Your guide to getting out of extreme debt
By Dawn Papandrea
August 25, 2016
There’s being in debt, and then there’s dealing with debilitating debt.
If you’ve reached a point in which your monthly bills are greater than the amount of income you have coming in, you’re dodging bill collectors or you’re being forced to decide which bills you can put aside in order to keep your electricity running, you’re deep in debt.
If you’re dealing with debilitating debt, trying to wait it out or hoping for some windfall to get you back on financial track isn’t the answer. The longer your debt festers, the more infectious it can become. While you may feel overwhelmed or even ashamed at the depth of the debt hole you’re in, you have to put those feelings aside and explore your options for rebuilding your financial future.
If you’re in extreme debt, know your options
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Because this guide is about how to handle extreme debt, the three options below are based on the assumption that you’ve already tried reworking your budget and increasing your cash flow to pay off your balances. (These tactics are covered in the guide “The last debt payoff plan you’ll ever need.”)
No matter how dire your debt situation, there is a solution to help get you back on track. This guide to how to get out of extreme debt will help you figure out which option best suits your needs. The road may seem long, but every step forward will get you closer to debt-free.
1. Debt management program
With a debt management program (DMP), you’ll work with a nonprofit debt counseling agency that will negotiate with your creditors on your behalf to reduce interest and fees. Once your debt management program is negotiated, your credit accounts will be closed, and you’ll owe a single monthly payment to the debt counselor, who will disburse funds to your creditors.
This option is good for people who owe multiple lenders and are having a hard time prioritizing how to pay them back.
How do you get started? Find a nonprofit debt counselor, such as one that is a member of the National Foundation of Credit Counseling or the Association of Independent Consumer Credit Counseling Agencies, so you’re working with a reputable organization.
A debt management plan is not a free service. A fee will be tacked onto your monthly bill. And, if you can’t show sufficient income to follow through on a DMP, you might not qualify.
Also worth noting: A debt management program is for unsecured debt, such as credit cards. A DMP won’t help you with a mortgage or car loan.
This option has its drawbacks. One is that it will be noted in your credit reports that you used a third-party service to pay your debts. While this signals to future lenders that you had some debt troubles, dealing with your financial woes head-on and re-establishing your credit will help you in the long run.
2. Debt settlement
Debt settlement is essentially reaching an agreement with a creditor who will take less than the total you owe as full payment of the debt.
Four things to consider about debt settlements:
1. Settled debt is reported on your credit file in the form of a note stating it has been settled for less than the amount owed.
2. There is the possibility that you might get sued by creditors while you’re in the process of trying to settle your debts if you stop making your payments.
3. Delinquencies are huge negatives on your credit file that will stay there for seven years.
4. You might have to pay taxes on forgiven debt, which is reported as income.
So how do you know if you’re a good candidate for debt settlement? Here are some factors:
- If you simply can’t pay your bills. Settlement is an option for someone experiencing serious financial hardship.
- If you don’t qualify for bankruptcy. While you might want to wipe the slate clean through a Chapter 7 bankruptcy (we’ll get into that more in a bit), you might not qualify. If that’s the case, debt settlement could be a more viable option.
- If you have the cash to settle the debt. Here’s the irony: You can’t pay your bills, but in order to do debt settlement successfully, you need to have enough funds to pay off a big chunk of the debt. Often, people resort to selling off something valuable, borrowing from a family member or cashing in a stock. Keep in mind that nearly all financial experts agree that draining your retirement accounts to do this is a bad idea.
One last word of caution: Be careful about debt settlement scams. If it sounds too good to be true, well… you know the rest. Some red flags are if a company asks for more than a nominal fee before providing services, or if they make any guarantees of a settlement.
- Many debts are wiped away.
- Debts that can’t be discharged in bankruptcy include federal or private student loans, the past three years of back taxes, spousal or child support, some government fines and debt stemming from a drunken driving incident.
- You must keep making payments on secured debts (home, car, etc.).
- Stays on your credit report for 10 years.
- You repay a certain percentage of your discretionary income to your creditors for three to five years.
- Stays on your credit report for seven years.
To qualify for either of type of bankruptcy, the first thing you must do is stop using your credit cards. If consumers planning to file bankruptcy engage in reckless spending in the hopes of having the charges wiped away, it could be considered fraud.
Other considerations: You want to stay current on all of your accounts before heading into bankruptcy. Also, make sure you’re not seeking bankruptcy for the wrong reasons, and understand the consequences that will come along with it.
In short, you should consult with a bankruptcy attorney who can give you the best advice on whether or not you’ll qualify and how to proceed.
4. On the road to credit recovery
Whichever option you decide to pursue to deal with your extreme debt, once the process is complete, you can begin rebuilding your credit almost immediately.
Though the action you took will remain on your credit report for seven to 10 years, you can start making incremental improvements in your credit score by exercising credit responsibly moving forward.
Your No. 1 goal is to always pay your bills on time every month. Beyond that, you need to use credit to rebuild your credit history and boost your credit score.
Though you might want to swear off plastic for a while, once you’re ready to jump back into the credit waters, you may want to open a secured card with a low credit limit to show you can manage credit wisely.
Why a secured card? Chances are you wouldn’t qualify for a regular unsecured card right after your debt settlement or bankruptcy. Make sure your secured card’s issuer reports to the three major credit bureaus since the whole point is to establish a record of positive credit use.
Over time, with good credit behavior, you can graduate from your secured card to an unsecured card. Just keep paying off your balances in full and on time each month (yes, it bears repeating!), and your credit score should continue to climb.
And one last note: After dealing with extreme debt, make a commitment to stick to smart financial habits, so you won’t go through this again. How to do this? Adopt a budget so that you will live within your means. Set aside money for emergencies, so you don’t have to turn to plastic to bail you out in a financial crisis. And use credit with caution and care. Do all these things, and before you know it, your extreme debt will be but a faint memory.
SEE RELATED: Guide: The last debt payoff plan you’ll ever need