Is debt settlement a good idea?
A reader named Brendan recently emailed me with a question about debt settlement. He explained that he was struggling with credit card debt, juggling the balances of about 10 cards and only paying a little more than the monthly minimums (about $1,000 in total). He is particularly worried because one of his card issuers recently reduced his credit limit from $12,000 to $2,000, the amount he currently owes. This increased his overall credit utilization ratio from 45% to 60% and caused his credit score to drop to 650.
Brendan says he makes about $65,000 a year and doesn’t have a lot of savings. The part of his email that concerned me the most was when he wrote that he was strongly considering maxing out a few more cards to purchase Visa gift cards. He’s worried about further credit limit reductions, so he says he could use the credit while he still has it, and then he could either live on Visa gift cards for a while or sell them. . He is also considering settling his debts for less than he owes, which he believes will have a major negative effect on his credit rating.
Brendan’s post began, “Thought I’d drop a line before I do something drastic with my credit here…”
Running up extra balances with Visa gift cards is a particularly bad idea. This could have legal consequences – it sounds a lot like money laundering – and go against the terms and conditions of Brendan’s credit card. It would also expose him to additional interest on purchases he doesn’t have to make right now.
I often hear people who seem to view debt settlement as a magic wand. They’re probably in love with those TV commercials that promise to settle your credit card debt for pennies on the dollar. Debt settlement companies often tell clients to stop paying their bills for a while and then try to use that as leverage to negotiate a settlement. But there are several problems with the approach:
- Late payments drastically lower your credit score
- Settling for less than you owe hurts your credit score even more
- There is no guarantee that this strategy will work
- Even if this is the case, debt settlement agencies charge fees and debt forgiveness is often taxable.
Even after hearing all this, some people still persist. I guess the siren song of getting out of debt now for next to nothing is too loud. They might also say that their credit is already weak, so they have nothing to lose. Or they don’t plan to apply for credit anytime soon.
For legal, credit, and ethical reasons, I view debt settlement as close to a last resort. It’s not as bad as bankruptcy. This reinforces why credit card rates are so high (the national average is about 16 percent), especially in relation to secured debts such as mortgages and car loans. Although credit card issuers have some options for recovering funds from delinquent borrowers, such as lowering your credit score, suing you, and garnishing your wages, credit card debt is often the most serious debt. easier to pay in the event of bankruptcy. That still doesn’t mean jumping on it is a good idea.
Non-profit credit counseling
I urged Brendan to find a way to pay back everything he owes, even if it takes time. He owes about $17,000. For context, the Federal Reserve reports that 45% of US households are in credit card debt. The average amount is $6,300 and the median is $2,700.
A good starting point could be non-profit credit counseling. Reputable nonprofit credit counselors, such as Money Management International and other agencies accredited by the National Foundation for Credit Counseling, will work with you and your creditors to develop a plan. These debt management plans often last three to five years.
They usually involve lower interest rates and a single monthly payment. Participants are often required to close the affected credit cards, indicating behavioral changes that should be incorporated into a successful debt repayment strategy. I know this can be hard to hear, and I don’t want to shame anyone for their credit card debt, but it’s essential to make changes moving forward.
Sometimes people run into credit card debt due to an unexpected event, such as a medical bill, home repair, or car problem. Although they can be serious, they can be easier to solve because they are isolated. This kind of emergency spending was the main explanation given by 35% of credit card debtors surveyed by our sister site CreditCards.com.
If you have credit card debt because your monthly expenses regularly exceed your income, as 26% of survey respondents indicated, this is a more systemic problem that you need to address. This will likely mean increasing your income (eg taking on a side hustle or finding a better paying job) or reducing your expenses (finding cheaper housing, selling a car, etc.). It might sound easier said than done, but any extra money you can funnel into your credit card debt makes a big difference.
You can also ask your card issuers for lower interest rates or shop around for a low rate Personal loan or credit card balance transfer. But those approaches have all become more difficult as lenders worry about job security and the economy in the wake of the coronavirus pandemic. I think they’ll get easier once things get better, but for now, that’s why nonprofit credit counseling is at the top of my list of advice for someone giving in under the weight of his credit card debt.
Have a question about credit cards? Email me at [email protected]and I would be happy to help you.