How To Get Out of Debt

There are ways to work yourself out of the debt trap . It requires patience, tenacity, and changes in your lifestyle. Below are strategies for restoring your financial health, and tips for maintaining it.

THE BEST DEBT-REDUCTION STRATEGY
If you consistently run out of money before the monthly bills are all paid, then you definitely need to take steps to get your financial situation under control - before it's too late. Most people try to ease their way out of a bad debt situation, but that seldom works. Severe financial problems generally require drastic solutions - and that means a concentrated debt-reduction strategy. According to most experts, the best plan involves three steps:

1. Stop Spending - That's what got you in trouble in the first place, and you can never expect to dig your way out if you continue the same patterns. Go into a strictly maintenance mode, repairing things rather than replacing them - or doing without if the items aren't really necessary to your day to day existence. (For example, if the electric can opener breaks, use an old-fashioned manual one for a while; they cost about $1.39.) Delay all major purchases, and eliminate all discretionary spending. Stay away from stores and shopping malls - particularly if you're prone to impulse buying. Your lifestyle may suffer for a while - but not nearly as much as if you keep spending yourself right into bankruptcy.

2. Stop Borrowing - Unless your troubles are due to a job loss or family illness, credit cards are probably behind your financial problems. Keep using them and you'll never dig yourself out- even if you can still make the payments - simply because of the steady addition of excessive interest charges. The best rule: If you can't pay cash for something, don't buy it. And, whatever you do, don't use credit cards for day-to-day expenses such as groceries. If you can't exercise this kind of self-discipline, the easiest course may be to cut up your cards. You don't have to close your accounts (which could trigger a demand for payment in full of the outstanding balance), but cutting up the cards will at least remove the temptation to use them until the bank mails out new ones at renewal time.

3. Find New Sources of Cash - Once you've gotten a handle on your spending and borrowing, it's time to start paying down debts. Obviously, the reduced spending will generate some extra money you can apply to payments, but to really make major inroads on your debt, you need to boost your short-term cash flow. Here are some potential sources of additional cash:

  • If you're already so far behind you're being hit with late-payment or overdraft fees, try to get a short-term loan from relatives to bring your accounts current and prevent further charges or bounced checks. This will give you time for other cash-generating strategies to kick in.
  • Review all your insurance policies. You may be able to substantially cut your monthly payments and free up more cash by increasing deductibles, eliminating some coverage and lowering the coverage amounts.
  • Look at all family life-insurance policies to see if any have cash values you can borrow or cash in. Cash-value policies are generally a bad deal anyway, so you can save money by terminating them and switching to term insurance. If, for some reason, you feel you must keep a cash-value policy, the interest rate for borrowing is only about 5 percent - much less than even the best credit card rate. Warning: If you do borrow against a policy, use all of the proceeds to pay down higher-interest debts. If you take money out for other purposes, you'll just be compounding your problems.
  • Let the money you do have make more money for you. Convert your passbook savings account into a money market fund, or boost cash flow by selling some low-yielding growth stocks and buying shares in companies with high quarterly dividends. (Note: If you're in real trouble, you may want to sell off your stocks and bonds entirely and apply the money to debt reduction. Stocks earned an average of 9.7 percent over the past 20 years and bonds about 9.1 percent - both before taxes - and it's likely you're paying a higher interest rate than that on your debt. Thus, you can actually boost your return by paying off your debts rather than keeping the money in securities.)
  • Increase the allowances claimed on your W-4 form to temporarily reduce the withholding tax bite and raise your take-home pay.
  • Take a temporary loan from your 401(k) or other retirement plan. In most plans, you can do this without incurring penalties - and some even allow interest-free loans. If you qualify under the plan's hardship definitions, you may also be able to make a permanent, penalty free withdrawal.
  • Ask your employer to let you work as much paid overtime as possible.
  • Take a second job for a few months until you're back on your feet.
  • Hold a garage or yard sale and sell off some of the stuff you bought but didn't really need.
  • Take your lunch to work. Lunch typically costs $5 a day. Brown-bag it, and you could save up to $1,000 a year! That's not chicken feed. Also consider car-pooling, taking the bus or train instead of driving or even riding your bike if it's feasible. You should save enough to make at least one credit-card payment a month, as well as deferring some future expenses such as a tune up or new tires for the car.

As you generate extra cash from these sources, don't just add small amounts to each of your monthly payments. Instead, make the minimum payments on accounts with low interest rates, and use the extra money to pay down the debts with the highest interest charges. That way you'll cut your overall interest burden and slow the growth in your non-spending-related debt.

A LESS PAINFUL ALTERNATIVE
If you own a home and haven't already damaged your credit rating with too many late payments and such, consider either a home equity loan, an equity line of credit or a total refinance. The equity line of credit is probably best because the application fees and upfront charges tend to be lowest. Interest rates on equity credit lines currently run 8 to 12 percentage points below the average credit-card rate, so you can significantly cut your monthly interest charges by switching your debt from plastic to an equity line. Home equity loans (second mortgages) and full refinancing usually involve substantial upfront charges - including application, documentation and appraisal fees and lender's points. As a result, they aren't as practical since it could take a year or more of lower payments just to offset the initial costs. However, if that's the only way you can pay off high credit-card balances and lower your monthly payment burden, it's worth a shot.

