What is the best way to pay off debt? Debt Avalanche vs. Debt Snowball

August 21, 2021CreditBy toptierfinancial

When you set your mind on a goal, you want to achieve it in the best way possible. What does “best” mean, exactly? That depends on the goal and the person. Here’s an analogy: imagine you are training for a marathon. Naturally, you want to do your best. Well, for some people the goal is simply to finish the marathon (and what an impressive feat that is, to run 26.2 miles!). For others, the goal is to hit a certain time and break a personal record. Competitive runners may even aim for a top-place finish or hope to qualify for an elite-level race.

You get the point, our goals and therefore our ideas of what is “best” or successful in any situation, are somewhat dependent upon our who we are as individuals.

Financial goals work the same way. We all have different goals and we all have different considerations for determining a “best” way forward. That said, there are some goals that we can all agree are good to have and that we should all work toward. One of those is paying off debt.

While we can agree to the goal itself, there are definitely different ways to get there! Let’s take a closer look at the two most common debt repayment methods so you can determine what’s “best” for you.

The Debt Snowball vs. The Debt Avalanche

If you haven’t heard of these terms before—the debt snowball and the debt avalanche—then let us explain. These are two different ways to approach debt. Both of these repayment methods are considered do-it-yourself (DIY) methods, because you can structure a simple repayment plan based on one of these methods and then self-manage your repayment.

As we hinted at earlier, these two approaches are essentially two different philosophies about the “best” way to pay off debt.

How the Debt Avalanche Works

The debt avalanche is a debt repayment strategy in which you pay off debts in order of their interest rate (from highest to lowest). Note: we have also heard this referred to as the “stacking method” and the “debt ladder.” To be clear, when using this method, you still pay the minimum monthly payment on all your debts, but then you put all extra money toward the debt with the highest interest rate. Once that debt is paid off, you continue this method, moving to the next highest interest rate. Do this until you are debt free.

If that sounds simple, it is. The basic idea is that when you pay off the debts with the highest interest rates first, you minimize the total cost of your debt. This is therefore the most mathematically efficient way to pay off debt.

How the Debt Snowball Works

The debt snowball is a debt repayment strategy in which you pay off debts in order of their size (from smallest to largest). Just like a snowball starts small and rolls into something bigger, here you start with the little debts and work your way up. You pay the minimum monthly payments on all your debts, then put all extra toward the account with the smallest balance. Repeat this process until all debts are paid. As you pay off accounts, you eliminate monthly payments, freeing up even more money to put toward your next smallest debt.

This method is all about momentum and seeing your progress. Because you can knock out small debts first, you typically get to see results very early in the process. The con is that this method incurs more interest costs and is therefore more expensive over time than the debt avalanche.

Quick Summary of the Two Methods

To recap, here’s a quick summary of the avalanche and snowball.

Debt Avalanche

Pay off debt with the highest interest rate first
Most efficient overall because it minimizes interest expenses
It may take longer than the snowball to pay off your first few debts

Debt Snowball

Pay off debt with the smallest balance first
Builds momentum and you can often see results early in the process
It costs you more in the long run compared to the debt avalanche

How to Pick the Best Method for You

If you are making a plan to pay off debt and need to choose which of these methods to use, there are at least three things you should consider.

Consider your financial personality.

Think about how each repayment option may align with your personality, financial or otherwise. If you are someone who is motivated by efficiency and embraces the fact that debt repayment is a long-term process, then the debt avalanche may be the perfect fit. You may be able to tolerate the fact that it could take longer to pay off individual debts at the beginning, and the interest savings would make it worthwhile to you.

On the other hand, if you like to see quick results and feel you need a spark or some low-hanging fruit to stay motivated, then the debt snowball may be the ideal solution. You won’t mind the fact that your repayment is slightly more expensive in the long haul, because the sustained motivation is worth it to you.

Consider the amount of your debts.

Before you make a plan, be sure to map out all your debts. Write down how much you owe along with the interest rates. One thing to look out for is whether your debts all have similar-sized balances. If so, then that may steer you toward the debt avalanche, because there would be less benefit to the snowball. On the other hand, if you have a range of small debts to some larger debts, then the snowball may make sense.

Consider the type of debt you have and other options for that debt.

Similarly, consider the type of debt you have. This can impact interest rates, refinancing options, and even your motivation. As a general rule, credit cards are good to pay off because of their high interest rates. However, you may be extra motivated by paying off a student loan instead. That may lead you to consider refinancing the credit card while you pay off the student loan. On the other hand, maybe you are exploring student loan forgiveness, in which case you would choose to focus on the credit cards. The point is to make sure that your decision to choose the debt avalanche or debt snowball also takes into account the bigger picture and all of your financial goals.

As you can see, the “best” way to pay off debt is whatever way works for your situation and goals. The most important thing is to stay committed to whichever plan you choose, whether that is the debt avalanche or the debt snowball. Whether you are gravitating toward the efficient avalanche method or the often more immediately gratifying debt snowball, be sure to make this decision as part of a larger plan.

And speaking of plans, the NFCC’s credit counselors are available any time to help you make a plan for your financial future. If you would like to review your budget, discuss your credit goals, or make a plan for getting out of debt, you can contact a credit counselor for a free counseling session today.

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Ask an Expert: Are Debt Settlement Companies Legitimate?

March 3, 2021CreditBy toptierfinancial

The NFCC often receives readers questions asking us what they should do in their money situation. We pick some to share that others could be asking themselves and hope to help many in sharing these answers. If you have a question, please submit it on our Ask an Expert page here.

This week’s question: Are any debt settlement companies legitimate? Do they have to be licensed?

