How to Decrease Debt

Accumulating bad debt (consumer debt) by buying things like new living room furniture or a new car that you really can’t afford is like living on a diet of sugar and caffeine: a quick fix with little nutritional value. Borrowing on your credit card to afford an extravagant vacation is detrimental to your long-term financial health.

When you use debt for investing in your future, I call it good debt. Borrowing money to pay for an education, to buy real estate, or to invest in a small business is like eating a well-balanced and healthy diet. That’s not to say that you can’t get yourself into trouble when using good debt. Just as you can gorge yourself on too much good food, you can develop financial indigestion from too much good debt.

In this article, I mainly help you battle the pervasive problem of consumer debt. Getting rid of your bad debts may be even more difficult than giving up the junk foods you love. But in the long run, you’ll be glad you did; you’ll be financially healthier and emotionally happier. And after you get rid of your high-cost consumer debts, make sure you practice the best way to avoid future credit problems: Don’t borrow with bad debt.

Before you decide which debt reduction strategies make sense for you, you must first consider your overall financial situation and assess your alternatives.

Using Savings to Reduce Your Consumer Debt

Many people build a mental brick wall between their savings and investment accounts and their consumer debt accounts. By failing to view their finances holistically, they simply fall into the habit of looking at these accounts individually. The thought of putting a door in that big brick wall doesn’t occur to them. This article helps you see how your savings can be used to lower your consumer debt.

Understanding how you gain

If you have the savings to pay off consumer debt, like high-interest credit-card and auto loans, consider doing so. (Make sure you pay off the loans with the highest interest rates first.) Sure, you diminish your savings, but you also reduce your debts. Although your savings and investments may be earning decent returns, the interest you’re paying on your consumer debts is likely higher.

Paying off consumer loans on a credit card at, say, 12 percent is like finding an investment with a guaranteed return of 12 percent — tax-free. You would actually need to find an investment that yielded even more — around 18 percent — to net 12 percent after paying taxes on those investment returns in order to justify not paying off your 12 percent loans. The higher your tax bracket, the higher the return you need on your investments to justify keeping high-interest consumer debt.

Even if you think that you’re an investing genius and you can earn more on your investments, swallow your ego and pay down your consumer debts anyway. In order to chase that higher potential return from investments, you need to take substantial risk. You may earn more investing in that hot stock tip or that bargain real estate, but you probably won’t.

If you use your savings to pay down consumer debts, be careful to leave yourself enough of an emergency cushion. You want to be in a position to withstand an unexpected large expense or temporary loss of income. On the other hand, if you use savings to pay down credit-card debt, you can run your credit-card balances back up in a financial pinch (unless your card gets canceled), or you can turn to a family member or wealthy friend for a low-interest loan.

Finding the funds to pay down consumer debts

Have you ever reached into the pocket of an old jacket and found a rolled-up $20 bill you forgot you had? Stumbling across some forgotten funds is always a pleasant experience. But before you root through all your closets in search of stray cash to help you pay down that nagging credit-card debt, check out some of these financial jacket pockets you may have overlooked:

• Borrow against your cash value life insurance policy. If you did business with a life insurance agent, she probably sold you a cash value policy because it pays high commissions to insurance agents. Or perhaps your parents bought one of these policies for you when you were a child. Borrow against the cash value to pay down your debts. (Note: You may want to consider discontinuing your cash value policy altogether and simply withdraw the cash balance.)
• Sell investments held outside of retirement accounts. Maybe you have some shares of stock or a Treasury bond gathering dust in your safety deposit box. Consider cashing in these investments to pay down your consumer loans. Just be sure to consider the tax consequences of selling these investments. If possible, sell investments that won’t generate a big tax bill.
• Tap the equity in your home. If you’re a homeowner, you may be able to tap in to your home’s equity, which is the difference between the property’s market value and the outstanding loan balance. You can generally borrow against real estate at a lower interest rate and get a tax deduction, subject to interest deduction limitations. However, you must take care to ensure that you don’t overborrow on your home and risk losing it to foreclosure.
• Borrow against your employer’s retirement account. Check with your employer’s benefits department to see whether you can borrow against your retirement account balance. The interest rate is usually reasonable. Be careful, though — if you leave or lose your job, you may have to repay the loan within 60 days. Also recognize that you’ll miss out on investment returns on the money borrowed.
• Lean on family. They know you, love you, realize your shortcomings, and probably won’t be as cold-hearted as some bankers. Money borrowed from family members can have strings attached, of course. Treating the obligation seriously is important. To avoid misunderstandings, write up a simple agreement listing the terms and conditions of the loan. Unless your family members are the worst bankers I know, you’ll probably get a fair interest rate, and your family will have the satisfaction of helping you out. Just don’t forget to pay them back.