Bonus: If you do manage to qualify for an equity-based loan and keep it current, you can quickly improve your credit rating as good performance on these types of loans is always ranked high by credit evaluators.

AVOID CONSOLIDATION LOANS
If you don't own a home and can't raise enough cash from other sources to get out of trouble, one other option is a commercial bill-consolidation loan. With these loans, you total all your existing loans - except for your mortgage and, in most cases, your car payment - and borrow enough money to pay them off. You then make just one monthly payment to the loan company - a payment that, because of the longer term of the consolidation loan, is considerably lower than the total payments you were making before.

These deals sound appealing, but they should be avoided unless you have no other way out. The reasons? First, they have fairly high interest rates - reflecting the added risk involved in loaning money to someone already in financial trouble. Second, because they lower your monthly payments by stretching your debt out over a longer period of time, you wind up paying substantially more in interest than you would have had you merely paid off your old debts on time. Finally, if you have several debts with only a few payments remaining, you may not really need a bill-consolidation loan. You would be better off to adjust your payments, paying the minimum on your longer-term debts and sending in extra on the short-term ones, until you get the shorter ones paid off. Once you're rid of the short-term loans, your monthly payment total will drop - even without benefit of a consolidation loan - and you can begin paying more on the longer-term debts. As a general rule, any time you have fewer than a year's worth of payments left on a loan, exclude it from any bill-consolidation package.

Caution: If you owe only a few more car payments, many lenders will try to get you to include the auto loan in the consolidation package because it gives them more security. However, this is a bad deal for you because it stretches your car payments out several more years, costing you additional interest, and also gives the lender a repossession claim against the car should you default.

STAYING OUT OF TROUBLE
Once you get out of debt - or at least get your debt load under control - the next step is to stay there. Here are some keys to keep from falling back into the same old traps:

  • o Continue to limit your spending. During the period you spent paying off your debts, you should have learned that it's not that painful to live a less lavish lifestyle. Keep looking for bargains on everything from food (take advantage of newspaper coupons and in-store specials) to entertainment (search out two-for-one offers at restaurants and theaters), and continue buying new household items only when older ones wear out.
  • o Other smart shopping ideas include things like buying your life insurance directly, rather than through an agent. You can save commissions by using a company like Ameritas Life Insurance Corp. (1-800-552-3553) or USAA Life Insurance Co. (1-800-531-8000), both of which allow you to purchase term or cash-value insurance directly.
  • o Anticipate major expenses - such as annual insurance payments, new tires for the car, holiday gift giving, etc. - and plan ahead for them. It's a lot cheaper to save money ahead of time and pay cash than it is to borrow money at the time and then pay back cash and interest. In fact, the best way to stay out of financial trouble is to develop a budget for all expenses, not just major ones, and then stick to it. If you have trouble keeping to a budget, use the automatic check deposit feature at your bank, office or credit union. It's easier to avoid spending money if you don't see it.
  • o Keep your credit cards in your pocket. A good rule of thumb for product purchases is not to use a credit card to buy anything that can be carried out of the store with less than two hands. Use credit cards only for large purchases that you've considered carefully (although a regular consumer loan is better if one's available), for emergencies or in instances where they're demanded for convenience (airline tickets, car rentals, etc.).
  • o If your total debt payments - including your car loan and mortgage - rise above 25 percent of your monthly pre-tax income, stop spending again and refocus your cash flow into paying off current debts.
  • o If you run short of cash, pay at least the minimum on all your bills on time rather than skipping or delaying one or two. You may incur some extra interest charges but you'll at least avoid late fees, which can be as high as $10 to $25 per month.
  • To prevent such cash shortages from happening, start a regular savings plan. Don't worry if you can afford only small deposits. Even $10 a week will add up to $520 in a year - and you'll soon have a cash cushion for future unexpected events.
  • Forget what your neighbors have. Trying to keep up with the Joneses was probably one of the things that got you in trouble the first time around.
  • Keep the family involved in what you're doing financially so they understand why you're asking them to make changes in spending habits or forgo purchases. If you can show them the potential long-term benefits, they won't view any short-term restraints as a form of punishment.

Finally, if you've managed to badly damage your credit rating as a result of the way you've handled your debts, don't use a credit-repair company. Ninety percent of these operations are phony - they'll take from $200 to $500 of your hard-earned cash and do nothing, or get the negative items removed only temporarily. It's best to contact the credit reporting company yourself and ask about their procedures for removing any blemishes from your credit history permanently.

Remember that credit-rating companies don't make the credit history—your creditors do. Once you've managed to get your accounts current, ask for a letter from the creditors removing the negative items from your record. Keep these letters in your files; then, if the black marks aren't erased from your record, you'll be able to show the credit-rating agency proof that they should be.

Submitted by Laura Hanson
Pittsburgh, PA