The debt relief industry has been growing in recent years, and debt settlement companies, also known as debt relief or debt adjusting companies, have been a part of that growth. Debt settlement is not the right repayment strategy for everyone. It usually benefits people who are already in debt and cannot afford any other debt relief option and are trying to avoid bankruptcy. There are legitimate debt settlement companies, and in most states, licenses are required. They must abide by industry regulations that seek to protect consumers. However, working with a legitimate company can be risky and turn out to be more expensive than other repayment options.

The Risky Business of Debt Settlement

When you settle your debt, you work out an agreement with your creditor to pay off your debt for less than what you owe. Debt settlement companies manage those negotiations for you. They may even ask you to set up an escrow-like account for you to send in payments. By law, they cannot charge any upfront fees and have to clearly inform you about all fees and payments. But, if you make just one payment under one of their settlement agreements, you may be on the hook for all fees related to the program, even if you have not paid off all your debts.

Debt settlement agencies cannot guarantee the outcome of a negotiation. In fact, your creditor may refuse their offers. And if you stop making payments on your debts while working with a debt settlement company, which is what some debt settlement companies advise, you will start accruing late fees and interest and could even face collections or a lawsuit. All that, in addition to a dramatic negative impact on your credit.

Another thing to keep in mind is that any forgiven debt greater than $600 is considered taxable income. So, be prepared to receive a 1099-C form to file with your taxes if your forgiven debt meets that criteria. When you add the company fees and any potential taxes, a debt settlement may not be saving you as much as you would have hoped.

Your Debt Relief Alternatives

Depending on how much you owe and your current status with your creditors, you may have other debt relief options. You can try nonprofit credit counseling as a way to connect with a financial counselor who can review your situation and offer free or low-cost advice to help you create a debt repayment strategy. Another option is to settle your own debt, working directly with each creditor. It may take time and often more than one call, but you can contact your creditors and offer reduced payments. Be sure to offer payments that you know you can afford and always get any new agreements in writing.

Choose Wisely

If you decide to let a third-party debt settlement company handle the situation for you, make sure you work with a reputable institution. Do your research and look for reviews and complaints online about the company you plan to work with. Check with the Better Business Bureaus and contact your state attorney general and consumer protection agencies like CFPB to determine if there are any complaints or enforcement actions against the company. They can also help you find out if the company is allowed to operate in your state and meet the license requirements. Be aware of red flags such as upfront payments and a failure to disclose fees.

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Ask an Expert: Should I Pay My Relative’s Debt?

January 23, 2021CreditBy toptierfinancial

The NFCC often receives readers questions asking us what they should do in their money situation. We pick some to share that others could be asking themselves and hope to help many in sharing these answers. If you have a question, please submit it on our Ask an Expert page here.

This week’s question: Should I pay my relative’s debt?

A relative is way behind in paying off credit card debt.  They owe about $20,000.00 across 18 credit cards and wants me to pay it all off, with a promise of paying me back over several years. Can you help settle with 18 credit card companies? Would this arrangement be made in writing, so there is no misunderstanding and there are no follow-up collection efforts?  Would the interest each credit card company foregoes be considered as income to be reported on my relative’s tax return, with taxes to be paid?

Helping Relatives can be Risky

We commend you for helping your relative get out of debt. It’s often overwhelming and confusing to find ways to manage debt effectively, especially for the elderly. Paying off your relative’s debt and expecting he’ll repay you with interest is often a risky scenario for more reasons than one. With limited income, it will become increasingly difficult for them to pay you back, and if your relative continues to use the newly paid-off cards, they may struggle once again with unmanageable levels of debt.

Explore Other Debt Relief Options

The good news is that there are other options to manage their debts, including your debt settlement suggestion. A debt settlement is an agreement between the creditor and the borrower to pay a debt for less than it’s owed and consider the debt as satisfied. Credi tors are not required to offer this kind of deal, and it’s usually challenging to do so if the accounts are current, but it’s not impossible. If you were to negotiate with creditors on your relative’s behalf, make sure to get all the settlement agreements in writing before sending any payments.

At the NFCC, we connect you with certified financial counselors who can help your relative manage his debt through personalized plans and programs through counseling sessions, which are often free of charge. However, our affiliated counselors do not negotiate debt settlements on behalf of others. There are for-profit debt settlement companies that promote debt negotiation programs, but there are numerous consumer advisories that caution against falling into the wrong hands when hiring a company to settle your debt. Debt settlement companies often ask borrowers to stop credit card payments and send their payments to them. This puts borrowers in a risky position, you may be defaulting in your payments and sending your cash to someone else without any guarantees that a creditor will accept an agreement. So, you will be dealing with collectors and out of cash. And, just like you mentioned, debt settlements can have fiscal consequences. Any forgiven debt greater than $600 is considered as taxable income.

Talk to a NFCC Certified Financial Counselor for Safe Recommendations

I suggest that you and your relative talk to an NFCC Certified Financial Counselor before you make a decision. Even if you live hundreds of miles away, you can all schedule a call with a financial counselor and explore your relative’s options. The counselor will start by reviewing your relative’s income and overall situation to determine what options are best for him. His options can include self-repayment strategies, which you could help him set up and manage, or even a Debt Management Plan (DMP). If a DMP is the right debt repayment strategy for your relative, it will offer him an easy way to consolidate his monthly payments in just one, typically with a lower monthly payment. His accounts will all be credited and paid in full and he can benefit from reduced interest rates and waived fees. This program is also an agreement between the creditors and the borrower through a nonprofit managing the plan. Creditors have preexisting relationships with creditors which makes their cooperation more likely.

With your support and a counselor’s guidance, your relative can implement a debt repayment strategy that won’t require you to spend $20,000, hefty fees to implement, and that will help him deal with the situation effectively. He is very fortunate to count on someone like you—best of luck to both.

