Getting into debt is as American as Mom’s apple pie and Fourth of July fireworks. It’s the American way! If that’s your way, too, you may be so deep in debt that you live paycheck to paycheck, using credit cards and home equity loans to make ends meet and pay for unexpected expenses. You may despair of ever being able to buy a home, enjoy a comfortable retirement, or take your kids on holiday. (Did we strike a nerve?) Your “American way” may have caused you to give up on the American dream.
Many creditors claim that consumers have too much debt because they spend irresponsibly, but recent studies tell a different story. For example, a 2006 study based on information from the Federal Reserve Board shows that wages in the U.S. (adjusted for inflation) have been stagnant since 2001, while the cost of such basics as housing, medical care, food, and other household essentials has risen. In other words, not all U.S. consumers are in debt because they are wasteful, but because we have all taken a national wage cut.
But you probably have not taken decisive action to improve your financial situation. Perhaps you have not even recognized the state of your finances, let alone changed your lifestyle and become more careful with your spending. Even if you are aware that you are in financial distress, you probably do not know what to do about it. You may be frozen with fear and confusion.
If you are trying to meet your financial obligations but feel like poor Sisyphus, struggling to keep the boulder he’s pushing uphill from rolling over him, you are in the right chapter. From here on, we will give you the information you need to get a grip on your debt and turn it around.
In this article, you will learn about the best tips to get out of debt. Before that, let’s distinguish the difference between good and bad debt.
Difference Between Good Debt and Bad Debt
Considering that you have serious problems with debt, you may be surprised to hear this: We eventually want you to use credit cards and get loans again. Why on earth would we steer you back into debt when getting out of it is such hard work?
Because owing money to creditors is not necessarily a bad thing. Whether debt is good or bad depends on why you took on the debt in the first place and how you manage it — whether you make your payments on time, for example. It also depends on how much debt you have relative to your income, because too much debt, even if you’re able to keep up with your payments, harms your credit history and brings down your credit score.
Why debt can be a good thing
Going into debt can be a good thing, in many circumstances. For example, you could go to your grave trying to save up enough money to purchase a home with cash, so a mortgage is a wonderful thing — especially if the value of your home grows over time. Also, a home equity loan is a good financial tool when you use it to improve or maintain your home (again, with the goal of increasing its value).
A car loan is another example of good debt because most of us need a vehicle to get to and from work, and most of us can’t afford to purchase a car with cash. Debt is also good when it helps you build your wealth; for example, you borrow money to purchase your home or rental property. Some debt helps you save money in the long run, like getting a loan to make your home more energy-efficient so you can reduce your energy bills.
When debt isn’t so good
Debt is detrimental to your finances when you run up your credit card balances to live beyond your means or to purchase goods and services that don’t have any lasting value for you or your family. For example, restaurant meals, happy hour drinks, clothing, jewelry, and body care services don’t have any lasting value, but they sure can run up your credit card balances.
Debt is also a negative thing when you have so much that you can’t afford to repay it (especially when your home is at risk), when the amount you owe lowers your credit score, or when you borrow money from shady operators (like finance companies or payday loan companies) that charge high-interest rates.
How To Get Out of Debt
1. Taking Stock of Your Finances
You need a clear idea of the current state of your finances to figure out the best way to deal with your debts.
Compare your monthly spending to your monthly income. Prepare yourself for a shock. Most people underestimate the amount that they actually spend relative to what they earn. By doing this comparison, you may quickly realize that you’re using credit to finance a lifestyle you can’t afford, and you’re spending your way to the poorhouse. If that’s the case, you must reduce your spending to meet your financial obligations, and you may need to do a lot more than that, depending on the seriousness of your financial situation.
Order copies of your credit histories from the three national credit- reporting agencies: Equifax, Experian, and TransUnion. Your credit history is a warts-and-all portrait of how you manage your money — to whom you owe it, how much you owe, whether you pay your debts on time, whether you are over your credit limits, and so on. Being charged higher interest rates on credit cards and loans is a direct consequence of having a lot of negative information in your credit history.
Find out your FICO score. Your FICO score, which is derived from your credit history information, is another measure of your financial health. These days, many creditors make decisions about you based on this score instead of on the actual information in your credit history.
We understand that things beyond your control — like bad luck and rising prices — may be partly to blame for your debt. We also know that chances are you’re at least partly responsible as well. For example, you may
Pay too little attention to your finances. You forget to pay your bills on time; you don’t pay attention to the balance in your checking account, so you bounce checks a lot; and/or you have a lot of credit accounts.
Maintain high balances on your credit cards. As a consequence, you can afford to pay only the minimum due on the cards, you pay a lot in inter- est on your credit card debts, and all that debt has lowered your FICO score.
