Ask John: The Truth About Getting Out of Debt

Hey John, how in the world can I get out of debt?

If I had a nickel for every time someone asked me that one at AskJohn@credit.com, I'd be a wealthy man. Rather than answering the question over and over again, I figure it's time to dedicate an entire article to the subject of getting out of debt.

We've all seen the ads for products that claim to help you escape your debt. You could spend thousands of dollars on books, DVDs, and home study courses that supposedly unlock the secrets to a debt free existence.

Well, here is my contribution to the already crowded menu of literature on how to deal with your debt. The difference is that mine is free and will take up much less space on your bookshelves. But, if you're one of those people who learn better when they read it from a book then here is a great one.

The bottom line -- there are really only five ways to get out of debt. I've listed them below with a brief “pros and cons” of each. They're in no particular order: 

1. Debt Settlement

With debt settlement you hire a company to negotiate with your lenders on your behalf. Essentially, they're negotiating a new, reduced amount of money that you would owe them. You pay the debt settlement company directly and they pay your creditors. They take their fee out of your contribution.

They all seem to have the same strategy, which is to tell their clients to stop communicating with their lenders. The theory is that if you can get your lenders so desperate for a payment, they'll be more open to accepting less than you really owe them.

Pro – If a settlement is accepted on an account, you will pay less than you initially owed the lender. Usually you will pay less than 50% of your original debt over 2-3 years. Debt settlement is more private than bankruptcy and usually more affordable than debt counseling.

Con – Debt settlement should only be used by people who already have really bad credit. Otherwise, your credit reports will be significantly damaged if you use a debt settlement company. Notations of “settlement accepted” on any of your accounts will damage your credit scores for seven years. And some of them won't tell you exactly how much of your monthly payment is going to settle the debt. In that case the debt settlement company doesn't want you to know how much of your payment is going into their pocket as their “fee. ”  Also, while you ignore your lenders, they report ascending levels of negative information to the credit bureaus, which is not good.

Suggestion – This is only a good solution if you already have damaged credit reports and scores. This option will further damage them.

Strategy Grade: C

2. Self-Budgeting

Deciding to repay your debts on your own is self-budgeting. With this process you account for every dollar that comes into the household and every dollar that is spent in a given month. Then you adjust and prioritize where the money is going based upon whether it is a basic human need, necessity, liability, or luxury. Credit.com has a worksheet called Do-it-Yourself Debt Reduction that can help you get started.

Budgeting is not fun. Most people have a hard time sticking to a budget for more than a few months. Having said that, most of the people I talk to would be able to make their payment deadlines each month with a little aggressive self-budgeting. Things like dinners out, movies, cell phones, vacations, car washes, spa treatments, expensive haircuts, even cable TV and gym memberships are fun but have to go if you're in a credit crunch.

Pro – Reducing your debts on your own will save your credit from damage and it's free. And you'd be surprised how flexible you can be when it comes to money. Sticking to a budget might eventually become second nature.

Con – Paying your debts off on your own will take time, time that you're being charged interest on your balances. The faster you can pay off your debts, the better. Budgeting is also boring and not a lot of fun. But if you want to get out of debt and save your credit, this is a good option.   

Suggestion – Come up with a detailed plan using our worksheet. Set up automatic bill pay so you won't have to force yourself to write checks each month. And if you have any money left over at the end of the month, put it all directly toward your debts. It doesn't make sense to be saving money at 5% APY when your credit card issuer is charging you 19% APR.

Strategy Grade: A

3. Debt Management Plans (DMPs)

A debt management plan is set up through a legitimate non-profit Consumer Credit Counseling Service. Essentially you hire them at a reasonable fee ($40 per month in some cases) to act as your trustee. They talk to your lenders and renegotiate your payment requirements. If your lender is willing to work with them, they'll even make your payments for you by drafting the money directly from your checking or savings account.

The goal with most debt management plans is to have them completed in less than five years. And, when you're done, you'll be completely credit card debt free.

Pro – There's usually no negative impact to your credit scores by signing up for a DMP. Most credit card issuers will work with the legitimate credit counseling services and report your account in good standing as long as they are getting paid each month.

Con – Debt management programs can take many years to complete; an expensive proposition at $40 a month. Even though there is no overt negative impact to your credit, you can expect lenders to avoid you while you're in your DMP.

You also have to be absolutely certain that you are working with a legitimate organization. There are a lot of scam artists out there and so-called debt counselors that could take your money and destroy your credit. If you want to be sure that you're working with a legit organization, you can find a local CCCS operation here:

http://www.nfcc.org/ or at 1.800.251.CCCS

Be certain that any organization you speak with is a member of the National Foundation for Credit Counseling. If they are not, keep looking.

Suggestion – If you have a great deal of credit card debt and are not able to manage it on your own, this could be a good option for you.

Strategy Grade: B

4. Bankruptcy

Bankruptcy is legal protection from your creditors. There are two types of bankruptcy that consumers can generally file: Chapter 7 and Chapter 13. A Chapter 7 allows consumers to “discharge” or do away with almost all of their debts. There are some exceptions, as always, and the new bankruptcy laws make Chapter 7 much harder to file.

Chapter 13 is also referred to as a wage earner plan and has become much more common with the bankruptcy reforms. You pay a monthly amount to a trustee who then distributes the money to your creditors.

Pro – If you file Chapter 7, you may walk out of the courthouse completely debt free, a good feeling to be sure. And, completing a Chapter 13 will still relieve you of a majority of your debts. Plus, depending on your state's laws, you may be able to keep your home and other property.

Con – A bankruptcy filing will stay on your credit reports for 10 years and your credit scores will be damaged by it the entire time. It will take some time before you can qualify for a loan at decent rates. There are also some lenders who will never do business with you again if you discharge one of their accounts in a bankruptcy.

Filing bankruptcy is also more expensive today than it has ever been. You can expect to pay well over $1,000 to file for Chapter 7 and you'll have to pay for mandatory credit counseling before you can even file.

Suggestion – Bankruptcy isn't always a bad option BUT it should usually be considered your last option.

Strategy Grade: D

5. Don't get into debt

This one is pretty self explanatory and kind of ridiculous if you think about it. The reason I include this one is because we have a significant amount of young visitors to Credit.com. The best way for them to stay out of crushing debt is to avoid the traps that many others didn't avoid.

Here are some rules to follow:

1. Don't apply for credit unless you need it.
2. Don't apply for a loan without understanding all of the terms of the deal including interest rate, introductory periods, grace periods, universal default policies, credit score requirements, primary credit bureau used, and credit bureau reporting policy.
3. Don't ever apply for credit in exchange for a discount on your purchases or a freebie.
4. Be careful when taking advantage of in-store financing offers. “No payment for 24 months” isn't always a good idea.
5. Pay all your credit card balances off in full each month.
6. Don't spend money you don't have.

Pro – You won't have to consider any of the less attractive options above, you'll save a lot of money on interest and have better overall financial health and credit scores.

Con – You'll have to save up for that jet ski you've always wanted.

Strategy Grade: A+

If you have a comment for John or would like to ask him a question then please feel free to drop him a note at AskJohn@credit. com

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