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This is the Free Budget Template You Need in 2021

January 21, 2021CreditBy toptierfinancial

At NFCC, we feel that tracking your monthly personal budget and household expenses shouldn’t require a finance degree. That’s why we’ve created this free budget template, based on a simple “Money In / Money Out” principle that will allow you to balance your budget and spend within your means each month. This budget template (available below as a Microsoft Excel spreadsheet) succeeds because of our unique “Money In, Money Out” strategy. This strategy is the result of helping thousands of people like you fix their credit each year and escape the heavy burden of debt that, frankly, stresses everybody out.

Download your free nfcc budget template

Money In, Money Out

There are 180 known currencies in the world, but only two types of money: money coming in (income) and money going out (expenses). Most budget templates only track your paycheck as money coming in, but we know that’s not realistic. The fact is, we have a variety of income sources each month, and it’s crucial to track every dollar. Money Out is where this spreadsheet holds all the power to balance your budget. The Money Out section of the spreadsheet tells you when you’ve spent beyond your income. This is important, because forgotten or overlooked expenses can chip away at your income – and it can add up. When you can see how your Money In and Money Out is balanced, you have the power to reduce the stress associated with debt, bad credit, and the trouble that comes with living beyond your means.

Tracking Your Money In

Income is not only your paycheck; it’s anything you received in the calendar month, including:

Refunds for items purchased the previous month (this does not include refunds already applied to your credit cards.)
Cash gifts received for birthdays, Christmas, Hanukkah, or being named “Employee of the Month.”
Gift cards received are as good as cash, so include them as Money In.
Winnings from gambling, which includes that card game with your friends and bets places on the big game
Help from the parents, such as $200 given to you for car repairs. Include it as a gift.
Loans are tricky; they can be counted as Money In and Money Out. If you have a $10,000 line of credit from your mortgage and take $2,000 of it for a vacation, include $2,000 as Money In, but include the debt repayment as Money Out as you are repaying it.
Include interest earned from your checking or money market bank account or any other interest that is yours to spend.
Important: Only include money in your possession from the calendar month you are budgeting for. This is money that is available to be spent.

Great work! Once you’ve added these items in the Money In section of the free budget template, you should have a clear view of the money you can spend during the month. On to the next step.

Tracking Your Money Out

Money Out is just that, money that you’re spending on bills, food, Uber, Spotify, concert tickets, gasoline and more. Even the cash in your pocket is going to be spent, but let’s not go crazy. Documenting every nickel and dime expense for cash spending is too tedious, so in this budget template cash is not itemized, it’s just a sum of “cash” that goes into your wallet each month for pocket expenses. Complete the spreadsheet with all of your household expenses in the Money Out section, including:

Nest Egg (Savings) You might not think of saving money as Money Out, but it is. You’re taking money from your Money In section, and you’re putting the money into a savings account (hopefully interest-earning). It’s an expense because you can’t use that money to pay for any other expense.
Wishlist can be a traditional savings account where you are saving up money for something special, such as a new iPad or vacation.
Monthly bills that include electric, mortgage or rent, NetFlix, landscaping, phone, or anything that comes in the mail as a monthly bill, should be added to the month when the bill was received, not the date of services.
Loan payments should be added to the budget month when the payment is due.
Credit card bills may include items like NetFlix, Pandora, or Uber. Only list these once on your spreadsheet, meaning a NetFlix charge to your credit card can be listed as NetFlix or credit card, but not both.

Why NFCC recommends budgeting for the month

We put Money Out nearly every day, even if it’s just a few dollars for lunch or gas in the car. But Money In happens less often, typically on payday, which may be weekly, bi-weekly, or monthly for some. For this reason, we recommend blocking your budget into months. This blocking is done to ensure that you set boundaries on how you collect and spend your Money In. For example, if you use your January Money In to fill up your gas tank on January 31st, you have basically paid for February’s gas with January’s money. Use the calendar month as boundaries for your Money In and Money Out. Another example comes from one of our credit counseling clients who forgot to pay the electric bill she received in October and instead paid it in November. When the November electric bill arrived, she paid it on time – also in November. Unfortunately, her November budget didn’t allow for two electric bills to be paid, so she overspent her budget in November. This can all be avoided by fixing your income and expenses to a single calendar month.

Trimming the fat in your spending habits is the last step

Once your Money In and Money Out has been added to the spreadsheet, there may be some fine-tuning to do. Look at the “Difference Remaining” row, which shows the difference between your spending and income. Did you overspend, or do you have money remaining? This is where the budget template really earns its high marks from our clients.

If your Money In is higher than Money Out…

Good news! Your Money In is higher than your Money Out. This means you earned more than you spent, and you can decide what to do with the remaining money. Using the spreadsheet, you may choose to increase your credit card payment, increase your payment on loans, or increase the money put into savings. Financial experts at NFCC agree you should prioritize a higher payment against any debt that includes additional interest. Pay the additional money on the debt with the highest interest rate first (often credit cards which, can be 14% to 24% interest.) As you add the additional payment in the spreadsheet, watch the Difference Remaining row automatically recalculate to show how the additional spending impacts your budget.

If your Money Out is higher than Money In…
Unfortunately, your current expenses are greater than your income. If this is allowed to happen, you may find yourself sinking further into debt. You’re not alone, however. Call us! We have world-class credit councilors that are just minutes away from helping you. In the meantime, look for areas in your budget where you can begin reducing your costs. Here are some tips:

Look at your cash line item. Can you get by with less pocket cash this month? Reduce that cash expense by 20% or more.
Seasonal renewals hit your credit card when you least expect it. Check your credit card bill for any seasonal renewal items you didn’t want, such as that NFL Football Season Pass on Direct TV. Call your cable TV provider as ask for a refund before it’s too late.
Look for extra income by hosting a garage sale, picking up some more hours at work, or sell investments.
Avoid price creep by renegotiating your monthly costs on cell phones, cable TV, streaming services, or insurance costs. These costs tend to “creep” up over time, even by small amounts that vendors hope go unnoticed. One debt consolidation counseling client told us their cable TV bill went up $22.06 in the course of a year, but the service programming remained the same. Call your providers and ask them to reduce the costs or risk losing you as a customer. Many times, they will agree to reduce the price increase or postpone it.

