A situation which no one wants to be in – credit card debt. Certainly harrowing and a likely debilitating situation for any unfortunate person caught in it, facing serious financial threats ranging from the immediate ones such as calls from debt collectors, employment denial, garnished wages or mortgages and lawsuits, to long-term, chronic ones that have far-reaching impacts such as bad credit and low credit score and possibly even not being able to get a cellphone contract.
So how do we prevent ourselves from getting into such a dire situation? Let’s start by understand what debts are and can lead to.
Many of such scary situations can be avoided with proper planning and with a little (and nearly hassle-free) discipline. First off, here’s a famous quote by Sun Tzu you probably have heard of:
“Know thy self, know thy enemy”
Therefore, it will be great to know what debts are, how people accumulate too much debt, ways to get out of debt (with pros and cons) and lastly how to maintain a good discipline with your finances.
Why people get into credit card debt
There are many reasons why people get into credit card debt, some unexpected due to poor spending habits. Other common reasons range from unemployment, having to deal with massive medical fees and for some, a bad combination of laziness and greed resulting in spending beyond actual purchasing power.
Sometimes it may just be bad luck: an ordinary office worker with average income takes on an average car loan and some household purchases (like TV, furniture, furnishing etc) paid using a credit card. He/she took into consideration the loan repayments for each month’s expenses, and expects to be stable and in control. Unfortunately, external forces need to be factored in and cannot be ignored. Due to political, economical, technological and natural disasters, one can easily be unemployed all of a sudden. The ordinary office worker is out of a job but did not save enough to tide over this period of unemployment. What if a family member (touch wood) falls ill or get into some unexpected accident? Hospital fees can be extremely high in some places and/or for treatment for certain situations. Everything suddenly changed, except for the loan he/she needs to pay monthly, which was calculated assuming he/she has stable income every month.
What happens from that point on? The office worker (now unemployed) is unable to pay loans, which becomes accumulated debt. The credit card contract that he/she signed with the company stated that every month of non-repayment will add interest, and the interest as time goes by adds to an absurd amount.
Settling Debts – Debt negotiation
Are there ways out of these situations? Fortunately there are, due to it unfortunately affecting more and more people. Most of them do not come without negative impacts to your life and future. Simply put, debt negotiation is when you try to negotiate with your creditors to settle for a debt payment that is less than the amount you originally owe. Some creditors may offer some flexibility in payment, but generally this happens less when debts are pressing.
Here are 5 common solutions offered during debt negotiations:
1 – Workout arrangement
The bank may lower or even eliminate your interest rate and minimum monthly payment. However, your credit line will most likely be cut off, so you won’t be able to draw funds or make any purchase using your credit card. Also, this will most likely lower your credit score, so there will be future issues when getting loans from a bank. In the end, you will still need to pay every cent that you owe.
In short: eliminate/lower interest rate and repayment per period, but lower credit score which can affect future loan requests
2 – Forbearance
If the financial problem is temporary such as an injury that puts you out of work for a few months, a forbearance arrangement might be better in easing off your debt. The payment plans are similar to the workout arrangement – interest rate and monthly payment can be eliminated, and the creditor may allow skipping of payments. However, it is important to note that forbearance solutions only offer a brief break from payments, and it is by no means debt forgiveness. You might even end up paying more than what you originally owed due to additional interest or any other charges incurred.
In short: eliminate/lower interest rate and even repayment for a period of time, but additional fees and interest may be incurred as a result
3 – Lump-sum settlement
If you have access to a sizeable chunk of money, such as from striking lottery or inheritance, you can try to use this to settle for a payment amount less than the amount you owe. Still, it must be noted that paying less than what you owe will negatively affect your credit score, even if it ends up in a charge-off (where the bank removes your debt entirely from its books for accounting purposes but not the obligation).
Also note that in some places taxation laws include forgiven debt as income, so if you are forgiven for a sum of $2000, it can mean that you will be paying taxes on that $2000 as additional income the following year.