Decreasing Debt When You Lack Savings

If you lack savings to throw at your consumer debts, not surprisingly, you have some work to do. If you’re currently spending all your income (and more!), you need to figure out how you can decrease your spending and/or increase your income. In the meantime, you need to slow the growth of your debt.

Reducing your credit card’s interest rate

Different credit cards charge different interest rates. So why pay 14, 16, or 18 percent (or more) when you can pay less? The credit-card business is highly competitive. Until you get your debt paid off, slow the growth of your debt by reducing the interest rate you’re paying. Here are sound ways to do that:

• Apply for a lower-rate credit card. If you’re earning a decent income, you’re not too burdened with debt, and you have a clean credit record, qualifying for lower-rate cards is relatively painless. Some persistence (and cleanup work) may be required if you have income and debt problems or nicks in your credit report. After you’re approved for a new, lower-interest-rate card, you can simply transfer your outstanding balance from your higher-rate card.

CreditCards.com’s website carries information on low-interest-rate and no-annual-fee cards (among others, including secured cards).

• Call the bank(s) that issued your current high-interest-rate credit card(s) and say that you want to cancel your card(s) because you found a competitor that offers no annual fee and a lower interest rate. Your bank may choose to match the terms of the “competitor” rather than lose you as a customer. But be careful with this strategy and consider just paying off or transferring the balance. Canceling the credit card, especially if it’s one you’ve had for a number of years, may lower your credit score in the short-term.
• While you’re paying down your credit-card balance(s), stop making new charges on cards that have outstanding balances. Many people don’t realize that interest starts to accumulate immediately when they carry a balance. You have no grace period — the 20 or so days you normally have to pay your balance in full without incurring interest charges — if you carry a credit-card balance from month to month.

Understanding all credit-card terms and conditions

Avoid getting lured into applying for a credit card that hypes an extremely low interest rate. One such card advertised a 1.9 percent rate, but you had to dig into the fine print for the rest of the story.

First, any card that offers such a low interest rate will honor that rate only for a short period of time — in this case, six months. After six months, the interest rate skyrocketed to nearly 15 percent.

But wait, there’s more: Make just one late payment or exceed your credit limit, and the company raises your interest rate to 19.8 percent (or even 24 percent, 29 percent, or more) and slaps you with a $25 fee — $35 thereafter. If you want a cash advance on your card, you get socked with a fee equal to 3 percent of the amount advanced. (Some banks have even advertised 0 percent interest rates — although that rate generally has applied only to balances transferred from another card, and such cards have been subject to all the other vagaries discussed.)

I’m not saying that everyone should avoid this type of card. Such a card may make sense for you if you want to transfer an outstanding balance and then pay off that balance within a matter of months and cancel the card to avoid getting socked with the card’s high fees.

If you hunt around for a low-interest-rate credit card, be sure to check out all the terms and conditions. Start by reviewing the uniform rates and terms disclosure, which details the myriad fees and conditions (especially how much your interest rate can increase for missed or late payments). Also, be sure you understand how the future interest rate is determined on cards that charge variable interest rates.

Cutting up your credit cards

If you have a tendency to live beyond your means by buying on credit, get rid of the culprit — the credit card (and other consumer credit). To kick the habit, a smoker needs to toss all the cigarettes, and an alcoholic needs to get rid of all the booze. Cut up all your credit cards and call the card issuers to cancel your accounts. And when you buy consumer items such as cars and furniture, do not apply for the E-Z credit.