Be prepared for next month

Don’t wait for your bills to become overwhelming next month. By looking at this month’s budget template, you’re well prepared to make tough decisions about facing next month’s Money In and Money Out. How can you prepare? Here are some ideas:

Some expenses that hit your credit card each month often go unnoticed, such as streaming services, subscriptions, and bills scheduled to charge your credit card automatically. These can quickly add up. Review your credit card statement in detail each month and cancel anything that isn’t critical.

This process of continually trimming the fat in your budget keeps you in ideal financial shape and can avoid surprises when tracking your Money In and Money Out each month.

Need additional help?

Get immediate relief from credit card debt. Connect to a trusted NFCC member agency, who will be there to help you find the debt relief solution that’s right for you without a loan. Contact us today.

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Ask an Expert: How Should I Start to Tackle My Debt?

January 19, 2021CreditBy toptierfinancial

The NFCC often receives readers questions asking us what they should do in their money situation. We pick some to share that others could be asking themselves and hope to help many in sharing these answers. If you have a question, please submit it on our Ask an Expert page here.

This week’s question:  My current financial state gives me anxiety and I would really like to get it under control.  I want to have financial freedom and peace of mind, but I don’t know where to begin. How should I start to tackle my debt?

It takes a lot of courage to reach out and ask these tough questions. Finances often cause people anxiety and can especially be stressful if you are not sure how to tackle your debt. 

Take the First Step

Take a deep breath and rest assured that you are already taking steps toward financial freedom by actively looking for a solution. And, yes, it can feel disheartening to think that your only way out is to get a consolidation loan with a lower interest rate, but the system won’t allow you to do so. It’s frustrating. However, it’s not as bad as you think. Loan consolidations are not always the best option, especially if you have substantial debt.

Loan consolidations don’t eliminate your debt; they just move it around. And if you have a lot of debt, the only way to get a low enough monthly payment is to have an extended repayment period, which can ultimately result in paying more interest over the life of the loan.

Learn About Other Debt-Relief Options

I suggest you focus on other debt-relief options that really offer the solutions you need. For instance, you can contact each of your creditors and ask for an interest rate reduction or a payment plan. You can also attempt self-debt repayment strategies, like the snowball method. With the snowball method, you pay as much as possible on your smallest debt while making the minimum payment on your other cards. When you pay your smallest debt off, you roll over that money to the next smallest debt until you pay it off and so on. It may take some time, but you will see results as you tackle one small debt after the other.

Talk to a Trusted Nonprofit Agency

If you prefer not to handle your debt on your own, I recommend that you work with a financial counselor from a trusted nonprofit agency. You can find NFCC Certified Financial Counselors near you here. It’s important that you work with counselors who genuinely have your best interest at heart because, more often than not, companies offering you solutions that seem too good to be true usually turn out to be scams. So, be aware.

When you work with a nonprofit counselor, you will benefit from holistic credit counseling. Your counselor will start by evaluating your overall financial situation, developing a budget, and helping you find the best way to become debt free. If you want the benefit of consolidating your payments in one, your counselor could recommend a Debt Management Plan (DMP). Similar to a loan consolidation, when you enroll on a DMP, you make one monthly payment to the agency managing your plan, and they pay your creditor. Additional benefits of a DMP include paying your debts in full, in less time, and usually with lower interest rates and monthly payments.

Working toward your goal of becoming debt-free can be difficult at first. But remember that you are not alone. Reach out to a counselor and get empowered to make the right decisions to tackle your debts and regain your peace of mind. Progress doesn’t happen overnight, be patient, and always move forward.

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How to Get Out of Credit Card Debt Without Paying Everything You Owe

October 18, 2020CreditBy toptierfinancial

Debt is tough. Sometimes it is hard to imagine getting out of it, and you can feel like your back is against the wall. One idea, that sounds good in theory, is to somehow get out of debt without paying it all off. Of course, this is an appealing strategy, but pursuing it can cause more harm than good. Here are the ways you can technically pay off debt without paying everything you owe, along with important reasons to consider other options instead.

Background

In this article, we are talking specifically about credit card debt. There are other types of debt that have “forgiveness” options, such as student loans. However, there are not typically formal “forgiveness” options through major credit card companies. When you use your credit cards, creditors have the full expectation that you will repay the money. After long periods of missed payments, your creditors may lower these expectations and charge-off the accounts and send them to collections. After this period, there may be opportunities to pursue alternative payment arrangements for less than what you owe. However, these always accompany damage to your credit score.

Settlement

Debt settlement is an agreement with a creditor to pay less than what you owe but still have the debt considered satisfied. There are two general types of debt settlement. The first is debt settlement that you negotiate on your own. We call this “DIY debt settlement.” The second type is a professional debt settlement. In a professional settlement, you work with a settlement firm that manages your debt reduction strategy.

Unfortunately, professional debt settlement is an extremely risky option that rarely works out in your favor. There are two reasons why you should avoid this option at all costs, no matter how good it may sound. First, you can cause significant damage to your credit score when you work with a debt settlement firm. Debt settlement revolves around a scheme in which you avoid paying creditors and you send payments to the settlement firm instead. Settlement firms claim that your lack of payment gives them negotiating leverage with creditors, and they are able to offer lump-sum payoffs to the creditors from the money you have been sending them. However, not only does this rarely work (more on that in a moment), but it wreaks havoc on your credit score. You will rack up delinquencies and other negative marks if you follow the scheme. Even if your settlement is successful, that will cause more credit score damage because settled accounts are listed on your credit report.