In short: Return less than the full amount by returning a huge sum, but lower credit score and can be taxed as income
4 – Debt management plan
Debt management plans (or programs) might be helpful if you don’t wish to negotiate with your creditors yourself (be it due to difficulty in communication or fear of accepting an even worse plan without realizing), but go through a third party individual or agency. A good counsellor will meet up with you to understand your financial situation, come up with a decent plan that suits your situation and negotiate with creditors on your behalf to work out ways in restructuring your debt so that it becomes more repayable. This can include negotiations in lowering your interest payments, along with lowering or dropping some payment fees depending on the proposal and results of the negotiations.
In short: a third party that is more familiar in this area may be able to get a better deal for you, but the service will not come free
5 – Debt settlement program
Settling your debt for less than what you owe by negotiating with creditors either personally or through a debt settlement company is typically the last resort before declaring bankruptcy. In a debt settlement program, you stop paying your creditors for months at a stretch until they are ready to accept a lower payment.
Stopping payments on debts does significant damage to credit score, though paying a portion of what is owed is better than paying nothing. Those accounts will stay on your credit record for at least seven years, which are often referenced to whenever you intend to take loans, apply for a new cell phone contract or even to get credit card benefits in future.
In short: pay less than owed, but does high amounts of damage to your credit score. Only use this as a final resort if nothing else works out, as the damage will stay for years
Debt settlement plan – the process
Example Case: Debtor engages a debt settlement company (the Middleman) to settle the debt between the Creditor and Debtor.
Debtor registers with Middleman for a debt settlement program. Middleman has 2 goals – making Debtor’s financial situation look desperate (so that Creditor will settle for less) and to prepare a sum of money (in order to make the settlement more convenient for Creditor and thus, more likely to be approved).
1st goal – making Debtor look desperate: Middleman usually will request that Debtor stops making payments to Creditor. By doing this, Debtor gives a signal to Creditor that he is facing financial difficulty, and may be unable to cough up the money to pay the full debt. Often this makes Creditor more willing to settle for less. From Creditor’s perspective, debt settlement can sometimes be more worth carrying out than selling the account to collections or losing out on the debt entirely if Debtor files for bankruptcy. It is worth noting that settlement may not always be with the original creditor – sometimes collectors or debt buyers will take over the debts.
2nd goal – prepare repayment money: Debtor will often be asked to make regular deposits to Middleman, in order to begin accumulating the lump sum while the repayment is temporarily paused. Essentially, Debtor is being put into a dangerous financial situation and can only hope that it all works out. However, the risk lies in Debtor not having much control over financial plans for the future, which may lead to repercussions in future.
Impacts of debt settlement
Among the many negative impacts, debt settlement directly damages FICO score, or credit score in unfavorable extents. The effects are lasting and will prove to be an obstacle in future indirectly, and would not be felt until then.
1 – FICO Score: What it is and why it is important
What is the FICO score? The FICO score was first introduced in 1989 by FICO, then called Fair, Isaac, and Company. The FICO model is still used by the vast majority of banks and credit grantors, designed to measure the risk of default by taking into account various factors in a person’s financial history. It consists of five main areas:
- payment history
- current level of indebtedness
- types of credit used
- length of credit history
- new credit
A person with a healthy FICO score will usually range between 300 and 850. A FICO score above 650 indicates that the individual has a very good credit history, and scores below 620 will often find it much more difficult to obtain financing at a favorable rate. This includes getting future loans, credit availability, some employment opportunities amongst many other unfavourable outcomes.
One direct effect of being stuck in a debt settlement situation would be garnishment. Garnishment, or more specifically wage garnishment, means your employer directly deducting from your regular salary the amount meant as payment towards servicing your debt. Wage garnishment can negatively affect credit, reputation, and the ability to receive a loan or open a bank account as well.
There can be fees higher than others that debt settlement companies levy on a person with low FICO score. They can range from $500-$3000, and so not go into resolving the debt but straight to the debt settlement companies.
2 – Bankruptcy
This is naturally the most undesired outcome of any debt situation. When one owes money in excess of $10,000 and is unable to pay up, one can be made a bankrupt.
