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Advice / Succeeding at Work / Money

In the Red: What to Do When You're in Debt

If you’ve recently found yourself buried in debt, you’re probably hoping to shut your eyes and make it all disappear. And, yes, while that would be nice, a better first step is taking time to understand how you got there. And then, more importantly, coming up with an action plan for getting out.

Most people can dig their way out of debt by taking a closer look at their spending, creating (and sticking to) a budget, and committing to monthly payments. But, if you’ve suffered a major financial setback, such as being laid off, getting a divorce, or being slapped with huge expenses, it can be much more difficult to pay off your credit cards with the limited income that you have.

If you’re having trouble making payments, or worried that you won’t be able to pay off your debt, it’s time to take a look at your options. Here’s a look at three common ways to get out of debt, what to consider for each approach, and how to know which one is right for you.

1. Call Your Creditors

If you’re having trouble making your payments, the very first thing you need to do is call your credit card companies to see if they have any internal hardship programs. Don’t be embarrassed—they won’t judge you for your financial problems—they just want you to repay the loan. They often have ways to help you lower your payment, which they can explain to you over the phone.

When this approach is right for you: As soon as you realize you’re in more debt than you think you can handle or think you might start falling behind on your payments.

Pros: One simple phone call might do the trick. Your creditors might be willing to reduce your interest rate for a short period of time (generally not more than six months) or put you on a longer repayment term. It's kind of like the Geico commercial—“15 minutes can save you 15% or more!”

Cons: Depending on your financial situation, your creditors might not be willing to work with you. Even if they do decide to lower your interest rate, there’s a possibility they will close your account. Or, if they don't think you can afford a lower monthly payment, they might refer you to a credit counseling agency.

2. Debt Snowball

This method involves paying off your credit cards starting from the one with the lowest balance first, regardless of what the interest rates are. Personal finance expert Dave Ramsey recommends this approach because he believes that getting out of debt is 80% mental and only 20% financial knowledge—paying off your smaller debts creates a positive, motivating effect that keeps you on track to becoming debt-free. (Others argue that the “debt stacking” method, which involves paying off the credit card with the highest interest rate first, is more effective. Technically, it will save you more money in the long run, but the difference in savings is often insignificant. Check out this breakdown on what you'll save using the different approaches.)

The debt snowball method only works if you’re able to pay more than your minimum payment each month. For example, say you have three credit cards with balances of $1,000, $3,000, and $6,000. Respectively, your minimum payments for each card are $40, $120, and $240, for a total of $400. If you can afford to increase your total payment to $450 each month, you would pay the minimum payments for the two larger accounts, and apply $90 to the smallest account until it’s paid off. Then, you move on to the next one.

When this approach is right for you: If you’re able to pay more than your minimum monthly payments—even if it’s just $20 more.

Pros: This is a DIY approach that doesn’t require the assistance of credit counseling companies. There’s also no impact on your credit score—in fact, your credit score will gradually improve over time with each on-time monthly payment.

Cons: This approach often takes longer than other debt relief options. Also, you need to be able to keep your monthly payments consistent—once you’re done paying off your first credit card, you need to apply the same amount you’ve been paying on that card to your next lowest balance.

3. Get Professional Help

We’ve all probably seen the late night infomercials that advertise “Reduce your debt by up to 60%—tomorrow!” But, though their reputation has been tarnished by unscrupulous companies, working with professionals to reduce your debt can actually be a viable option if you don’t think you can do it on your own.

One option is a Debt Management Plan (DMP), a structured program to get you out of debt in five years or less, administered by a credit counseling company. These organizations have special concessions with your creditors, and are able to get you lower interest rates than you pay currently—anywhere from 0-15%. You make one monthly payment to the credit counseling company, which then disburses your payments to your creditors accordingly.

If you can’t afford payments on a DMP, debt settlement, which involves negotiating a lump sum payoff for less than what you owe with a third-party company, is an option. So, for example, if I owed my credit card company $5,000, I could negotiate a settlement for $2,000. Most debt settlement companies will hold your monthly payments into an escrow account and negotiate with your creditors once you have enough funds to start paying them.

When this approach is right for you: If you’re deeply in debt, unable to make your current monthly minimum payments, or behind a few months on your bills—with no end in sight.

Pros: These types of programs can help you get out of a lot of debt while avoiding bankruptcy. You’ll pay one fixed monthly payment, which will be lower than paying your creditors directly.

Cons: For starters, no more credit cards—your creditors will close your accounts, and you won’t be able to use them (or open any new ones) until you pay off your debt. These approaches also impact your credit score—although it’s tough to say exactly how many points your score will decrease, let’s just say it’s not pretty. (Though, if you’re at this stage, you’re probably already delinquent on your debts—so your credit score is already affected.)

If you choose debt settlement, the company won’t disburse payments to your creditors right away, so you can expect your phone to be ringing off the hook with collection calls. And since creditors only negotiate with you if you’re already behind on your payments, there's a chance they might file a lawsuit instead of turning you over to a third-party collection agency. (Your credit card companies have every right to sue you if you don’t pay back your debts in full.) Finally, if you do have a successful debt settlement, you may be liable on taxes for any debt forgiven over $600.

There isn’t a one-size-fits-all approach when paying off your debts—everyone’s situation is different. The most important thing to remember is to be proactive and noticing early warning signs that you might be in trouble. There’s help out there—you just need to know where to look.

Photo courtesy of 401KCalculator.