Second, debt settlement has a very low success rate. So not only can your credit take a beating, but it may take a hit without you ever seeing the purported benefits of actually settling your debts. Studies have shown that most debt settlement clients do not settle half of their debts, even years into the debt settlement process. Very few people are ever able to settle all of their debts when working with a settlement firm.

Debt settlement is not cheap, either. You can expect to pay fees between 15 and 25 percent of the enrolled debt. On top of that, if your debt is forgiven then the forgiven amount is treated as taxable income!

As you can see, while settlement sounds like a good shortcut it can create significant headache, expense, and credit damage, and it may leave you much worse off than you were before.

What about DIY settlement?

While working with a firm to achieve a debt settlement has many drawbacks, negotiating a settlement on your own can be a more viable and safe alternative. However, it is not perfect and only makes sense in a few situations. To achieve DIY debt settlement, you would contact your creditor and negotiate a lump sum payment for less than you owe that the creditor would accept in exchange for considering the account satisfied. If you reach such an agreement with a creditor, you must get the terms in writing. Otherwise, you risk paying a lump sum without being able to prove that the creditor agreed to accept it as a settlement.

DIY settlement can be difficult to achieve before your account is charged off by the creditor. Creditors just do not have much incentive or interest in accepting a settlement offer until you are very far behind. By that point, your credit score will likely have taken a pretty big hit. Additionally, a settlement you negotiate on your own can still be reported to the bureaus. Therefore, while DIY settlement is safer than working with a fly-by-night settlement firm, it does have many of the same drawbacks. The main advantage is that you can avoid the fees charged by a firm.

Bankruptcy

Another debt relief strategy that may provide for partial debt forgiveness is bankruptcy. There are several different types of bankruptcy, but individuals usually file for Chapter 7 or Chapter 13 bankruptcy. Whether you can file for Chapter 7 or Chapter 13 depends on your income and whether you qualify for Chapter 7 under the “means test.” Chapter 7 bankruptcy is a fairly quick process and can wipe out your unsecured debts through what is called a “discharge.” Chapter 13 bankruptcy can also provide for a discharge, but typically only after you complete a repayment plan, which takes three to five years.

Bankruptcy can cause major credit damage. The lead up to bankruptcy will create significant harm, but even the bankruptcy itself will be reported to the credit bureaus. Chapter 7 bankruptcy remains on your credit report for 10 years, while Chapter 13 remains for seven years.

For some, bankruptcy is the best option for moving forward. In fact, the NFCC provides guidance related to bankruptcy through two forms of counseling that are required by law as part of the bankruptcy process. Particularly if you are eligible for Chapter 7 bankruptcy, it may be your best option moving forward. However, it is a very serious decision with long-term consequences and should always be thought of as a last resort. Those who are not eligible for Chapter 7 may find that there are more favorable alternatives to bankruptcy that will create less long-term harm.

Better Options

There are better options than debt settlement and bankruptcy. If you are struggling to make your payments then you may benefit from changing the terms of what you owe rather than attempting to pay less than your full balance.

Consolidating or refinancing your credit card debt is one way to make it cheaper. You could roll your debt into a new account with a lower interest rate which, could make your payments cheaper and accelerate your repayment. However, if your credit score is not very good then you likely will not qualify for good rates, and this method will not make financial sense for you. Do not fall for the trap of a “consolidation loan” with terrible terms that really does not make you better off.

For most people, a debt management plan may be the best option. This program provides for a structured repayment plan to pay off everything you owe under the direction of, and with the help of, a credit counselor. Typically, debts on the plan qualify for waived fees and reduced interest rates, which means that the plan provides many of the same benefits as consolidation while still being a viable option for people with less than stellar credit.

Recap

Paying less than what you owe sounds like a great solution when you are in debt. But the methods that can turn this dream into reality have very serious negative consequences. If bankruptcy is the best way forward for you, then should certainly pursue it. Just remember that it is a last resort, and you will want to consider other options first. Debt settlement, on the other hand, is seldom a good idea. If you can negotiate a settlement on a debt that is already overdue then that may be a good solution. But you should stay away from professional debt settlement firms at all costs.

If you can’t have any debt forgiven, you can still receive helpful modifications, such as lower interest rates. Alternatives like this can make your debt load easier to manage without harming your credit score to the same extent as settlement and bankruptcy. If you would like help reviewing your options and making a plan to move forward, you can contact a credit counselor for free assistance.

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Debt Consolidation vs. Refinancing – The Differences Explained

September 26, 2020CreditBy toptierfinancial

Consolidation and refinancing are two commonly-discussed debt repayment solutions. Though these terms are sometimes used interchangeably, there are some important differences between the two and considerations that go into choosing which one is best for you. Adding to the complication is that “consolidation” is often associated with credit card debt while “refinancing” is often used to describe a particular mortgage repayment strategy. In reality, most types of debt can be consolidated or refinanced. Each of these options may be a viable strategy for your credit card debt. Here is a closer look at the two approaches, with an emphasis on how you might use them for credit card debt.

Debt Consolidation

We have discussed debt consolidation quite a bit lately, including smart strategies you can use to consolidate debt and its impact on your credit score. Here is a quick refresher. Debt consolidation is the process of paying off two or more existing debts with a new debt, effectively combining the old debts into one new financial commitment.

As a simple example, imagine you have three credit cards: A, B, and C. Let’s say you open a new balance transfer credit card (we’ll call that card D). You can transfer the balances from card A, B, and C to card D—meaning that A, B, and C now have zero balances. Now, you will make payments toward card D, and that will be your only credit card obligation (assuming you close card A, B, and C or don’t use them). That’s consolidation.

Its primary benefit is that it simplifies repayment and makes your debt easier to manage. In our example, sending one payment each month would be easier than three. A secondary benefit is that consolidation can be used to get better terms on your debt, which makes repayment faster. For example, assume that card D had a promotional, zero-percent interest rate while cards A, B, and C had been racking up interest with rates over 15 percent. Just keep in mind that consolidation does not always get you better terms. It depends on your credit score and the purpose of your consolidation.

