-consolidation loan proceeds to pay them off. There are some serious downsides to doing this, however. One is the potential for a reduced credit score (depending upon what other information is already in a consumer’s credit file). A second is that, while the monthly payment will likely be smaller than the amount owed on previously overwhelming debt obligations, there will be a higher total cost to repay outstanding debt because loan payments are stretched out over time. A third disadvantage of debt-consolidation loans is the danger of losing your house if the loan is secured with home equity. A fourth is the danger of getting into trouble with credit cards all over again (once their balances are back to zero) and having to make both consolidation loan and new credit card payments. Finally, a fifth disadvantage of debt consolidation is the potential to pay a higher interest rate than what was previously charged or, worse yet, to pay interest on debt (e.g., legal or medical bills) that were previously interest-free.
The bottom line is that you cannot borrow your way out of debt. Yet, many people try to do this with a consolidation loan and end up compounding their financial problems. It can be very tempting for some people to overspend if monthly debt payments are reduced, this providing the illusion of “extra” money. In many cases, debt-consolidation loans are not a good solution to debt problems. They should be considered only if the interest rate on the debt-consolidation loan is lower than that on previous debt and if no new debt will be incurred until the loan is repaid.
Fold-Down/PowerPay Plans
Fold-down (a.k.a., PowerPay) plans can be a very effective way to accelerate debt repayment when someone owes a number of creditors. The first step is to completely repay an initial debt, perhaps by using a tax refund or freeing up money through reduced household expenses, Next, the amount of the monthly payment for the debt that is completely repaid is applied (folded down) to one of the remaining debts, in addition to the amount that had previously been paid. This is sometimes referred to as a “power payment.” All other monthly payments remain the same so the amount spent monthly on debt repayment does not change. Over time, remaining creditors receive increasingly larger monthly payments as other debts are repaid. Hundreds, and sometimes thousands, of dollars in interest can be saved.
Power payments can be made in a variety of sequences including starting with debts with the highest interest rate first, smallest balance first, or shortest term first. While paying off debt with the smallest balance can provide a psychological boost, starting with the highest interest rate first often provides the greatest reduction in interest and repayment time. The Utah State University Extension PowerPay® Web site provides a free personalized analysis. Users simply need to enter the names of creditors, the interest rate (APR) on debts, the monthly payment, and the outstanding balance. PowerPay® will provide a customized debt analysis (i.e., the time and interest savings) for each repayment scenario and a debt repayment calendar to follow. For further information, see www.powerpay.org.
Refinancing/Balance Transfers
Transferring existing debt to a new loan or credit card with a lower interest rate can help alleviate debt problems. This strategy will only work if a debtor is able to qualify for a less expensive line of credit and the interest savings outweighs fees associated with the transaction. A key factor with mortgage refinancing transactions is whether a homeowner will stay in the home long enough to recoup the closing costs associated with a new mortgage.
Voluntary Surrender
Voluntary surrender occurs when debtors realize that they are unable to make monthly payments on an asset used as collateral for a loan (e.g., a car) and either return the secured asset to the creditor or obtain the creditor’s permission to sell the asset. By returning collateral voluntarily, debtors save repossession and/or storage fees and avoid having repossession or foreclosure listed in their credit report. In some instances, the secured property may be accepted by the creditor as complete repayment of the debt. Otherwise, the debtor is responsible for repaying the remaining balance (called a deficiency) after the asset is sold. Voluntary surrender of a house used as collateral is referred to as “deed in lieu.”
When people have trouble paying back what they owe, their credit history often suffers and it is easy to be lured into credit repair scams. You’ve probably seen advertisements for companies that claim to be able to “fix” a bad credit history so that you’ll be able to qualify for future credit. Their messages can be very tempting, especially for someone who has had prior credit problems (e.g., charged-off accounts) and desperately wants to borrow money for a home or new car. The term “credit repair organization” refers to firms that provide services, in return for payment, for the express or implied purpose of: improving a consumer’s credit history or credit rating or providing advice or assistance connected with this.
Two types of credit repair organizations, both of which should be avoided, are:
• Organizations that use practices that are clearly illegal. An example is those that advise people to take on a new identity by applying for a taxpayer identification number to use in lieu of their debt-linked Social Security number.
• Companies that don’t do anything illegal but charge high fees (e.g., $250 to $3,000) for things that people can do for themselves (e.g., negotiating the reporting of debt repayment with creditors).
In many cases, the only remedy to improve a poor credit history is time; i.e., time to show creditors that your debt repayment practices have improved and time for negative information to drop off your credit report. By law, correct, negative information, such as late payments and repossession of a car, can stay in a person’s credit file for seven years (ten years in the case of bankruptcy). There is no “magic” way to make correct negative information “disappear.”
The Credit Repair Organizations Act defines what credit repair firms may not do:
• Make any statement, or counsel or advise consumers to make any statement, which is untrue or misleading with respect to a consumer’s credit worthiness.
• Make any statement or counsel or advise any consumer to make any statement, the intended effect of which is to alter the consumer’s identification to prevent the display of the consumer’s credit history.
In addition, credit repair organizations cannot accept payment for services until they have been performed. Consumers must be provided with a dated, written contract and have the right to cancel it without penalty within three business days of when it was signed. Cancellation procedures must be explained in the contract.
Beware of credit repair companies that: 1. want you to pay in advance for credit repair services before any services are provided, 2. do not tell you about your legal rights or what you can do for yourself for free, 3. suggest that you invent a “new” credit identity by applying for a taxpayer identification number (TIN) to use instead of your Social Security number, and/or 4. advise you to repeatedly dispute information in your credit report. These are all “red flags” of a fraudulent credit repair organization. Not only is it likely that you’ll lose some money but, if you follow illegal advice obtained from a credit repair organization and commit fraud, you may be subject to prosecution.