- 6 min read
Boxed-In By Debt? Learn Your Options For Escaping The Debt Trap
It’s easy to overspend. Even if you’re frugal and save every penny, a job loss, medical emergency or other calamity not covered by your insurance can push you to the edge of a financial cliff. High interest rates and penalty fees for missed payments can turn a manageable pile of bills into an insurmountable mountain of debt. You may ask yourself, “How do I break out of this debt trap?”
Self Assessment & Self-Help
Step back and and look at your situation without emotion. If you have to, pretend you’re looking at someone else’s budget. Start by making a list of your debts, including the name of the creditor, the total amount due, your monthly payment, and the interest rate for each. Once that task is complete, add up all of your spending. Separate them into three group, as we show in the table below:
|Categorize Your Spending|
|Essentials||Groceries Rent/Mortgage Utilities Insurance Transportation Other|
|Near-essentials||Cable/Satellite/Internet Clothing (not work related) Cell Debt (ongoing medical provider and similar) Other|
|Luxuries||Entertainment Clothing Hobbies/Toys Vacation Debt (non-essential, such as credit card) Gifts Other|
Sit back and look over your household spending. Where can you cut spending, realistically? The idea here is to save in one area, such as your cable or cell phone bill, so that you can apply those savings to paying off your debt.
Now look at your household income. If there's one income earner in your household, ignore the second two rows.
|Wage Earner||Monthly Take-Home|
|* Part-time job, investment income, or alimony/child support|
Chances are your expense number is larger than your income number. The challenge here is to make the two numbers match. Where can you cut your spending? Is a part-time job a realistic option? Will doing one or even both make the numbers match while paying-off your debt? If your honest answer is yes, then you can free yourself from your debt trap on your own. If your answer is no and you cannot make the numbers work to pay off your debt, then you need help.
Three Types of Professional Debt Help
You have three options for resolving overwhelming debt — credit counseling, debt settlement, and bankruptcy. Let’s look at all three.
Credit Counseling is a three-step process designed to repay 100% of the debt you owe. It is used for credit card debt primarily, although, some credit counseling programs accept other debt, too.
In step one, you and a credit counselor go over your household budget to learn where you can cut your expenses. This step also determines if you can afford a payment plan that frees you from debt in 5 years or less. A quick rule of thumb credit counselors use is to multiply the total amount of your enrolled accounts by .03. If you can, realistically, afford that payment, then credit counseling may be an option for you.
In step two, the credit counselor contacts your creditors and informs them you two created a debt management plan (DMP) to pay-off the account. The credit card issuers may offer a different interest rate while you are in the DMP.
In step three, you make your DMP payment to your credit counselor each month. The counselor will pay each creditor an agreed-upon amount.
Strengths: Credit counseling repays each enrolled creditor the entire amount due. A DMP tends to have a lighter impact on a person’s credit score than the other two options.
Weaknesses: Some creditors view a DMP in the same light as a chapter 13 bankruptcy, and it is not realistic to expect to qualify for a car loan or mortgage while you are enrolled in a DMP. The interest rate some creditors offer credit counselors is higher than the consumer's present rate, which makes enrolling some accounts in a DMP more expensive than if you would have not enrolled at all. Unfortunately, due to the high payments in most DMPs, the success rate of credit counseling is lower than the other two options. In fact, many who enroll in credit counseling often give up and file for bankruptcy.
Debt Settlement shares many features of credit counseling, but is a more aggressive option that costs less than credit counseling with a shorter time to debt freedom. Like credit counseling, it has a three-step process. In step one, a debt settlement counselor will go through your budget with you to learn how much you can afford each month to repay the debt. The more you can afford, the faster you will become debt free.
In step two, you make monthly deposits into a special bank account in your name. You also stop paying your enrolled creditors.
In step three, the debt settlement company will open negotiations with your creditors, informing them you are enrolled in a debt settlement plan. Over time, the negotiator and creditor will agree to a lump-sum payment to resolve the debt.
Strengths: The monthly deposit you make is less than in a DMP, and the time to debt freedom is typically 3 or 4 years. Results vary, but the industry average settlement amount is 40 to 60 cents on the dollar. This makes the overall cost of debt settlement less than credit counseling. The success rate of debt settlement is higher than credit counseling, perhaps because the monthly payment is usually less and average time in the program is less.
Weaknesses: Your credit score will suffer when you stop paying your creditors. Some creditors will react negatively when person enrolls in a debt settlement plan, and may file a lawsuit. However, big debt settlement firms have legal departments that specialize in negotiating pre-trial settlements. Lawsuits are rare, but because they happen, you should be aware of this risk.
Want a little help figuring out your debt resolution options? Give the Bills.com Debt Coach tool a try. Debt Coach costs you nothing, and gives you customized view of the pluses, minuses, and time to debt freedom with each debt resolution program.
Bankruptcy is your nuclear option for resolving debt. There are two forms of bankruptcy available to most consumers: chapter 7 and chapter 13 bankruptcy. In a chapter 7, the court wipes-out your debts, which the law calls discharging your debt. A chapter 13 is similar to a DMP, where the court supervises your payments for a period of 5 years. At the end of that time, the court will either discharge the remaining debt, or require you and remaining creditors to negotiate a new payment plan.
Strengths: If you qualify for a chapter 7, the time to debt freedom is short and the cost is relatively low. Chapter 13 is a great choice if you have an aggressive creditor that will not negotiate in good faith to resolve your debt. A chapter 7 can remove your personal liability for mortgages and co-signed debts. A chapter 13 can strip the lien on a second mortgage.
Weaknesses: A strong negative on your credit report. Also, some jobs, such as those involving government security clearances, may be in jeopardy if you file for bankruptcy. If you have such a job, look to credit counseling or debt settlement as your options.
Bills Action Plan
It does not matter what put you in the debt trap you find yourself in now — there is always a way out. You can fight your way out by squeezing your expenses and increasing your income, by working with a credit counselor, or taking a more aggressive approach in debt settlement or bankruptcy.
Did you know?
Debt is used to buy a home, pay for bills, buy a car, or pay for a college education. According to the NY Federal Reserve total household debt as of Q2 2023 was $17.06 trillion. Auto loan debt was $1.582 trillion and credit card was $1.031 trillion.
According to data gathered by Urban.org from a sample of credit reports, about 26% of people in the US have some kind of debt in collections. The median debt in collections is $1,739. Student loans and auto loans are common types of debt. Of people holding student debt, approximately 8% had student loans in collections. The national Auto/Retail debt delinquency rate was 4%.
The amount of debt and debt in collections vary by state. For example, in Colorado, 21% have any kind of debt in collections and the median debt in collections is $1682. Medical debt is common and 11% have that in collections. The median medical debt in collections is $693.
Avoiding collections isn’t always possible. A sudden loss of employment, death in the family, or sickness can lead to financial hardship. Fortunately, there are many ways to deal with debt including an aggressive payment plan, debt consolidation loan, or a negotiated settlement.