A few weeks ago we touched briefly on the topic of getting out of debt. This week we'll go into more detail on how to tame the Debt Monster.
The Fine Print
The articles in this series do not offer specific financial advice. Instead they will present financial tips, with occasional smart-aleck observations and commentary, that may or may not be useful in the reader's particular situation. You should always seek advice from a professional who is familiar with your personal circumstances before acting on any of the information presented in this series.
If You're in a Hole, Quit Digging
A credit card is like a piece of rope: a useful tool, a lifeline, or something that can hang you if you don't watch out.
Recall the example of the person who bought himself a $3209 TV using a credit card. If the buyer makes only the minimum payment each month, it would take him over 50 years — yes, years — to pay for that TV, spending over $33,000 in interest during that time. It isn't just the unwise purchases that can cause trouble. A person may lose his or her job and use a credit card to pay for food, rent and other necessities until he or she finds another job. Or someone may have unexpectedly large medical bills and use a credit card to pay for them. No matter what the reason, a person can dig himself into a very deep hole very quickly if he's only able to pay a small amount on his balance each month.
A large credit card balance is the most obvious source of financial difficulty because of the high interest rates and penalties charged by the card issuer, but you can get into trouble with debt of any kind. Take mortgage loans, for example. Nowadays in the US there are many different loan terms and repayment schedules available to a borrower. The ones to watch out for are the adjustable rate mortgage (ARM) and the interest-only loan. These are very attractive because they generally mean much lower payments in the first few years, but watch out! An ARM may be appropriate if you expect your income to rise or if interest rates are fairly stable, but if that raise doesn't materialise or if interest rates rise significantly, you may find yourself unable to afford your house. The interest-only loans are particularly insidious, as they allow people to buy houses that they really can't afford. The first few years are great when you are paying only the interest on the loan and then WHAM! you have to start repaying principle as well as interest1. This kind of loan can be appropriate if your income rises dramatically or if you plan to sell the house within a few years (and housing prices don't fall dramatically before you can sell). As with the ARM, if things don't go as you'd planned, you can find yourself up to your eyeballs in debt and at risk of losing your house.
How to Dig Yourself Out
As with anything else, getting into trouble is a whole lot easier than getting back out. Bankruptcy is the last resort of those who find themselves hopelessly bogged down in debt, but it should really be the last resort. Bankruptcy carries a lot of unpleasant consequences, such as difficulty in obtaining credit in the future and having to pay much higher interest rates. And the laws are changing in the US, making it much more difficult for the average person to declare bankruptcy and raising the amount of debt that must be repaid2.
Fortunately there are steps that a person can take to get himself out of debt. Here is a summary of steps that many financial advisors suggest if you find yourself unable to pay your bills:
Always contract your creditor and try to arrange a different payment schedule. Don't ignore the bills or try to hide. Most creditors are willing to work with you on this, and you are demonstrating that you're a responsible person who intends to honour his debts.
Try to negotiate a lower interest rate on your credit card. Many people don't realise that credit card companies will often lower the rate if you ask, particularly if up until now you've been making regular payments. They want to keep your business, and there are many other companies offering attractive low rates to new customers.
If your current credit card company won't lower your rate, then find another company that offers the low rates and transfer your balance to the new card. That way you'll be paying more toward the principle each month, which will decrease the total amount of interest you'll owe and will allow you to pay off the debt much faster. And be sure to cancel the old card afterwards — having a lot of active credit cards lowers your credit score.
Consolidate your debt. You can use either a card with an attractive rate or a loan to pay off several small accounts. The amount that you need to pay each month will be lower, allowing you to remain in good standing more easily. Be sure that you don't use the card to add more debt, though! That won't get you anywhere. Think of the cartoon where one character is busily trying to dig a hole while another character is busily filling it in — you don't want to do this to yourself.
Work with a debt counsellor, but be sure you're working with a legitimate company and not some scam artists. A counsellor is invaluable in cases where you can't see your way out; he or she can untangle the mess, help you negotiate with your creditors, and show you how to avoid get into financial trouble in the future. Legitimate counselling services are often non-profit organisations that charge no fee or a modest fee based on what you can afford to pay, unlike the scam artists who are simply preying on the distressed and charge as much as they can get their hands on (this is one way to distinguish the good from the bad). You can find debt counsellors by looking in the phone book — there also resources on the Web (see links below).
Above all, you want to maintain your reputation as a responsible person who intends to live up to his responsibilities. This may sound unimportant, but it's literally money in the bank. Companies are much more willing to work with you, and you will be able to negotiate more attractive terms if companies are convinced that you will repay them. (Think about the affluent person whose mail box is stuffed with attractive offers for new credit cards versus the poor soul who is forced to go to a loan shark or pawn broker to raise cash.)
Debt counselling links for the UK
Debt counselling links, no country specified
This debt counselling Web site contains informative articles as well as a section with consumer complaints, which can help you avoid the bad actors in the profession.