Any type of high-interest consumer debt is detrimental to your financial success and overall well-being. The ongoing interest and fees can destroy your ability to manage monthly cash flows and prevent you from reaching your most important financial goals. Furthermore, research has shown that debt can lead to numerous health problems.
If you are currently in debt and choose to make minimum monthly payments, you will be paying interest for years. The better solution is to tackle your debt with the utmost urgency, allocating 110% of your effort and resources toward eradicating the heavy debt burden in your life.
There are an overwhelming number of suggestions aimed at helping people become debt free, but many are unhelpful or unrealistic. I hope that the solutions outlined in this article will provide some guidance for your journey. Also to note, the most common type of consumer debt is credit card debt, but the recommendations in this article should broadly apply to any form of high-interest debt.
Ask for Loan Reduction
Most credit card companies are unlikely to forgive all of your credit card debt, but they do occasionally accept a smaller amount in settlement of the balance due and forgive the rest.
If you stop paying on your credit card debt and become delinquent, some credit card companies will write off the debt and consider you uncollectible. However, this offers no benefit to you, because a write-off is not legal debt forgiveness. The credit card company simply registers the debt as a loss – but the debt still exists, and can be sold to a third party for collection. If the collection agency files a lawsuit to collect the debt, they can garnish your wages or attempt to collect elsewhere. Furthermore, your credit will be destroyed.
That is not the scenario you want.
Instead, you can offer a lesser amount to settle the entire debt. The credit card company may accept your offer, because a settlement is sometimes less risky than suing. A lawsuit takes time and costs money, and the creditor might still fail to collect the full balance through wage garnishment.
If the creditor agrees to accept your offered settlement, it will accept your offered payment and forgive the remaining loan balance. You will likely owe taxes on any settled debt because the balance forgiven is often considered taxable income.
Everything needs to be in writing, and you shouldn’t expect a customer service agent to be helpful. You will need to speak with someone in authority (sometimes called a “credit manager”) who can authorize the debt settlement. You can also seek counsel from a reputable credit counseling organization, who might negotiate on your behalf.
Negotiate Better Rates
Loan forgiveness is a very rare occasion, reserved for individuals in the most dire situations. A much more likely scenario involves negotiating the terms of your debt.
Your goal is to work out a modified payment plan that reduces the amount of interest and fees paid. To achieve that goal, consider the following:
You are a valuable customer – The first thing you need to realize is your value to the creditor. Because your outstanding debt balance carries a double digit interest rate, you are a profitable customer. The financial institution loves you, because you are paying ridiculous amounts of interest each month.
You have other options – The next step involves doing your homework. You can consider a slew of other loan options (discussed in detail later in this article), including other balance-transfer credit cards, home equity lines of credit, personal loans, etc. If you can identify the competition, you can be in the driver’s seat.
Find the right person – After researching your available options, it’s time to negotiate. Don’t expect a simple phone call with the low-level customer service agent. You need to immediately ask to speak with a credit supervisor. When you get someone important on the line, tell them the following:
- You have enjoyed being a loyal customer for (x) amount of time. If you pay your bills on time, mention that too.
- While you appreciate the relationship, you have other opportunities available that will benefit your family and save money.Be ready to list the other options (0% balance transfer, low-interest loans, etc.) and the respective interest rates.
- Say that you would prefer to maintain the existing relationship, if the manager will agree to match the other competing interest rates.
- If accepted, immediately ask for the terms in writing. They can draft the document and mail it to your home.
- If denied, do not accept defeat. Ask the individual to provide their lowest rate possible.
- If you don’t like the offer, be ready to hang up and walk away. You can either call back later, or choose to transfer the debt elsewhere.
Maintaining the existing debt agreement is not an option. Do not agree to continue paying ridiculous interest or fees.
Consolidate or Transfer Your Debt
If you are unsuccessful in negotiating the amount or terms of your debt, consider transferring the debt or consolidating.
Consolidation means that your various debts are rolled into one new type of debt (hopefully with a lower interest rate). When you have multiple consumer debts, consolidation may be a way to simplify and lower the monthly payments, all while eliminating late fees or penalties. If you have just one type of consumer debt, you can transfer the balance to reduce your interest rate (and monthly payment).