Refinancing

Refinancing is simply changing the finance terms on a debt obligation. Typically, this occurs by taking out a new loan or other financial product with the different terms. The most basic example is a mortgage refinance. There are different types of mortgage refinances, but we will focus on the “rate-and-term” refinance. This has been incredibly popular in recent years given the historically low interest rates that have been available. It works like this: let’s say a homeowner has a mortgage at 4 percent interest but wants to refinance to a lower rate, say 3.5 percent. The homeowner could basically take out a new mortgage to pay off the original mortgage. The new loan would have new terms, meaning a new interest rate (here it would be 3.5 percent) and potentially a new repayment period.

What about for credit cards? You do not hear about “refinancing credit cards” as often, but it is possible and quite common. It can be difficult to decipher the difference between refinancing credit card debt and consolidating it. The confusion comes from the fact that different industries, companies, and individuals use this financial vocabulary in different ways. For instance, some companies may refer to balance transfers as credit card refinancing, and will only use “debt consolidation” to refer to a strategy involving a consolidation loan.

But, that does not quite hold true. Balance transfers are often used to consolidate multiple debts. Instead, think of it this way: All consolidation involves refinancing, but not all refinancing involves consolidation. The primary distinction is based on the number of debts you have. You cannot consolidate a single debt, because you do not have other debts to combine it with. However, you can refinance it. On the other hand, if you move multiple debts into a new debt, you will have new repayment terms (meaning you refinanced) but you have also consolidated into a single debt obligation.

There is, arguably, one other form of refinancing. However, it does not adhere to the strict, traditional definition. As mentioned above, refinancing typically involves a new financial obligation that replaces an old obligation. However, it could also involve keeping the financial obligation you already have, but negotiating the terms. In the credit card context, you may be able to negotiate a lower interest rate on your credit card, for example. That is effectively a refinancing of the credit card debt without taking on a new debt.

One argument against considering this to be a “refinance” is that often the negotiated terms are temporary. Your creditor might lower the interest rate for a short period of time because of a hardship you are experiencing, but that is much different than agreeing to a fundamental change to the interest rate for the rest of your time as a card holder.

What About a Debt Management Plan?

You might think of a debt management plan (DMP) as combining the best features of consolidation and refinancing. A DMP does not technically consolidate your debts, but it allows you to pay one monthly payment for all your credit cards on the plan. You pay the credit counseling agency one payment, and they distribute that payment to your creditors. It also has the perk of a being an effective “refinance” because your debts are often charged lower interest rates while on the plan.

The Takeaway

The various terms used to describe debt repayment options can create some confusion. At the end of the day, the exact language does not matter as much as the outcome. Keep in mind that managing your debt is important and consolidating your payments may make the management easier. Also, the terms of your debt are important because they will affect how affordable the debt is and how quickly you can pay it off. There are a variety of repayment strategies that incorporate these variables. If you would like help thinking through the strategy that may be best for you, contact a credit counselor for free assistance.

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The Difference between Secured and Unsecured Debt and Which You Should Pay First

September 7, 2020CreditBy toptierfinancial

There are two general categories of debt: unsecured debt and secured debt. The difference is very important. Knowing the difference will help you recognize each type of debt and develop a smart debt repayment strategy when you have both secured and unsecured debts. Here is a closer look.

What makes a debt secured?
Debt is secured when the creditor takes a “security interest” in collateral. That sounds confusing, but the concept is very simple. For some types of debt, creditors want to be sure that they can get their money back without too much trouble if you do not pay them. They want the debt to be secure—meaning they want to be sure they can recover. Taking a security interest accomplishes this. How does the creditor take a security interest? For personal debts, the language creating the interest is often included in the contract that the borrower signs when purchasing the collateral.

That security interest gives the creditor rights to the collateral. Collateral is simply property that you pledge to give the creditor if you fail to pay the money you owe them. This can get fairly complicated for business debts. In the business setting, many types of property can be used as collateral—business inventory, machines and equipment, and even accounts receivable. But for personal debt, this tends to be much simpler. Usually, the collateral on a secured debt for personal use is the very property that you purchased with the loan you were given.

Two simple examples are mortgages and auto loans. Both are typically secured debts and the collateral is the house or the vehicle. When you take out an auto loan, you use that auto loan to purchase a car. The creditor who is making the auto loan to you will take a security interest in that same car. The car is the collateral. If you pay off your debt in full, the car will become yours. If you fail to pay, the creditor can exercise its rights and take the collateral back from you. You may be able to “redeem” (get the car back) before the creditor sells it. You will either have to pay the payments you missed or the full balance of the loan, depending on your agreement with the creditor and your state’s law.

If the collateral does not cover the debt owed (say, for example, that the car was only worth $5,000 but you owed $7,000), then the creditor can pursue a deficiency judgment against you to collect the rest.

To recap: a secured debt is a debt for which the creditor has a security interest in collateral, meaning the creditor has a right to take property to satisfy the debt.

What about unsecured debts?
An unsecured debt is a debt for which the creditor does not have a security interest in collateral, and the creditor is therefore not entitled to take property from you to satisfy that debt without a judgment.

Common types of unsecured debt are credit cards, medical bills, most personal loans, and student loans*. These debts help you do something (buy items, pay your doctor, get an education), but they are not backed by a specific asset. So if you fall behind and can’t pay, there is nothing the creditor can take without further legal action. To compel payment, the creditor has to sue you and get a judgment against you. Before that happens, the creditor can use other tactics, which can have negative financial impacts—like using debt collectors and reporting missed payments to the credit bureaus. So, you do not want to ignore a creditor just because they are unsecured. But you should keep in mind that their legal recourse is more limited than a secured creditor.