In the event of a bankruptcy declaration, the Official Assignee (OA), a public servant in charge of administering all affairs in bankruptcy will take stock of one’s available assets and sell as many of these as possible in order to pay the creditors. Any income received while bankrupt will be disclosed to the OA. One will be required to contribute a portion of income to the bankruptcy pool to pay the creditors.
There are many adverse effects of being made a bankrupt including but are not limited to being unable to:
- leave the country without the OA’s permission
- take up or continue in public office
- start up any business without the OA’s approval
- sue anyone in court except for personal injury or action, without the OA’s approval
The state of bankruptcy will also leave a black mark on credit history, which will make it very difficult to get loans, credit cards or any other form of obtaining financial aid or funds in future. It may also adversely affect one’s lifestyle, along with relationships with friends and family.
Prevention: It’s never too late to maintain good financial habits
Having mentioned so many details about the implications and complications of credit card debt, ultimately it is always better to stick to the tried and tested adage: “Prevention is better than cure”. Instead of waiting for issues to snowball, always clear the snow from the streets to avoid skidding accidents.
There is not quick and easy way to “cheat” this, but every little bit goes a long way if good practices are followed and maintained. It can be as simple a self-disciplining trick – each time you are tempted to get the $6 coffee, go for the $4 one instead and put that $2 in a deposit box as savings/reward for yourself. It may not seem like much but every $2 you save per day adds up to about $60 a month and $730 in a year! That is way more than what bank interests and low-risk investment plans pay to an average, middle-class worker with average savings.
In this day and age where most of our money is digital, it can be harder to carry out such saving strategies, as many banks only provide information of the balance you have in your account and do not allow you to micro-manage your money.
Instead of lamenting about digitisation, there are positive sides to the progresses in technology! For example, there are apps that can let you create as many categories and input as much details as you want into every account you have and every transaction record. Instead of trying to have a deposit box in your office (which is a bad idea obviously), you can do the sorting and recording in apps, and only withdraw/transfer the money to your deposit box or another bank account for “additional savings” at the end of the week or month.
The following smart app tips are all possible in Expense IQ, which is developed from the start to encourage good spending and saving habits, so you may not find the same functions in other similar apps.
- Set aside savings: Create a “Savings Discipline” account in the app, and each time you save money (like the $6 coffee example above), transfer that amount into that account
- Record expenses and evaluate: Record all your expenses, then evaluate your spending habits at the end of the month. Are you spending too much during coffee breaks? Alcohol? Dinner? The pie charts in Expense IQ can help in finding out areas you can get more savings out off which you may not have realized.
- Set up bill reminders: Never forget to pay your bills every time. Each time you forget to pay, the penalty and/or interest means less savings you can have, and less money is never good.
- Budgeting: Once you are more comfortable with daily expense tracking, go for budgeting! If you are more comfortable starting budgeting from the beginning, nobody is stopping from doing that too! In Expense IQ, you can set a budget to each category, and receive smart color-coded warnings if you are in danger of overspending or have already overspent. For a start, set budgets for food, transport, groceries, entertainment etc, which are relatively easy to adjust if required.
- Keep your data secure and backed up: Turn on Cloud Sync! You may wonder why that is even necessary, but you may be surprised how the convenience and security of your data can encourage you to continue maintaining the good habit of expense tracking. For example, use your phone to record when you are out at work or with friends, use your tablet at the end of the day for an overview and evaluation making use of the bigger screen estate. Of course, never worry about losing your data if your phone gets reset or lost.
Check out Expense IQ in the Google Play Store, and start enjoying the rewards that good finance habits bring!
Do you have more ideas and tips? Share and discuss in the comments below!
This article is brought to you by the team behind Expense IQ, with a goal to improve everybody’s financial awareness and create tools to support that cause.
Expense IQ: Free Download on Google Play Store
This article is contributed to by our guest writer Kenneth. Thank you Kenneth! If you would like to contribute an article to our blog, contact us through any of our communication channels!