Keep in mind, all of the following options are still forms of debt. They aren’t a magic bullet, and you cannot borrow your way to financial freedom. Paying less interest can help you eliminate debt more quickly, but only if you use the money as intended and follow through with your debt repayment plan.
You have numerous transfer/consolidation options:
Credit card companies love to compete for your business. Many offer a very low (0%) introductory interest rate if you move your debt from another bank – known as a balance transfer.
If you play the game properly, a 0% balance transfer is tough to beat. But there are a few important considerations that you need to understand.
Your credit score – A balance transfer requires that you sign up for a new credit card. For most approvals, you have a solid FICO score, which usually means above 700. Even if you are approved for the new card, you may not be approved for a big enough credit limit to cover all of your debt. If that happens, you can transfer the maximum amount, pay it off, and then apply for another balance transfer.
Spending discipline – If approved for the balance transfer card, you now have more available credit. If you cannot use that credit wisely, you will end up digging yourself into a deeper hole. Furthermore, your monthly minimum payment will go down because of the reduced interest rate. If you don’t have the discipline to pay more than the minimum due, you will not accelerate your debt repayment.
The timing of your debt – Most (not all) of the available credit cards charge a “balance transfer fee” when you transfer your existing debt to the new card. Each debt transfer would incur the fees, and the amount is often 3% of the loan balance. You will have to do the math, but if you can pay off your original debt in a few months, paying the transfer fee might not make sense. If you decide to proceed with the balance transfer, there is another concern. At the end of the promotional period, the interest rate will increase dramatically, leaving you in the same situation as before. Taken together, that means a balance transfer is most appropriate for individuals who need 6-24 months to repay their debt (or are willing to make another balance transfer at that time).
If you are comfortable with the considerations outlined above, you can proceed to compare available balance transfer cards.
With a personal loan (sometimes called a debt consolidation loan), you borrow a fixed amount of money at a fixed interest rate for a fixed period of time. Personal loans often carry higher interest rates than a balance transfer, but the terms and conditions are easier to understand.
Most personal loans provide a longer repayment period than 24 months, which could be good or bad, depending on your situation. Personal loans are traditionally unsecured, which means you don’t pledge any collateral on the loan. That is the main difference between personal loans and home equity loans (which pledge your home as collateral). Because the loan is unsecured, it is more risky for the lender, which increases the interest rate on the loan.
Many of the same considerations discussed above apply to personal loans.
Your credit score – With a personal loan, your interest rate will depend on your creditworthiness. That means you still need to have a solid FICO score, and most loan providers will want to see evidence of employment, your debt-to-income ratio, and other financial metrics before approving your application. If you have poor credit, the interest rate will be much higher on the loan, making this option much less attractive. The good news is that if you are approved, a personal loan may improve your credit score by transferring credit card debt over to the installment loan column.
Spending discipline – If you are approved for a new personal line of credit, will you be tempted to increase spending? The loan is meant to help you get out of debt, not increase your spending limits.
The timing of your debt – Personal loans frequently (but not always) carry loan origination fees, which can be 1% to 10% of the loan balance. If you can pay off your original debt in a few months, paying the origination fee might not make sense. If you need several years to repay your debt, a personal loan makes more sense.
You have numerous personal loan options, with new online lenders appearing on a consistent basis. In my opinion, the best options are:
- SoFi – Offers personal loans 100% online. Loans can have a 3, 5, or 7 year term. You can borrow between $5k-$100k at a fixed (best rate currently 5.95% APR) or variable (best rate currently 4.84% APR) interest rate. No origination fees or pre-payment penalties. SoFi is one of the largest and most successful loan lenders, with more than $13 Billion in funded loans.
- Lending Club – Offers personal loans 100% online. The loans are 3 – 5 years at a fixed rate (best rate currently 5.99% APR), and can be prepaid without penalty. They charge a 1-6% origination fee (depending on your creditworthiness), which is built into the loan repayment schedule.