The world worked fine back in the years B.C. (Before Credit). Think about it: Just a couple generations ago, credit cards didn’t even exist. People paid with cash and checks — imagine that! You can function without buying anything on a credit card. In certain cases, you may need a card as collateral — such as when renting a car. When you bring back the rental car, however, you can pay with cash or a check. Leave the card at home in the back of your sock drawer or freezer, and pull (or thaw) it out only for the occasional car rental.

If you can trust yourself, keep a separate credit card only for new purchases that you know you can absolutely pay in full each month. No one needs three, five, or ten credit cards! You can live with one (and actually none), given the wide acceptance of most cards.

Retailers such as department stores and gas stations just love to issue cards. Not only do these cards charge outrageously high interest rates, but they’re also not widely accepted like Visa and MasterCard. Virtually all retailers accept Visa and MasterCard. More credit lines mean more temptation to spend what you can’t afford.

If you decide to keep one widely accepted credit card instead of getting rid of them all, be careful. You may be tempted to let debt accumulate and roll over for a month or two, starting up the whole horrible process of running up your consumer debt again. Rather than keeping one credit card, consider getting a debit card.

Discovering debit cards: The best of both worlds

Credit cards are the main reason today’s consumers are buying more than they can afford. So logic says that one way you can keep your spending in check is to stop using your credit cards. But in a society that’s used to the widely accepted Visa and MasterCard plastic for purchases, changing habits is hard. And you may be legitimately concerned that carrying your checkbook or cash can be a hassle or can be costly if you’re mugged.

Debit cards truly offer the best of both worlds. The beauty of the debit card is that it offers you the convenience of making purchases with a piece of plastic without the temptation or ability to run up credit-card debt. Debit cards keep you from spending money you don’t have and help you live within your means.

A debit card looks just like a credit card with either the Visa or MasterCard logo. The big difference between debit cards and credit cards is that, as with checks, debit card purchase amounts are deducted electronically from your checking account within days. (Bank ATM cards are also debit cards; however, if they lack a Visa or MasterCard logo, they’re accepted by far fewer merchants.)

If you switch to a debit card and you keep your checking account balance low and don’t ordinarily balance your checkbook, you may need to start balancing it. Otherwise, you may face charges for overdrawing your account.

Here are some other differences between debit and credit cards:

• If you pay your credit-card bill in full and on time each month, your credit card gives you free use of the money you owe until it’s time to pay the bill. Debit cards take the money out of your checking account almost immediately.
• Credit cards make it easier for you to dispute charges for problematic merchandise through the issuing bank. Most banks allow you to dispute charges for up to 60 days after purchase and will credit the disputed amount to your account pending resolution. Most debit cards offer a much shorter window, typically less than one week, for making disputes.

Because moving your checking account can be a hassle, see whether your current bank offers Visa or MasterCard debit cards. If your bank doesn’t offer one, shop among the major banks in your area, which are likely to offer the cards. Because such cards come with checking accounts, make sure you do some comparison shopping among the different account features and fees.

A number of investment firms offer Visa or MasterCard debit cards with their asset management accounts. Not only can these investment firm “checking accounts” help you break the credit-card overspending habit, but they may also get you thinking about saving and investing your money. One drawback of these accounts is that most of them require higher minimum initial investment amounts. Among brokerages with competitive investment offerings and prices are TD Ameritrade (phone 800-934-4448), Vanguard (phone 800-992-8327), and T. Rowe Price (phone 800-537-1936).

Turning to Credit Counseling Agencies

Prior to the passage of the 2005 bankruptcy laws, each year hundreds of thousands of debt-burdened consumers sought “counseling” from credit counseling service offices. Now, more than a million people annually get the required counseling. Unfortunately, some people find that the service doesn’t always work the way it’s pitched.

Beware biased advice at credit counseling agencies

Leona Davis, whose family racked up significant debt due largely to unexpected medical expenses and a reduction in her income, found herself in trouble with too much debt. So she turned to one of the large, nationally promoted credit counseling services, which she heard about through its advertising and marketing materials.

