If you have attempted, and failed, to negotiate settlements with your creditors, you may need to consult a debt settlement company. The debt-settlement industry has found a niche among troubled borrowers who are trying to avoid bankruptcy. Debt settlement is different than debt consolidation, where borrowers are offered one big loan to pay off their smaller debts, and than credit counseling, where agencies set up low-interest repayment plans so borrowers can pay off their debts over time.
You’ll need to exercise caution if you hire a debt settlement company because the industry is largely unregulated. The federal government doesn’t regulate debt-settlement companies, and few states regulate the industry. Some companies offering debt settlement are run by scam artists, eager to take big fees upfront and then disappear.
Debt settlement can be expensive. Some companies charge 14% to 18% of the total face value of the debt you want settled. Some others require you to pay them a large percentage of the amount they end up settling for you. The difference between what you owe and what you pay in a settlement typically is considered taxable income by the IRS. So, you could owe $2,500 for every $10,000 in debt that’s forgiven if you’re in the 25% federal tax bracket.
Settling a debt for less than what you owe can do also additional damage to your credit scores, in addition to the damage done by missing payments. Creditors are increasingly using debt collection law firms to file lawsuits quickly when borrowers default, instead of trying to settle the debt. A successful lawsuit can lead to wage garnishment or property liens.
The average debt settlement process takes close to two years, although it still may be faster than going through a bankruptcy. However, people who file such a Chapter 7 bankruptcy get a fresh start that allows them to begin rebuilding their credit immediately. They no longer owe their creditors, and the upfront cost for filing is usually far less than the cost of debt settlement, so if you can’t pay your bills filing for a Chapter 7 bankruptcy may be a better course than debt settlement.
How credit scores are created is a mystery to most people. While many know that a credit score can affect their ability to get a loan, credit card, car, or job, fewer know what actually goes into calculating a credit score. A credit score calculation is designed to help lenders better predict risk by using an automated system to rank the likelihood of a borrower paying on time each month, based entirely on information found in a credit report. A basic knowledge of how scores are developed can be helpful to anyone trying to manage their credit more effectively.
The information used for calculating a credit score is obtained from the credit reports of consumers. The data used reflects two points in time, typically two years apart. The differences between the data points are reviewed for trends and correlations. Credit score calculations tend to focus on defaults, bankruptcies and other negative credit outcomes as predictive behaviors for the future. This information is used to create various scorecards that can be used to weigh predictive characteristics and determine the risk of a consumer defaulting on their loans.
Calculating The Credit Score
Within each credit-scoring model, a number of different scorecards tailored to a specific type of credit profile are created. This allows the credit bureaus to predict the creditworthiness of a consumer within a wide range of different credit experiences, including people who have just come out of bankruptcy, people who have never missed a payment, and everyone in between. Once the most predictive scorecard for a particular consumer has been identified, the consumer’s score is calculated by compiling the points earned for each of the scorecard characteristics according to the information found in the credit report.
Certain actions will cause your credit score to rise and fall. For example, making a big purchase on a credit card with a low credit limit will cause your credit score to fall because you a using a higher percentage of your available credit. However, when the balance of that credit card is paid down, your credit score will rise. Missing payments will also cause a decrease in your credit score. To have the highest credit score, you will have to avoid all of the actions that cause your score to decrease while taking advantage of every opportunity to increase your score. No matter how low your score is to begin with, if you do the right things, you will see a significant increase in your credit score.
There are many ways to pay down your credit card debt. Over the course of the next few weeks, I am going to share the different methods espoused by the various financial experts out there. Today, I’ll explore the system that helped reduce my account balance to zero: Dave Ramsey’s Debt Snowball.
Write Down All of Your Debt List out your amount of outstanding debt. List it all out. Write it all down. Your student loans, your car loan, credit card debt, the money you owe your parents or your family, your mortgage. Everything should be listed. Don’t leave a single debt off your list.
Start Paying Down Debt As you begin paying down your debt, it is important that you are current in all of your payments and that you continue to make all the necessary minimum payments. Now, list out your debts from lowest outstanding amount to highest outstanding amount owed. It’s almost counter-intuitive, but you are going to start with the lowest amount owed first. Disregard interest rates. Disregard rationale for a moment. Throw all your extra money that you have at the lowest bill. Keep knocking it down, little-by-little. In no time, that debt will be eliminated. Next, take all the money that you had used to pay off the lowest amount and apply it to whatever bill is the next lowest amount. As you knock off your debt, you keep applying higher and higher sums of money to your debt. Effectively causing what Dave Ramsey has called a “debt snowball.”
For those of you who have outstanding debt owed to various sources, this approach may be helpful in that it provides the emotional satisfaction of eliminating individual debts more quickly. But, if you can’t justify paying off a $200 debt to your mom with no interest before you attack your $9,000 credit card debt at 15% APR, then this approach may not be the best approach for you. I’ll get to other theories on the best way to eliminate/reduce debt in the upcoming weeks.
The Debt Snowball belongs to Dave Ramsey, a syndicated radio host and the author of many books, including the Total Money Makeover. If you are interested in a learning more about Dave’s appraoch to getting out of debt and getting your financial life in order, I recommend you read his book.
There comes a time when you have to say, “Enough is enough.” I sometimes feel like a lone wolf in the wilderness howling against the continuation of the credit card trap. These cards dangle carrot after carrot in front of your face hoping to get you to lunge forward and take a bite of it. And once you’ve devoured that orange veggie, they just dangle another larger, juicier, crisper, carrot that is even more vibrantly orange than the previous one.
Don’t Fall For the Trap
Ignore the incentives! We know that cards offer rewards points that you can apply towards big-ticket purchases or hotel stays or airplane flights. We know that the actual worth of these incentives is highly debated. In my opinion, it all boils down to this simple fact: behavior. If you are able to pay off your credit card in full at the end of each month, then you should think about signing up for a rewards program. You have a level of financial responsibility that some Americans don’t have.
Be honest with yourself. Is it possible that you credit cards will get out of hand? If so, don’t jump at the most potentially dangerous of all credit card incentives: the Zero Percent Balance Transfer. If you have a proven track record of being current with your credit cards, then this 0% balance transfer might help you out financially. (But please don’t start using that card though!) However, if you don’t have the discipline to stay current on your payments, you might find yourself right back where you started in no time flat. Read the fine print, because usually these 0% balance transfers only retain the rate for a certain period of time and you only maintain that APR if you stay current. (If you miss even one payment the APR can explode to 30%.)
These companies are ruthless with trying to garner new customers. They’re just as bad as Big Tobacco, in my opinion. Seriously. We have to wake up and stop our dependency on bad debt.