- Local Banks or Credit Unions – If you want a physical bank to service your loan, shop around at local institutions. The terms will vary considerably, so get all of the facts and numbers. The biggest benefit to working with a local bank or credit union is flexibility. Many will work with you on a personal loan, even if your credit is less than stellar.
HEL (Home Equity Loan) or HELOC (Home Equity Line of Credit)
This strategy only applies to homeowners who have built some equity in their home. People often use the terms HEL and HELOC interchangeably, but HELs are typically fixed rate, fixed term loans, while a HELOC is a revolving, variable line of credit.
A HEL usually pays a lump sum upfront, but must be repaid on a typical loan repayment schedule (often 5, 10, or 20 years). A HELOC is a revolving line of credit, much like a credit card. You can borrow at will against the line of credit, and the repayment schedule depends on the amount borrowed.
Both loan types are secured, with your home pledged as collateral. Should you fail to repay the loan, the bank will foreclose on your home. These loans are not suitable for individuals who have difficulty controlling their spending.
With that said, these loans are a great option for individuals who are serious about crushing consumer debt. These loans often carry a lower interest rate than a comparable personal loan, because your home is pledged as collateral. Furthermore, the interest that is paid on the loan is often tax-deductible (if you itemize your deductions), which reduces the effective interest rate even further.
To determine the value of your home equity, calculate the difference between the market value of your home and the balance you owe on your mortgage. For example, if your current home value is estimated at $200,000 and your mortgage balance is $100,000, you would have $100,000 of home equity. Banks will typically lend customers between 75 – 85% of your home equity, dependent on your creditworthiness. In our example, that means you could obtain a loan in the amount of $75,000 – $85,000.
If you must sell your home, the outstanding balance of your home equity loan is deducted from the proceeds of your sale. Continuing our example, if you obtained a $80,000 HEL and were forced to sell your home for $200,000, the bank would collect $100,000 for the mortgage balance + $80,000 for the HEL balance. You would retain $20,000 after repaying the debts.
Fewer online lenders offer home equity loans, so my recommendation is to shop around locally.
Your last option, and the one most commonly frowned upon, is a loan from your retirement account.
Yes, it’s risky and can impede your ability to save for retirement. If there is any chance that you will be unable to repay the loan, run the other way.
On the other hand, using the loan to pay down consumer debt is like earning a guaranteed return equal to the interest rate on your debt. If your debt carries double digit interest, there is no comparison because no investment in your 401k is going to offer double digit, guaranteed returns.
401k plans were traditionally the most likely to offer a loan provision, but other retirement accounts now offer loans as well. You can call your plan provider and ask the following
- Does the plan offer loans?
- What are the terms of repayment?
- What are the current and historical loan interest rates (often tied to LIBOR or another market rate)
If you quit or lose your job, you typically have to repay your 401(k) loan in full soon thereafter (often 60 days grace period), regardless of the original loan terms. If you’re unable to pay by the deadline, the loan is treated as an early withdrawal and is taxed as ordinary income with an additional 10% penalty.
Summary and Conclusions
The solutions outlined in this article are not one-size-fits-all. The optimal strategy is dependent on multiple behavioral and rational factors.
Amid so many considerations, there is one absolute takeaway. None of these strategies will correct the underlying behavior which first led you into debt. You can’t borrow your way out of debt, and none of these solutions will fix a compulsive spending problem.
You should examine your motives before making any major decisions. If you aren’t 100% determined to destroy your debt, don’t waste your time transferring or consolidating your debt.
If you are 100% determined to crush your consumer debt, then consider the following cliff-notes:
Best short-term repayment strategy – 0% balance transfer
- You can transfer your existing debt to a new credit card offering 0% interest for 12-24 months.
- But if you can’t repay before the promo period ends, you revert back to outrageous interest rates.
Best long-term repayment strategy – A home equity loan (or line of credit)
- You can lose your home if you fail to repay the loan.
- But because your home is pledged as collateral, you can obtain a long-term loan at a low interest rate.
Lowest risk repayment strategy – Personal loan
- No collateral required to obtain the loan, which lowers your risk but increases the lender’s risk.
- With good credit, personal loans offer reasonable interest rates with a 3, 5, or 7 year loan repayment schedule.