How To Settle Debt And Improve Your Credit
Finding a way to settle debt can be problematic. Especially when you have a good credit rating because you want to make sure you don’t destroy your credit score you worked so hard to build. For those looking to get out of debt and have a fresh start in life, there are a few options that I will cover in this article. I would like to warn you that these options can have adverse effects on your credit score so before exploring any of these options it’s wise to first find out what your goal is. Decide if you will need your high credit score to purchase any major in the three to six months like a house or a car. If you are not looking to purchase anything major anytime soon and your first priority is to get out of debt, then this article is for you.
At first glance, this does not seem like an option but this is an option many people take. Doing nothing is a choice. Doing nothing means to continue paying your minimum payments each month. The main problem with only paying the minimum payment each month is that unsecured credit cards have high interest rates. Normally, the interest rate on a credit card is 19.9% or higher. The reason why credit card interest rates are so high is because it’s an unsecured line of credit that is not secured by any kind of collateral like a house or car.
Therefore, it’s considered a slightly riskier lending opportunity for banks and investors and yields a higher interest rate.
For the purpose of this article, I will use an example of a $10,000 debt with an interest rate of 24%. In order to estimate how much you pay in interest each month, you take your annual percentage rate (APR) and divide it by 12 months and then multiply that percentage by how much you owe. For this example, your monthly interest would be $200 (24% / 12 = 2%). If your minimum payment is $300 each month on this credit card, that means only $100 of your payment is going towards the principle balance. The rest is going towards interest.
Doing nothing or only paying the minimum payment is an option but as you can see it’s an option that only prolongs the date you will finally be out of debt. Most credit card statements will give you an estimated amount of time it will take to pay off your debt if you are only making the minimum payment. If you only made the minimum payment on a $10,000 debt with 24% interest, it would take about five years to pay off the debt and you would end up paying about $6,500 in interest according to this debt payoff calculator.
This option will take a long time to get out of debt, but your credit score will stay whole and will continue to improve as you pay down your balances, maintain timely payments, and build your length of history. If your credit score is something you are very concerned with and want to do nothing to hurt it, you have to decide what matters more to you; getting out of debt or your credit score.
Another option that will keep your credit whole and help pay off your debt faster would be to simply pay more than the minimum payment. If you were just to pay an extra $100 each month on your $10,000 debt, you would pay off the debt in less than 3 years. You would also only pay about half in interest compared to just paying the minimum payment.
Paying more than the minimum payment each month is proven to get rid of debt faster and will also improve your credit score faster because you will be lowering your debt-to-credit ratio faster. In order to determine how much more you could pay each month, I recommend that you do a thorough review of your finances and do a solid budget. Look for ways to lower your expenses by cutting out things you don’t really need like cable TV or eating at fast food places or restaurants. Also, look for ways to increase your income by asking for a raise at work or starting a business on the side.
Bankruptcy Chapter 7
One option that is normally not that attractive to people is bankruptcy. For individuals, there are two types of bankruptcy; Chapter 7 and Chapter 13. Chapter 7 bankruptcy is where the court makes the determination that you cannot afford to pay your debt off in a reasonable amount of time and will allow you to completely walk away from your debt. However, if you file bankruptcy it will be on your credit report for 10 years and will be a public record for life. Also, most mortgage lenders will not approve you for a home loan for at least 2 years after you have filed bankruptcy.
Bankruptcy Chapter 13
This form of bankruptcy is where you don’t qualify to walk away from the debt that you owe. This is where the judge or court sets up a payment plan for you to repay 100% of what you owe over the course of 3-5 years. Interest and fees are frozen or eliminated and you will make your monthly payments to a trustee. The trustee will then distribute your payment to each one of your creditors. It’s kind of like a debt consolidation program, but it is still bankruptcy. Therefore, it will remain on your credit report for 10 years and a public record for the rest of your life.
Robbing Peter to pay Paul is a simple way to put this option. This is where you get a loan from a bank or a lender to consolidate all of your debt into one new debt with one new payment. It doesn’t get rid of the debt, but it does make things a little more manageable with one new monthly payment at a lower interest rate.
Debt consolidation is based on your credit score and your ability to repay back this new debt so many don’t qualify. A consolidation loan can also be obtained through a home equity loan. You can use your equity in your home to pay off your unsecured debt. This is very risky because you are turning an unsecured debt into a secured asset. If you don’t pay your credit cards, your credit score goes down. If you don’t pay your mortgage, you could lose your house. Also, if you get an equity loan to pay off your credit cards but continue to use your credit cards after they have been paid off, you will just accrue more debt.
Consumer Credit Counseling Service
There are services that will negotiate lower interest rates with your creditors and set up new payment plans. This is similar to debt consolidation that you will only have 1 payment and similar to Chapter 13 bankruptcy in the sense you will have your interest rate frozen and your monthly payment will be distributed to your creditors.
Consumer Credit Counseling Services or CCCS typically are non-profit. Some will charge a monthly maintenance fee added to your monthly payment. CCCS generally be listed on your credit report as “third party intervention” or “paid by the third party”. This will not lower your credit score, but that remark could be frowned upon by future lenders.
Typically, CCCS takes about 3-5 years to pay off your debt.
An option to not only reduce your interest rates but also your principle balance is called Debt Settlement. This is where you would negotiate for a payoff about 20-50% of what you owe and pay that amount in 1-3 payments. A creditor would only agree to do this if you are past due on your payments about 3 months or more. Therefore, your credit score has already taken a hit from the late payments that have reported. If you are already past due at this point, this is not a bad option to consider because the creditors are very motivated to work something out with you. If you have a creditor who is willing to negotiate for a lower amount, they will want payment within 1-3 installments so be sure to have at least 40% of what you owe set aside.
The drawback with this option is that the creditor can report the amount they forgave as income and send you a 1099 tax form. Essentially, you could be responsible for the taxes on the forgiven debt. You still come out ahead and the end of the day with how much you saved over the lifetime of your debt.
When settling your debt, there is no positive reflection of this in your credit score. The current FICO scoring models don’t treat paid collections has a positive situation. Paid collections are treated the same as unpaid collections. The objective is to get the creditor to agree to remove the account from your credit report while you are negotiating. There is only one good kind of collection; a non-reporting collection. Now, there are talks with newer FICO versions like FICO 9.0 that settled collection accounts will be ignored when your credit score is calculated.
There are many options to get out of debt. The ones that take the longest will have little to no negative effect on your credit rating. The options that take the shortest amount of time will have a negative impact on your credit ratings like bankruptcy or debt settlement. One of the hottest new options right now that actually helps people get out of debt fast as well as doesn’t have a long-lasting negative credit score impact is called Debt Assumption.
Debt assumption is where an owner or entity will assume the debt that you owe. This owner or entity will negotiate new terms with your original creditors. The terms will more than likely be violated by the creditor and they will accrue penalties from the violations. Over time, there will be enough penalties on the books against the creditor that the debt will be a wash. This option works if you have someone or entity that is an an expert on the consumer protection laws or is a consumer debt attorney.
The beautiful part about debt assumption is that is like debt settlement in the sense that you will end up paying only about 40% of what you owe and the creditor will not issue a 1099 for the debt because it was washed away by the violations.
Also, part of the debt assumption process is to remove the account from your credit report so you have the ability to improve your score and start fresh.
There are many ways to get out of debt. You have to decide which option works best for you. If you have questions about any of these options, contact The Credit Agents at 800-786-2120 or online at CreditAgents.com