I won’t waste time with verbose prefatory comments.
If you need immediately relief from your debt, then the three main options are these.[1]
Debt Consolidation
When you “consolidate” something, you bring many things together into one thing. In a nutshell, “debt consolidation” is where you bring many debts together into one. That’s going to be one big debt, for sure.
Essentially, you use one loan to pay for many (or all) other loans that you have.
So, the first step is that you take out one more loan, or open up one more line of credit, than you currently have. This may seem counterintuitive. But this new loan is calculated to serve a debt-reduction purpose. *If approved*, you use this new loan or line of credit to pay off other credit cards or loans.
Pros of Debt Consolidation
There are a number of things in favor of this approach.
After it’s successfully completed, you have one payment instead of several. This will simplify your budgeting and help you better manage your finances moving forward.
Additionally, consolidating can accelerate your ability to pay your debts down – or off.
This is partly because, often, the consolidation loan will have a lower interest rate than (at least some of) your other debts. It’s not uncommon for department-store credit cards to have interest rates around 25-30%. Consolidation loans seem to average between 10-20%. (I can sometimes dip below 10%. On the other hand, some companies seem to try to levy almost as much interest as a department-store charge card! Be wary.)
So, this is a savings. A bit of a savings.
Finally, since all you’re doing is borrowing money and paying off loans, you’re using credit to fix a credit problem. (In theory.) Therefore, you don’t take (as big of) a hit on your credit report. You might see a slight reduction in your score. But, in the long haul, you may end up a lot better off.
Cons of Debt Consolidation
You have to be approved.
This means that your credit has to be in fair to good shape. We’re usually talking about scores somewhere between 600 and 700.
The lower the score, predictably, the higher the interest rate. That’s how the game is played, my friend.
According to Experian’s website, theoretically, credit scores could be as low as 300. Now, with a score that low, you are unlikely to be approved for any credit at all. But even scores in the 500s are considered pretty bad. So, unfortunately, a fair number of people seeking credit-debt relief may be unable to avail themselves of the consolidation option.
A further point to consider is that consolidation loans require collateral.
For those whose financial vocabulary might be a little impoverished, “collateral” is what you put forward as “security” when you take out a loan. It’s something – often real property, like your home – that you promise the creditor can take from you if you fail to make your payments. (Failure to make payments on time is called “defaulting.” …Except in the case of student loans repayments, where it could possibly be termed “forebearance.” It’s as clear as mud, right?)
Another negative is that many of your credit lines remain open and – IF YOU ARE UNDISCIPLINED – the consolidation loan can simply ignite a further spending spree.
Realize that, if this happens, you won’t just be back to square one. You could theoretically end up with double the amount of debt as before! That is: You could end up with the consolidation loan PLUS credit cards and loans maxed out from fresh spending.
So, just as freeing up money doesn’t do you much good if you don’t have a plan for using the dollars that you save, so too, consolidating your debt doesn’t do you any good unless you have a plan for paying the consolidation loan AND freezing whatever spending got you into credit trouble in the first place.
Remember how I mentioned that this really cannot be accomplished without discipline?
Debt Settlement
An alternative to debt consolidation is debt settlement.
This approach is where someone – either you yourself or some professional arbitrator/negotiator – gets your creditors to agree to accept less than the full amount that you owe. But, here’s the kicker: If the negotiation is successful, then the reduced balance is considered to be a total payoff of the debt.
I actually did this myself.
I owed approximately $15,500 on a credit card. The company agreed to settle with me at 59%. So, I paid around $9,100, and the card balance was considered paid in full.
It turns out that you don’t need to go through a settlement company. You can negotiate yourself. This works best if you have a lump sum of cash that you can settle with.
If you are looking to negotiate new payments, then you might employ a company.
Pros of Debt Settlement
Without question, a settlement can save you a lot of money.
This is the main benefit. And you really can’t gainsay it.
Cons of Debt Settlement
If you go through a debt-settlement company, then you can expect to pay a fee. Sometimes, the “fee” is a percentage of the total amount of debt that you owe. This number can range widely. I’ve seen figures between 10% on the low end, all the way to 30% or more on the high end.
Moreover, debt settlement does have a negative impact on your credit score. Your actual impact will vary. It partly depends on other elements of score – including what the score was before the settlement, your payment history, the length of time you’ve had credit lines open, and so on. But estimates are that your rating could be adversely affected by anywhere from 75 to 150 points on average.
“Strikes” against your credit remain on your report for around seven years.
So, debt settlement is a better option for people who already have a low credit score to begin with.
Finally, expect to be “1099’ed” for the amount that the credit company writes off.
In my case, if I had $15,500 in credit-card debt, and I settled for $9,145 (let’s suppose), then I will expect to receive an Internal Revenue Service (IRS) form 1099MISC for the difference: $6,355.
Why?
Well, you don’t pay taxes on money that you’re loaned.
Most people pay their loans down (or off) with money they obtain as regular income. And you’re taxed on regular income.
So, you might put it this way.
You are taxed as you pay the loan back.
But when a portion of your debt is written off, the IRS considers the written-off amount to be money that you received and used but were never taxed on.
I know, right?
The upshot is that you should expect to have to report the written-off portion of your debt as regular income the next time you file your income taxes.
Click HERE for a strategy that might help you to offset that extra reportable income.
Debt Counseling
If you need help being – or staying – disciplined, then you might want to see credit counseling.[2]
One of these is run by the National Foundation for Credit Counseling, a nonprofit financial-counseling organization. You can reach out to the folks at the NFCC by clicking HERE or by calling their toll-free number: (800)388-2227.
Of course, there are a few books and videos that you might want to check out as well.
I list my top picks HERE.
Reach out for Personalized Attention
I’m no expert, but I have a bit of experience.
For a no-cost, no-obligation review of your situation, call (636)447-1169.
[1] In theory, there are numerous ways to get out of debt. Other authors mention things such as borrowing from family or friends, using credit-card balance transfers, availing yourself of Home-Equity Lines of Credit (HELOCs), and taking out personal loans. In future articles, I may tackle some of these.
[2] I should also add that there are debt-management programs around, too.