meeting the minimum required monthly payment terms for each loan, I strongly advocate that you channel extra payments toward paying down those loans with the highest interest rates first. The financial benefit of doing so should be obvious. If you have one loan at a 15 percent annual interest cost and another at an 8 percent annual interest cost, you’ll be saving yourself a 7 percent annual interest cost by paying down the higher-cost loan faster.
I’m amazed at the wrong-headed advice I continue to see on this topic, especially on the Internet. One guru with no discernible training in the financial-planning/personal-finance field advises that you rank your debt payments by their total outstanding balances and that you channel extra payments to those with the lowest total balance owed. The “theory” behind this is that the psychological boost from paying down smaller debts completely will lead you to keep paying down your other debts.
In my real-world experience as a financial counselor, I’ve found folks to be intelligent and more responsive to the psychological rewards of saving money. And you best save money by paying down your highest-interest debts first.
Getting Help for Extreme Debt
More drastic action may be required if you have significant debts or simply are overwhelmed with what to do about it. In this section, I discuss getting help from a credit counseling agency and the last-resort option of bankruptcy.
Seeking counseling
If you’re seriously in debt, you may consider a credit counselor. The ads for these agencies are everywhere. Although some of these organizations do a decent job, many are effectively funded by the fees that creditors pay them. Before you hire a credit counseling agency, make sure you do your research on the company.
Do you offer debt-management programs? In a debt-management program (DMP), a counseling agency puts you on a repayment plan with your creditors and gets paid a monthly fee for handling the payments. You should avoid agencies offering DMPs because of conflicts of interest. An agency can’t offer objective advice about all your options for dealing with debt, including bankruptcy, if it has a financial incentive to put you on a DMP.This creates a bias in their counsel to place debt-laden folks seeking their advice on their debt-management programs wherein the consumer agrees to pay a certain amount per month to the agency, which in turn parcels out the money to the various creditors. Agencies typically recommend that debtors go on a repayment plan that has the consumer pay, say, 3 percent of each outstanding loan balance to the agency, which in turn pays the money to creditors. Although credit counseling agencies’ promotional materials and counselors highlight the drawbacks to bankruptcy, counselors are reluctant to discuss the negative impact of signing up for a debt payment plan.
What are your fees, including setup and/or monthly fees? Get a specific price quote and contract in writing. Avoid any credit counseling service that charges a high upfront fee before it provides any services. And watch out if the service tells you to stop paying your bills; it may take your money and run while your credit gets ruined.
Are you licensed to offer your services in my state? You should only work with an agency licensed to operate in your state.
What are your counselors’ qualifications? Are they accredited or certified by an outside organization? If so, by whom? If not, how are they trained? Try to use an organization whose counselors are trained by a nonaffiliated party.
What assurance do I have that information about me will be kept confidential and secure? This information includes your address, phone number, and financial information. Reputable agencies provide clearly written privacy policies.
How are your employees compensated? Are they paid more if I sign up for certain services, if I pay a fee, or if I make a contribution to your organization? Employees who work on an incentive basis are less likely to have your best interests in mind than those who earn a straight salary that isn’t influenced by your choices.
Considering bankruptcy
When the amount of your high-interest consumer debt relative to your annual income exceeds 25 percent, filing bankruptcy may be your best option. Like any tool, it has its pros and cons.
Bankruptcy’s potential advantages include the following:
Certain debts can be completely eliminated or discharged. Debts that typically can be discharged include credit card, medical, auto, utilities, and rent. Eliminating your debt also allows you to start working toward your financial goals, such as saving to purchase a home or toward retirement. Depending on the amount of outstanding debt you have relative to your income, you may need a decade or more to pay it all off.Debts that may not be canceled through bankruptcy generally include child support, alimony, student loans, taxes, and court-ordered damages (for example, drunk-driving settlements).
Certain assets are protected by bankruptcy. In every state, you can retain certain property and assets when you file for bankruptcy. Most states allow you to protect a certain amount of home equity; some states allow you to keep all of your home equity regardless of its value. Additionally, you’re allowed to retain some other types and amounts of personal property and assets. For example, most states allow you to retain household furnishings, clothing, pensions, and money in retirement accounts. So don’t empty your retirement accounts or sell off personal possessions to pay debts unless you’re absolutely sure that you won’t be filing bankruptcy.
Filing bankruptcy, needless to say, has it downsides, including the following:
It appears on your credit report for up to ten years. As a result, you’ll have difficulty obtaining credit, especially in the years immediately following your filing. (You may be able to obtain a secured credit card, which requires you to deposit money in a bank account equal to the credit limit on your credit card.) However, if you already have problems on your credit report (because of late payments or a failure to pay previous debts), damage has already been done. And without savings, you’re probably not going to be making major purchases (such as a home) in the next several years anyway.
It incurs significant court filing and legal fees. These can easily exceed $1,000, especially in higher cost-of-living areas.
It can cause emotional stress. Admitting that your personal income can’t keep pace with your debt obligations is a painful thing to do. Although filing bankruptcy clears the decks of debt and gives you a fresh financial start, feeling a profound sense of failure (and sometimes shame) is common.
It becomes part of the public record. Another part of the emotional side of filing bankruptcy is that you must open your personal financial affairs to court scrutiny and court control during the several months it takes to administer a bankruptcy. A court-appointed bankruptcy trustee oversees your case and tries to recover as much of your property as possible to satisfy the creditors — those to whom you owe money.
Deciphering the bankruptcy laws
If you want to have a leisurely afternoon read, then the bankruptcy laws are definitely not for you. I’m here to help clarify the two forms of personal bankruptcy in case you’re considering taking this action:
Chapter 7: Chapter 7 allows you to discharge or cancel certain debts. This form of bankruptcy makes the most sense when you have significant debts that you’re legally allowed to cancel.