The credit counseling agency Davis went to markets itself as a “nonprofit community service.” Davis, like many others I know, found that the “service” was not objective. After her experience, Davis feels that a more appropriate name for the organization she worked with would be the Credit Card Collection Agency.

Unbeknownst to Davis and most of the other people who use supposed credit counseling agencies is the fact that the vast majority of their funding comes from the fees that creditors pay them. Most credit counseling agencies collect fees on a commission basis — just as collection agencies do! Their strategy is to place those who come in for help on their “debt management program.” Under this program, counselees like Davis agree to pay a certain amount per month to the agency, which in turn parcels out the money to the various creditors.

Because of Davis’s tremendous outstanding consumer debt (it exceeded her annual income), her repayment plan was doomed to failure. Davis managed to make 10 months’ worth of payments, largely because she raided a retirement account for $28,000. Had Davis filed bankruptcy (which she ultimately needed to do), she would’ve been able to keep her retirement money. But Davis’s counselor never discussed the bankruptcy option. “I received no counseling,” says Davis. “Real counselors take the time to understand your situation and offer options. I was offered one solution: a forced payment plan.”

Others who have consulted various credit counseling agencies, including one of my research assistants who, undercover, visited an office to seek advice, confirm that some agencies use a cookie-cutter approach to dealing with debt. Such agencies typically recommend that debtors go on a repayment plan that has the consumer pay, say, 3 percent of each outstanding loan balance to the agency, which in turn pays the money to creditors.

Unable to keep up with the enormous monthly payments, Davis finally turned to an attorney and filed for bankruptcy — but not before she had unnecessarily lost thousands of dollars because of the biased recommendations.

Although credit counseling agencies’ promotional materials and counselors aren’t shy about highlighting the drawbacks to bankruptcy, counselors are reluctant to discuss the negative impact of signing up for a debt payment plan. Davis’s counselor never told her that restructuring her credit-card payments would tarnish her credit reports and scores. The counselor my researcher met with also neglected to mention this important fact. When asked, the counselor was evasive about the debt “management” program’s impact on his credit report.

If you’re considering bankruptcy or are otherwise unable to meet your current debt obligations, interview any counseling agency you may be considering working with. Remember that you’re the customer and you should do your homework first and be in control. Don’t allow anyone or any agency to make you feel that they’re in a position of power simply because of your financial troubles.

Ask questions and avoid debt management programs

Probably the most important question to ask a counseling agency is whether it offers debt management programs (DMPs), whereby you’re put on a repayment plan with your creditors and the agency gets a monthly fee for handling the payments. You do not want to work with an agency offering DMPs because of conflicts of interest. An agency can’t offer objective advice about all your options for dealing with debt, including bankruptcy, if it has a financial incentive to put you on a DMP.

The Institute for Financial Literacy is a good agency that doesn’t offer DMPs (phone 866-662-4932).

Here are some additional questions that the Federal Trade Commission suggests you ask prospective counseling agencies you may hire:

• What are your fees? Are there setup and/or monthly fees? Get a specific price quote in writing.
• What if I can’t afford to pay your fees or make contributions? If an organization won’t help you because you can’t afford to pay, look elsewhere for help.
• Will I have a formal written agreement or contract with you? Don’t sign anything without reading it first. Make sure all verbal promises are in writing.
• Are you licensed to offer your services in my state? You should work only with a licensed agency.
• What are the qualifications of your counselors? Are they accredited or certified by an outside organization? If so, by whom? If not, how are they trained? Try to use an organization whose counselors are trained by a nonaffiliated party.
• What assurance do I have that information about me (including my address, phone number, and financial information) will be kept confidential and secure? A reputable agency can provide you with a clearly written privacy policy.
• How are your employees compensated? Are they paid more if I sign up for certain services, if I pay a fee, or if I make a contribution to your organization? Employees who work on an incentive basis are less likely to have your best interests in mind than those who earn a straight salary that isn’t influenced by your choices.

Stopping the Spending/Consumer Debt Cycle

Regardless of how you deal with paying off your debt, you’re in real danger of falling back into old habits. Backsliding happens not only to people who file bankruptcy but also to those who use savings or home equity to eliminate their debt.