Have little (or nothing) in savings, so you have to use credit to pay for every unexpected expense.
Mismanage your finances because you don’t know how to manage them correctly.
The National Foundation for Credit Counseling surveyed its member credit counseling agencies in early 2006 to determine the key reasons consumers were filing for bankruptcy. The survey showed that 41 percent of consumers blamed their bankruptcy on poor money-management skills, 34 percent attributed it to lost income, and 14 percent cited an increase in medical costs.
If compulsive spending is the cause of your financial problems, get help from an organization like Debtors Anonymous or from a mental health therapist. Compulsive spending is an addiction just like alcoholism, and you can’t beat it on your own. You’ll always have debt problems if you can’t control your spending.
2. Using a Budget to Get Out of Debt
After you assess the seriousness of your financial situation, you need to prepare a plan for handling your debt, including keeping up with your creditor payments — or at least keeping up with payments to your most important creditors. One of the first things you should do is prepare a household budget (or spending plan, as some financial experts euphemistically call it).
Whether your annual household income is $20,000 or $100,000, living on a budget is probably the single most important thing you can do to get out of debt and avoid debt problems down the road. A budget is nothing more than a written plan for how you intend to spend your money each month. A budget helps you
- Make sure that your limited dollars go toward paying your most important debts and expenses first.
- Avoid spending more than you make.
- Pay off your debts as quickly as you can.
- Build up your savings.
- Achieve your financial goals.
Learn more about how to create a budget. In the guide, we walk you through the budget-building process from start to finish. Reducing your spending and making more money often go hand in hand with creating a budget.
Getting out of debt usually requires that you change your spending habits. Because those changes may affect everyone in your family if you have children (especially preteens or teens), you and your spouse or partner should invite them to help you create your household budget.
They can suggest expenses to cut and things they can do to improve your family’s financial situation. If you involve them, your kids will be less apt to resent the effects of budget cuts on their lives. Also, you’ll be giving your kids the education they need to become responsible money managers as adults.
3. Distinguishing Between Types of Credit
You may think that all credit is created equal. A lot of people think so, which is one of many reasons they run into debt problems. In this section, we brief you about various types of credit. They definitely aren’t created equal, and you should get familiar with these terms so you can become a better credit consumer.
Here are the types of credit you should be familiar with:
- Secured: With this kind of credit, the creditor guarantees that it will be paid back by putting a lien on an asset you own. The lien entitles the creditor to take the asset if you don’t live up to the terms of your credit agreement. Car loans, mortgages, and home equity loans are common types of secured credit.
- Unsecured: When your credit is unsecured, you simply give your word to the creditor that you will repay the money that you owe. Credit card, medical, and utilities bills are all examples of unsecured credit.
- Revolving: If your credit is revolving, the creditor has approved you for a set amount — your credit limit — and you can access the credit whenever you want and as often as you want. In return, you must pay the creditor at least a minimum amount on your account’s outstanding balance each month. Credit cards and home equity lines of credit are examples of revolving credit.
- Installment: With installment credit, you borrow a certain amount of money for a set period of time and you repay the money by making a series of fixed or installment payments. Examples of installment credit include mortgages, car loans, and student loans.
To be a savvy consumer, you also need to know the criteria that creditors use to evaluate you when you apply for new or additional credit. Although creditors may take other factors into account, the following are the three biggies:
- Your character: Does your credit history show that you’ve got a history of repaying your debts?
- Your financial capacity: Can you afford to repay the money you want to borrow?
- Your collateral: If you have a poor credit history, or if you are asking to borrow a lot of money, creditors want to know whether you have assets that you can use to secure your debt or guarantee payment on it.
These criteria not only determine whether a creditor will approve or deny credit, but they also impact how much credit you’re given, what your interest rate is, and what other terms of credit application.
4. Cut Deals With Your Creditors
Ask your creditors to help you keep up with your debts by lowering your monthly payments on a temporary or permanent basis, reducing the interest rate on your debts, or letting you make interest-only payments for a limited period of time. Before you approach any of your creditors, you’ve got homework to do.
For example, you need to create a list of all your debts and the relevant information pertaining to each one. You should also review your budget to figure out how much you can afford to pay on your debts every month, starting with the ones that are the most important. Don’t allow a creditor to pressure you into agreeing to pay more than you can afford.
Whenever you talk with a creditor, explain why you’re calling and exactly what you’re asking for. If the first person you speak with says no to your request, politely end the conversation and ask to speak with a manager or supervisor.
5. Borrow Money to Pay Off Debt
When you get the new debt to pay off exist- ing debt, the process is called consolidating debt. We realize that going into debt to get out of debt may not sound sensible, but if it’s done right, it can be a smart debt-management strategy. To do it right, however, all the following should apply when you consolidate:
- The interest rate on the new debt is lower than the rates on the debts you pay off.
