How To Settle Debt And Improve Your Credit
If you’ve found yourself in what seems like a mountain of debt and you feel like all hope is lost, we’re here to tell you that there is a way out. When the process of eliminating all of your debt and regaining control of your credit score seems impossible, just know that it all starts with a few simple steps.
This article is designed to give you clear insights and steps that you can take today to begin your journey of zero debt and sky-high credit scores.
It will take time, effort, planning and patience (just like any huge goal you have).
For anyone looking to get out of debt quickly with a fresh start in life, there are a few options that I will cover. I will warn you that these options can have significant negative effects on your credit score so before exploring any of these options it’s important you plan and determine what strategy works best for you.
If you plan on purchasing a home, financing a car, refinancing a loan, or any other large financed purchase, then you may want to skip ahead.
If you are not looking to purchase anything major anytime soon and your first priority is to get out of debt and your credit scores can take a dip, then these first options are for you.
Options That Can Affect Your Credit Score
Do Nothing To Settle Debt
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 or letting your debts go to collections and spiral your credit scores down further.
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 decision 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. This option should only be pursued in worst case scenarios.
Bankruptcy can be costly if you decide to hire legal representation.
Consult with a financial expert before making a decision about filing for 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. 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 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 and the cycle never stops.
Options That Don’t Hurt Your Credit
Paying The Minimum
The main problem with only paying the minimum payment each month is that unsecured credit cards typically 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 that it’s an unsecured line of credit that is not secured by any kind of collateral like a house or car. The credit card companies will do everything they legally can to squeeze as much money out of you as possible to lessen their risk of losing a profit.
Which is why it is important that you get your balances down as much as possible, as soon as possible. Never ending high-interest credit card payments is a cycle you want to break as soon as possible.
If you’re looking for ideas about how to budget yourself better and find money in the least likely of places (money that you already have) then you be sure to read our free budget guide.
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 principal balance. The rest is going towards interest (insane isn’t it?).
Doing nothing or only paying the minimum payment is an option but as you can see it’s an option that only delays 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 our debt payoff calculator.
Paying your debts like this will take you a long time, but your credit score will stay whole (if you’re not paying late) 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, weekend jobs or starting a side gig.
An option to not only reduce your interest rates but also your principal 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 1-12 payments or more. A creditor most likely will only agree to do this if you are past due on your payments by 90 days or more.
If you are past due by more than 30 days then your credit score has probably already taken a hit from the late payments that have been 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 in 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 as 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. Be sure to get any agreements sent to you in writing. You will need this just in case the creditor does not honor their end of the agreement. You can then send the bureaus a copy of this agreement to assist with any disputes you file. There is only one good kind of collection; a non-reporting collection.
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 where you only have 1 payment and also similar to Chapter 13 bankruptcy in the sense that you will have your interest rates frozen and monthly payments distributed to your creditors.
Consumer Credit Counseling Services or CCCS typically are non-profit. Some may 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.
Improving Your Credit
Part of your credit score is the number of open credit lines you have. The ideal mixture is 3 credit cards, and installment loan (such as an auto loan) and a mortgage. If you have all 3 and they are active and open, congrats you’re on your way!
If you are lacking one, then you may want to consider opening an account to supplement your credit and beef up your profile. If your credit scores are low, then secured cards offer an easy way to begin developing a strong credit profile again.
Another aspect if your credit is the balances you carry on your open revolving credit lines. The golden rule for credit cards is to maintain a balance under 30% of your limit. For example, if you have a credit card with a $1,000 limit then ideally you would want to keep your monthly balance under $300 each month.
If your balances are above 30% of your limit, don’t freak out. Once you pay your balances down under 30% of your limit, you should see a significant improvement to your credit scores.
One of the single biggest negative impacts on your credit is late payments. We’ve seen credit scores drop as much as 100+ points because of a single, reported late payment. Avoid paying late AT ALL COSTS.
If you do have late payments reporting to your credit report, don’t worry. There are a few things you can do to help turn your credit scores around.
- Negotiate with your creditor. Sometimes creditors will forgive a late payment for reasonable excuses. Give your creditor a call and explain your situation to them.
- Get caught and stay current. If you can’t get any late payment forgiveness, then it is important that you get caught up as soon as possible and continue to pay your creditors on time. In about 6 months of on-time payments, you’ll see the “negative weight” of the previous late payments affect your credit less and less.
- Avoid allowing any accounts to go into collections. Collections are another item that can dramatically lower your credit scores.
How long you’ve had your accounts also impacts your credit score. So when your previously open accounts go into collections they effectively close and impact your credit twice. On top of that your late payment also hits your credit profile as a negative. So now one account has negatively impacted your credit profile 3 times (ouch!).
It is important to keep your accounts open and healthy for as long as possible to get the maximum influence to your credit scores as possible.
If you have accounts in collections you probably have seen your credit score plummet. No need to stress, there are some things that you can do to improve your credit profile.
- Offer a settlement in exchange for a letter of deletion. As we mentioned previously, if you negotiate a settlement with a creditor for debt in collections and get them to agree to delete the item from your credit report upon payment, then you want to get that agreement in writing. This written agreement will serve as proof of your agreement in case you need to dispute the item after paying because the creditor did not honor their end of the bargain.
- Wait until it falls off. This option is only if you have plenty of time to wait for negative items to drop off your credit report after 7 years. This is by far the longest and most tedious way to improve your credit score.
- Dispute inaccuracies in the reporting of the collection accounts. If you need some pointers on what and how to dispute negative items on your credit report, then please refer to our credit improvement article.
- Hire a professional credit repair company. Sometimes, you need professional help to get the job done and have peace of mind. We offer a free 15-minute credit repair consultation to all new clients.
There are many ways to get out of debt. You have to decide which option works best for you and your circumstances. With patience, planning, dedication, and focus you can eliminate the stress of debt and move on towards a healthy financial life. The Credit Agents are here to help you explore our professional credit repair services. Please feel free to call us Mon-Fri at 1-800-786-2120 or request a free 15-minute credit review.