Resisting the credit temptation

Getting out of debt can be challenging, but I have confidence that you can do it with this book by your side. In addition to eliminating all your credit cards and getting a debit card, the following list provides some additional tactics you can use to limit the influence credit cards hold over your life.

Reduce your credit limit. If you choose not to take my advice and get rid of all your credit cards or get a debit card, be sure to keep a lid on your credit card’s credit limit (the maximum balance allowed on your card). You don’t have to accept the increase just because your bank keeps raising your credit limit to reward you for being such a profitable customer. Call your credit-card service’s toll-free phone number and lower your credit limit to a level you’re comfortable with.

• Replace your credit card with a charge card. A charge card (such as the American Express Card) requires you to pay your balance in full each billing period. You have no credit line or interest charges. Of course, spending more than you can afford to pay when the bill comes due is possible. But you’ll be much less likely to overspend if you know you have to pay in full monthly.
• Never buy anything on credit that depreciates in value. Meals out, cars, clothing, and shoes all depreciate in value. Don’t buy these things on credit. Borrow money only for sound investments — education, real estate, or your own business, for example.
• Think in terms of total cost. Everything sounds cheaper in terms of monthly payments — that’s how salespeople entice you into buying things you can’t afford. Take a calculator along, if necessary, to tally up the sticker price, interest charges, and upkeep. The total cost will scare you. It should.
• Stop the junk mail avalanche. Look at your daily mail — I bet half of it is solicitations and mail-order catalogs. You can save some trees and some time sorting junk mail by removing yourself from most mailing lists. To remove your name from mailing lists, contact the Direct Marketing Association (you can register through its website).

To remove your name from the major credit reporting agency lists that are used by credit-card solicitation companies, call 888-567-8688 or online. Also, tell any credit-card companies you keep cards with that you want your account marked to indicate that you don’t want any of your personal information shared with telemarketing firms.

• Limit what you can spend. Go shopping with a small amount of cash and no plastic or checks. That way, you can spend only what little cash you have with you!

Identifying and treating a compulsion

No matter how hard they try to break the habit, some people become addicted to spending and accumulating debt. It becomes a chronic problem that starts to interfere with other aspects of their lives and can lead to problems at work and with family and friends.

Debtors Anonymous (DA) is a nonprofit organization that provides support (primarily through group meetings) to people trying to break their debt accumulation and spending habits. DA is modeled after the 12-step Alcoholics Anonymous (AA) program.

Like AA, Debtors Anonymous works with people from all walks of life and socioeconomic backgrounds. You can find people who are financially on the edge, $100,000-plus income earners, and everybody in between at DA meetings. Even former millionaires join the program.

DA has a simple questionnaire that helps determine whether you’re a problem debtor. If you answer “yes” to at least 8 of the following 15 questions, you may be developing or already have a compulsive spending and debt accumulation habit:

• Are your debts making your home life unhappy?
• Does the pressure of your debts distract you from your daily work?
• Are your debts affecting your reputation?
• Do your debts cause you to think less of yourself?
• Have you ever given false information in order to obtain credit?
• Have you ever made unrealistic promises to your creditors?
• Does the pressure of your debts make you careless when it comes to the welfare of your family?
• Do you ever fear that your employer, family, or friends will learn the extent of your total indebtedness?
• When faced with a difficult financial situation, does the prospect of borrowing give you an inordinate feeling of relief?
• Does the pressure of your debts cause you to have difficulty sleeping?
• Has the pressure of your debts ever caused you to consider getting drunk?
• Have you ever borrowed money without giving adequate consideration to the rate of interest you’re required to pay?
• Do you usually expect a negative response when you’re subject to a credit investigation?
• Have you ever developed a strict regimen for paying off your debts, only to break it under pressure?
• Do you justify your debts by telling yourself that you are superior to the “other” people, and when you get your “break,” you’ll be out of debt?

To find a Debtors Anonymous (DA) support group in your area, visit the DA website or contact the DA’s national headquarters by phone at 800-421-2383 or 781-453-2743.