- The monthly payment on the new debt is lower than the combined monthly total for all the debts you consolidate.
- The new debt has a fixed interest rate.
- You commit to not using credit again until you’ve paid off the new debt.
See our guide to learn the various ways to consolidate debt, including transferring credit card debt to a lower-rate card and getting a bank loan. We also discuss debt-consolidation offers that will do you more harm than good.
6. Get Help From a Credit Counseling Agency
The advice and assistance of a credit counseling agency can be a godsend when you have a lot of debt and are struggling to take control of it (see our guide to credit counseling). This kind of agency can especially help when you are confused about what to do or lack confidence about your ability to improve your finances on your own. A credit counseling agency can
- Help you set up a household budget.
- Evaluate a budget you have already created, to suggest changes that will help you get out of debt faster and avoid loss of assets.
- Negotiate lower payments with your creditors and put you into a debt management plan.
- Improve your money-management skills.
Not all credit counseling agencies are on the up and up, so take time to choose a reputable one. First and foremost, that means working with a nonprofit, tax-exempt agency that charges you little or nothing for its services. If you’re not careful, it can be an easy mistake to make because some debt settlement firms try to appear as though they are credit counseling agencies. However, the two have big differences between them.
The goal of debt settlement firms is to profit off financially stressed consumers — not help them improve their finances. These firms charge a lot for their services, and many of them don’t deliver on their promises. Consumers who work with debt settlement firms often end up in worse financial shape than they were before.
7. File For Bankruptcy
When you owe too much relative to your income, your best option sometimes is to file for bankruptcy, especially if you’re concerned that one of your creditors is about to take an asset that you own and don’t want to lose.
You can file a Chapter 7 liquidation bankruptcy, which wipes out most but not all of your debts, or a Chapter 13 reorganization bankruptcy, which gives you three to five years to pay what you owe and may also reduce the amounts of some of your debts.
Sometimes filing bankruptcy actually provides a way of paying all your debts instead of escaping them. If the value of your property is sufficient to pay all your debts if only you had enough time to sell your assets, you can use bankruptcy to hold aggressive lenders at bay until your property is sold for the benefit of all your creditors — and possibly producing a surplus for you. Say, for example, that you own investment property worth $150,000, on which you have a mortgage of $100,000, and that you have other debts total- ing $25,000.
If you can sell the property, you can pay off the mortgage and other debts and still have something left over for yourself. But if the mortgage-holder forecloses, neither you nor your creditors will likely receive a cent.
Although the property is put up for public auction in a foreclosure, bidders rarely show up, and the only bidder typically is the mortgage-holder, which merely bids the amount that’s owed on the mortgage. In other words, the mortgage company ends up owning the property without paying any cash. Filing bankruptcy interrupts the foreclosure so that the property can be sold for everyone’s benefit.
Learn more about how bankruptcy works.
8. Build a Better Credit History
Right now, when you’re smothered by debt, you may not be able to think about improving your credit history — you’ve got too many other immediate concerns. But tuck this topic into the back of your mind because when you’ve had money troubles, rebuilding your credit history should be one of your first goals. Having a positive credit history is essential to getting new credit with attractive terms.
The credit-rebuilding process is quite simple: You get small amounts of new credit and repay the debt on time. For example, you get a MasterCard or Visa card, use it to purchase some goods or services you need, and pay off your card balance according to your agreement with the card issuer. You could also borrow a small amount of money from a bank and pay off the loan according to the terms of your agreement with the lender.
As you do these things, you add new positive information to your credit history. Meanwhile, the negative information in your credit history gradually begins to disappear because, with a few exceptions, most damaging credit record information can be reported for only seven years and six months. As time passes, your credit history will gradually contain more positive than negative information, assuming that you manage your finances responsibly.
Why is rebuilding your credit history so crucial? First, if you have a negative credit history, you won’t qualify for a credit card with a low-interest rate, you’ll have trouble borrowing a significant amount of money from a bank, and your credit score will be lower than it would be if your credit history was full of positive information. Consider some other potential consequences of negative credit history:
- Potential employers who review your credit record as part of the job application process may not hire you. You may also be denied a promotion with your current employer if it checks your credit report as part of the process.
- Life insurance companies may penalize you by charging you a higher premium or not selling you as much insurance as you would like.
- Landlords may not want to rent to you.
- You may not be able to get a security clearance or certain types of professional licenses.
Avoid companies that promise to rebuild your credit or claim to be able to — presto chango — make the negatives in your credit history disappear. Not only are you wasting your money, but (depending on the tactics a credit repair firm uses) you also may violate federal law if you do what the firm tells you to do.