*Note: While student loans are unsecured, there are some important differences between student loans and other unsecured debts, such as the very limited availability of discharge in bankruptcy.

Why does this matter?
The major lesson here is that you should be aware of the difference between secured and unsecured debt, and keep in mind that you typically have more to lose with secured debt. This means that secured debt should generally be the top priority in your repayment strategy. However, that will not always be the case. Here are two quick examples, one of when you would probably want to prioritize your secured debt and one for when you may want to prioritize unsecured debt.

Example #1
Let’s imagine that you have a single-family home. You budgeted wisely for your home purchase (meaning that it was reasonably priced for what you can afford), and it suits your family well. You still have a mortgage payment due every month, but you also have some credit card debt and medical bills from a recent unexpected surgery. Money is tight all of a sudden—what debt should you prioritize?

The answer is that you should probably prioritize your mortgage. This is important for your family—providing a place to live. It is affordable, and if you were to lose your home, or even sell your home, you may not find another that is as good of a fit. You would want to make sure you pay your mortgage in full each month, and then come up with a secondary plan for your unsecured debts. You may not be able to pay your credit cards or medical bills in full. In that case, you should look into your options for handling those. It is better to risk falling behind for a short period on those bills than on your mortgage.

Example #2
This time, let’s imagine you have a car that is financed. Things were going well for you a few years ago, so you bought a vehicle for $20,000. You have made your payments every month. You still have payments left, but you only owe $5,000 on the car now. It has depreciated quite a bit, but it is still worth $10,000. Recently, you had an unexpected medical emergency, which led to medical debt and some new credit card bills. What should you prioritize here?

There is not a right or wrong answer to this question, and it would vary based on some additional specifics. But here’s one way to think about it. You certainly would not want to default on the car loan at the expense of the medical bills and credit card debt—that would hurt your credit and potentially lead to repossession of the car. However, you might consider prioritizing the unsecured bills to avoid any damage to your credit. How might you do that? By selling the car, which should give you $5,000 back, and then buying a cheaper car, which you may or may not need to finance. This solution is certainly not ideal—chances are your money would still be a little tight—but it could allow you to reduce your debts significantly, avoid any damage to your credit, make it through the financial emergency, and then rebuild without too much difficulty.

The point is this—secured debt puts your assets at risk. If an asset is very important, you can try to avoid losing it by prioritizing the secured debt over unsecured debt. If the asset is not critical, you may choose to prioritize the unsecured debt. It would be best to do this without falling behind on any of your financial commitments.

To review, keep these tips in mind:

Secured debt puts an asset at risk, called collateral
Secured creditors can take the collateral when you default
Unsecured debt is less risky, but still poses a financial risk
Unsecured creditors can send your account(s) to collections and report to credit bureaus; they can also pursue legal action against you
When determining which debt to prioritize think about the importance of the asset at risk, and the impact of your decision on your finances as a whole
Try to avoid defaulting on any type of debt

Need help with either type of debt?
If you have debt—whether secured, unsecured, or both—and you are not sure how to move forward, a credit counselor can help. Credit counselors are experts in creating debt repayment strategies customized to your specific situation and keeping your financial goals in mind. You can contact a credit counselor today for a free budget review and counseling session.

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Does Debt Consolidation Hurt Your Credit Score?

August 24, 2020CreditBy toptierfinancial

Debt consolidation can be a smart way to pay off debt in some cases. We have written before about specific debt consolidation strategies that you can use, including balance transfers, consolidation loans, and debt management plans (though DMPs are slightly different than true “consolidation”). But despite some of the perks, consolidation has drawbacks.

One potential drawback is the impact to your credit score. You might be wondering if consolidation hurts your credit. It turns out that the answer is a mixed bag. Some aspects of debt consolidation can hurt your credit score slightly in the short-term. Other aspects could cause positive changes to your credit score over the medium- and long-term. It really boils down to the specifics of your situation and how you manage your debt after consolidation. Let’s take a closer look.

Reminder: Components of a Credit Score

Before we talk about the impact of debt consolidation, it’s important to recap the components of a credit score. A FICO score is made up of your payment history (35%), amounts owed (30%), length of credit history (15%), credit mix (10%), and new credit (10%).

Debt consolidation can potentially impact all of these categories.

Minor Impacts

First, debt consolidation involves opening a new loan or line of credit (i.e. a balance transfer card). This will involve at least one new credit inquiry and lower the average age of your accounts, which can create a short-term drop in your score. One tip is to do your research first. As Experian points out, by knowing your credit score in advance and researching the loans or credit cards available, you can limit the number of inquiries, protecting your score.

If you use a balance transfer card to consolidate pre-existing credit card debt, you won’t affect your “mix” of debt. However, if you use a consolidation loan and you have not had a loan before, this could have a favorable impact on your credit mix, since you would then have credit cards and a loan on your file.

Major Impacts

The greater impacts to your score will come from payment history and amounts owed, since they are the two most heavily weighted categories of your credit score. The term “amounts owed” can be a little misleading, because it is not just about the total debt balance that you owe. What matters more is your credit utilization. This is a ratio of how much credit you are using (total balance) to how much you have available (total credit limit). A high utilization can hurt your score.

All things equal, debt consolidation can improve your credit utilization and therefore improve your credit score. To give a quick example, imagine you had three credit card accounts. Each had a $10,000 credit limit, and on each you had a $5,000 balance. This means you had a total debt balance of $15,000 out of your total $30,000 credit limit. Your utilization was 50 percent. But let’s say you then opened a balance transfer card. We will assume you could move all of your existing debt ($15,000) to the new card, and that the new card had a credit limit of $15,000. Assuming you left your previous cards open, you would now have a total balance of $15,000, but a total credit limit of $45,000. Therefore, your utilization would have dropped to 33 percent, which should have a positive impact on your credit score.

