Last week we shared some strategies to use when tackling the problem of credit card debt. This week we offer a few additional strategies and one final bit of advice.
Strategy: Borrow against your life insurance.
Do you have life insurance with a cash value? If so, borrow against the policy. Yes, you’re borrowing your own money. But the interest rate is typically well below commercial rates, and you can take your time repaying the loan. Do repay it, though. If you die before it’s repaid, the outstanding balance plus interest will be deducted from the face value of the policy payable to the beneficiary. While that seems a small price to pay to get out of debt now, it could be burdensome to your loved ones should you pass away suddenly before paying it back.
Strategy: Get a home equity loan
If you own your own home and have accumulated equity through the years by paying off the mortgage you could consider a home equity loan (HEL) line of credit to help you pay off your credit card debt.
A HEL gives you two ways to save. First, by using the loan proceeds to pay down your debt, you trade a loan at 18% or more (the credit card interest rate) for a 6%-7% loan. Second, if you itemize deductions on your income tax returns, HEL interest is a deductible item under most circumstances. In a 25% marginal tax bracket, the 6% loan really has an effective rate of 4.5%, and that’s probably the cheapest interest rate you’ll see on personal indebtedness.
A common mistake many people make when using an HEL to pay off existing debt is to ring up the charges on the credit cards all over again once they are paid off. The problem if you fall into that trap is that you won’t have the option of getting another HEL to repay the new credit card debt. If that happens you’re in a hole twice as deep as the one you were in before! Avoid this trap by using the HEL to pay off the credit cards and then keeping them paid off until you have repaid the HEL.
Strategy: Borrow from your 401(k)
Most 401(k) plans have a feature that lets you borrow up to 50% of the account’s value, or $50,000, whichever is smaller. Interest rates are usually a point or two above prime, which makes them cheaper than credit card interest rates and a good option for some people. Not only is the interest typically much lower than that on credit cards, the best part is you pay it to yourself. That’s right, every dime in interest paid on a 401(k) loan goes directly into the borrower’s 401(k) account, not the lender’s!
Unfortunately this method also has drawbacks. First, the loan and interest will be repaid with after-tax dollars, but the interest will be taxed again when you withdraw money from the 401(k) years later. Additionally, you must repay this loan within five years. If you leave your employment prior to full repayment, the outstanding balance becomes due and payable immediately. If it’s not repaid, that amount will be treated as a distribution to you. You’ll be taxed on that amount at ordinary rates. And if you’re under the age of 59 and one-half years, you will also be assessed an additional 10% excise tax as a penalty for an early withdrawal of retirement funds. Accordingly, ensure any 401(k) loan can be repaid before you leave your job.
Strategy: Use some savings for debt reduction.
If your debt is overwhelming, you might decide to dip into your savings. Just don’t bleed it completely dry, advises Dave Ramsey. Having a $1,000 emergency fund while you get out of debt is a good idea because let’s face it, emergencies happen. Vehicles sometimes break down, people sometimes end up in the ER, and out-of-town relatives sometimes need you in a hurry. The last thing you want to do is put yourself in a position where you have to borrow money (and add to your debt) when the unexpected happens. After you’ve paid off your credit card debts you can shift your focus onto building an emergency fund that will cover three to six months’ worth of expenses.
Strategy: Renegotiate terms with your creditors
You feel like you’re against that proverbial wall. The money just isn’t there and none of the other strategies work for you. Before you think about filing for bankruptcy use the threat of bankruptcy as a negotiating tool with your creditors. Tell them that if you are unable to renegotiate terms, you’ll have no other recourse but to declare bankruptcy. Ask for a new and lower repayment schedule; request a lower interest rate; and appeal to their desire to receive payment. Faced with the prospect that you may resort to such a drastic step, creditors will do what they can to protect themselves against a total loss.
One nice thing about this strategy is that you have nothing to lose except time. If you feel uncomfortable doing the negotiations this yourself, organizations exist that can do it for you. Try contacting the National Foundation for Credit Counseling or the Department of Housing and Urban Development to find a credit counselor in your area. Services are available for free or at low cost depending on your situation.
Last Resort Strategy: File bankruptcy.
If you can’t pay down your debt using any of the methods listed above the absolute last resort is bankruptcy. While everyone has a moral obligation to repay their debts to the utmost of their ability, there are times when repayment may be impossible. In those cases, bankruptcy may be the only available course of action. Nevertheless, be aware of the significant drawbacks.
Your credit report will contain this information for 10 years and your credit score will suffer considerably, thus ensuring you will have a tough time obtaining credit you can afford during that period. Additionally, as odd as it seems, it costs money to file for bankruptcy. Attorney and court filing fees cost in the hundreds of dollars, and they must be paid to obtain the relief sought. Finally, bankruptcy laws have gotten a lot tougher in recent years, so you may not qualify for complete relief.
There are two types of personal bankruptcy relief: Chapter 7 and Chapter 13. Chapter 7 is straight bankruptcy that allows the discharge of almost all debts. Those that aren’t discharged are alimony, child support, taxes, loans obtained through filing false financial statements, loans not listed in the bankruptcy petition, legal judgments against the petitioner, and student loans.
While Chapter 7 relieves you of the responsibility of repaying most creditors, you may have to surrender much of your property to help satisfy the debt. However, different states have different laws that grant you exemptions on certain types of property, such as a certain amount of equity in your home, a low-value vehicle, small amounts of jewelry and other personal property, and tools you use in your trade or business. These exemptions usually aren’t huge, but they do mean you won’t have to start over with absolutely nothing.
Chapter 13, sometimes called the “wage-earner plan,” is different. You keep your property but surrender control of your finances to the bankruptcy court. The court approves a repayment plan based on your financial resources that provides for repayment of all or part of your debt over a three-to-five-year period. During that time, your creditors are not allowed to harass you for repayment. You also incur no interest charges on the indebtedness during the repayment period. When all conditions of the court-approved plan have been fulfilled, you emerge debt-free from the bankruptcy.
To close for this week we offer this final bit of advice: Stop charging. Whatever pay-down strategy you choose, it’s essential that you curb your credit card spending. It’s awfully hard to pay down credit card debt when you keep adding to your balances each month. Put your credit cards on ice while you focus on paying down card debt. (Some people actually do put them in the freezer!) Pay with cash, check, or debit card instead. If you must use your credit card, only charge items you can pay off in a month or two.
Tips for Paying Off Credit Card Debt by Lucy Lazarony, Credit.com
Nine Ways to Pay Off Debt from the Motley Fool
Six Ways to Pay Off Debt by Dawn Papandrea, Bankrate.com