To have an immediately positive effect on your utilization, you will need to leave your previous accounts open. You have to be careful here, and know your personality. If leaving those credit cards open will be tempting—and you might run up additional credit card bills—then it may be better to close them. However, closing them will increase your utilization and lower your average age of accounts, probably hurting your score in the short-term. So, it can be a difficult choice.

Whatever you decide, the last major category is your payment history. If you have been making regular payments, but chose consolidation simply to get a lower interest rate, then you may not have much difficulty with making on-time payments, and that should help your score. In fact, you may find payments to be more manageable after consolidation. On the other hand, if you are already struggling and you leave old accounts open (again, creating the opportunity that you might spend more than you can repay), this could lead to missed payments and, in turn, hurt your credit score.

Are You Asking the Right Question?

If you are considering debt consolidation or other repayment strategies, it is only natural that you want to know the impact to your credit score. Credit scores are important, particularly when it comes to major financial goals like buying a home. However, you do not want to miss the forest for the trees. You might want to consider what your top priority is. In all likelihood, it’s that you pay off your debt efficiently and reliably.

Debt consolidation, through a balance transfer or consolidation loan, may be the right way to achieve that goal. It is likely a great option if you already have good to excellent credit, can pay off the debt quickly (before promotional interest rates expire), and can avoid some of the hefty fees consolidation loans and balance transfer cards often charge. However, the short-term boost to your credit will not be worth very much if you find yourself in significant debt again in the near future. What’s best for your credit score in the long-term is whatever approach allows you to reduce your debt to a manageable level and keep it there.

If you would like more help deciding which repayment option is best, consider checking out our debt relief comparison guide, or working with a credit counselor.

For more information about other debt repayment options check out our Ultimate Debt Relief Comparison White Paper.

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What You Need to Know About Bankruptcy Credit Counseling and When to Consider It

August 10, 2020CreditBy toptierfinancial

If you are considering filing for bankruptcy, you need to know about an important requirement: credit counseling. It may not be the first thing that comes to mind when you think about bankruptcy, but it is an important step in the process. In this post, we will take a closer look at the requirement, how to satisfy it, and other considerations to keep in mind.

Background

By law, you must complete “pre-bankruptcy credit counseling” before filing for Chapter 7 or Chapter 13 bankruptcy as an individual. The government maintains a list of approved pre-bankruptcy credit counseling providers (filers in Alabama and North Carolina can find approved providers here). Most NFCC-certified agencies provide this service, and the NFCC can match you with an approved bankruptcy counselor when you fill out this form.

Upon completion of the counseling, you will be issued a certificate, demonstrating that you met the requirement. The certificate is valid for 180 days, meaning that you will have up to 180 days to file for bankruptcy. Wait longer than that and you will have to retake the pre-filing counseling.

In addition to pre-bankruptcy credit counseling, there is a second “counseling” requirement. After you file for bankruptcy, but before your debt(s) is discharged, you are required by law to complete pre-discharge debtor education. Most agencies that offer the credit counseling service offer debtor education, too. This article focuses on the pre-filing credit counseling, but you should keep in mind that there are two counseling/education requirements.

What is Involved?

The purpose of the pre-filing credit counseling requirement is to ensure that consumers only file for bankruptcy if necessary. Other options may be available. Making significant changes to your household budget or enrolling in a debt management plan to pay off credit card debt, are two potential options that could allow you to bypass bankruptcy altogether. While bankruptcy may be the best option in some cases, it has drawbacks. These drawbacks include damage to your credit score, a bankruptcy notation on your credit report for 10 years, and attorney’s fees and court costs. This whitepaper discusses some of the pros and cons of bankruptcy compared to other debt relief methods.

So, what happens in an actual counseling session? The counselor will work with you to prepare an estimated budget based on your income. The counselor will assess whether a repayment plan other than bankruptcy seems feasible, and if it does then the counselor will provide a plan. There is no requirement that the you accept the plan, but this exercise can be very helpful. If the session reveals an alternative to bankruptcy, you may decide to pursue that option instead. Counselors should explain the alternatives to bankruptcy fully, and explain the pros and cons of each option. Counselors may also be able to connect you to local resources that could help further.

Choosing a Counselor

You may decide to choose your own bankruptcy credit counseling agency (we included links at the top of this post for doing just that). However, many people seek the advice of a bankruptcy attorney and then use the counseling service recommended by that attorney. There is nothing wrong with this approach, but there are a few things to keep in mind.

Perhaps the most important thing to consider is this: how committed are you to filing for bankruptcy instead of pursuing a different option? You may be interested in bankruptcy simply because you are facing significant debt. Most people have heard of bankruptcy and know that it can discharge some obligations. But you may not be familiar with other repayment options. On the other hand, you may already be certain that bankruptcy is the right choice for you.

If you go to a bankruptcy attorney after being 100 percent sure that you want to file for bankruptcy, then the pre-filing counseling may be just a formality. On the other hand, if you are focused on solving a debt problem in a general sense, you will care much more about the quality of your pre-filing counseling session because you will want to learn about additional options that may be available. Therefore, if there is any doubt in your mind about bankruptcy, you should take some time to pick the counseling agency that is right for you and will provide a personalized approach to the counseling session. We recommend NFCC member agencies for this purpose.

Key Points to Remember

Pre-filing credit counseling is a requirement for individuals who file for Chapter 7 or Chapter 13 bankruptcy. You may pick your own agency or use a referral from your bankruptcy attorney. We recommend working with an NFCC-member agency, and encourage you to consider alternatives to bankruptcy when feasible. Your counselor should review these alternatives with you. Lastly, remember that a counseling certificate is valid for 180 days, so you will need to file within that time-frame after the counseling session. Have more questions? See our Bankruptcy FAQ.

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