How to dig yourself out of debt

By Elizabeth O'Brien, MarketWatch

MarketWatch photo illustration/Shutterstock

Maybe it was a big, unexpected expense. Maybe it’s crept up so gradually, you didn’t realize it. But no matter how it happens, we — almost all of us — find ourselves in debt at some point. It might be just enough to make you uncomfortable, or perhaps it has become a crushing, sleep-stealing weight you know you can’t handle anymore.

There are four basic ways to dig out of debt, be it a small or big amount. You need to look at your debt and your income honestly and figure out which option is best for you.

1. You can sit down with pencil, paper and calculator and build a realistic budget that lets you pay off your bills on a consistent and effective basis, pay for your basic needs and — if you stick to it — gives you all the peace of mind you need to get through it.

2. You can ask a credit counseling company for help. This is a good solution if you have a lot of unsecured debt, such as credit card debt for which the interests rates are high or which have defaulted to high penalty rates. Credit counseling companies work with your lenders to get the interest rates greatly reduced. Typically, these companies help you with a basic budget, come up with a single payment, and then you pay them each month. They send the new, negotiated payment to the different creditors and credit card companies, and they change a monthly fee. If this works for you, and you stick with it, the debt burden is greatly eased and before you know it, you’ll be in better shape financially. Be sure to work with a legitimate, experienced and transparent company.

3. You could use a debt settlement company. Debt settlement companies are very different from credit counseling companies, and the process is not for the faint of heart. A debt settlement company will help you through the process negotiating down your total debt. To do this, you stop making any payments. The late fees, interest and penalties will continue to build. But you will put money aside in an escrow account. When enough has accumulated, the debt settlement company will contact your creditors and attempt to get them to accept a much smaller amount, say 10% to 50% of the total you owe, and write the rest off as a bad debt. If you can brave the process, you might get to pay off your debt and be rid of the burden for far less than you owe. But keep in mind a few things: It won’t save your credit, creditors don’t always accept the lower offer, and there could be tax consequences.

4. Bankruptcy: It may be the last option, but it’s probably not the end of the world. The key to deciding if bankruptcy is the right option is to consult a bankruptcy lawyer and to know what kinds of debt are — and are not — discharged through bankruptcy. You also need to weigh the long-term future consequences.

Let’s explain these different strategies and show you how to get started digging out of debt.

Be sure to read our related stories, How to make a budget and 10 things you need to know about debt consolidators.

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How to dig out of debt

Big or small, debt can be a heavy burden. Here are ways to dig out of debt and tips to help you stay afloat and improve your finances, your credit and your peace of mind.

Sacha Millstone recalls the time a client called her to liquidate a brokerage account. The Boulder, Colo.-based financial adviser thought it was an odd request from a woman who hadn’t tinkered with her portfolio in the years she and her husband had been clients.

With some gentle prodding, Millstone discovered the reason behind the request: the woman had racked up more than $50,000 in credit card debt that she had hidden from her husband, and she was hoping to use the brokerage funds to quietly pay it down. “People have a lot of shame about being in debt,” Millstone said.

And yet, that woman has plenty of company. Americans owe a whopping $712 billion on their credit cards, according to an analysis of Federal Reserve and other government data by NerdWallet, a personal finance website. At the household level, this breaks down to $15,355 per average household that carries credit card debt, according to the analysis. The average household is paying $6,658 in interest a year, which eats up 9% of the average household income, NerdWallet found.

Indebtedness cuts across all income levels. “There’s no amount of money that keeps you safe,” said Larry Luxenberg, a financial adviser at Lexington Avenue Capital Management in New City, N.Y.

Experts expect household debt to grow, as credit card companies continue to loosen their standards after tightening them during the Great Recession. “People are charging again,” said Phil Heinemann, executive director and president of Debt Management Credit Counseling Corp. in Lighthouse Point, Fla., a nonprofit credit-counseling firm.

People are charging, but not necessarily splurging. Adjusted for inflation, wages have stayed largely flat in recent years as the cost of health care has continued to climb. Rents are also rising sharply in many areas, and, at 37% of all households, the share of all households renting has grown to levels not seen since the mid-1960s, according to the Joint Center for Housing Studies of Harvard University.

To stay above water, many would have to decrease their spending — and for those in that position, credit cards help bridge the gap. It’s an understandable yet unsustainable strategy. Jonathan Unverzagt, 52, a pastor in Onalaska, Wisc., found himself juggling about $39,000 of debt across several credit cards after years of spending above his means. Yet with 11 children to support, he was hardly living large.

Unverzagt lost sleep from the stress of living on the financial edge. “If you’re living from paycheck to paycheck and your washing machine breaks down and you get a $300 bill, that has a massive ripple effect,” Unverzagt said.

Finally, he’d had enough. “I just got sick of debt,” he said. He cut up his credit cards and, with the help of a nonprofit credit management program, methodically paid off his debts and built up a $1,500 emergency fund. “We’ve got much more freedom now,” he said of his family.

There are plenty of ways to dig out of a financial hole, from penny pinching on one end of the spectrum to bankruptcy on the other, and the right method will depend on your circumstances.

Make a budget, cut spending

Many people don’t have a great handle on where their money goes, financial advisers say. To free up money to pay bills, you have to first see what kind of money is available. Financial advisers often ask their clients to track their spending for a few weeks. There are plenty of online tools and mobile applications, such as Mint , to help.

Tracking spending is a tedious but eye-opening exercise. “99% of the time people way, way underestimate their living expenses,” said Rose Swanger, a certified financial planner and principal at Advise Finance in Knoxville, Tenn.

Once you recognize your true outlay, you can start trimming the fat in your discretionary spending. If a morning Starbucks run is essential to your mental health and job productivity, then you could save by bringing a bag lunch from home each day and cutting out all restaurant meals.

For those with relatively small debts, this belt-tightening might be all that’s needed to free up money to pay off the credit card balance. Online tools, such as the payoff calculator at creditcards.com , can help by showing how long it will take to pay off debt under various scenarios. Or try the one at Credit Card Finder , which allows users to input the information for up to nine credit cards and then obtain a ranking of the cards order of payoff priority.

Credit card companies can raise interest rates after just one late payment. Once you’re late paying one card, after 45 days’ notice other cards you have can also raise their rates on you for future purchases, even if you’re current on those payments. While anyone can call their credit card company individually and request a lower interest rate, that’s unlikely to work, experts say.

That’s why those with high-interest debt from multiple creditors will likely need to seek outside help to pay them down, experts say. That help could come from a financial adviser, a debt management firm, or even a bankruptcy attorney.

Many experts advise against using brokerage or retirement accounts to pay down debt, as Millstone’s client was tempted to do. Not only will you lose hard-won savings, but you’ll also miss out on any gains that money might have made in the stock market, compromising your retirement security. What’s more, outside of certain specific circumstances — and simply running out of money doesn’t count — you’ll have to pay a tax penalty if you withdraw money from a 401(k) or IRA before age 59.5.

Experts also dislike this approach because it doesn’t impose any discipline or change behavior. Before he went into a debt management program, Unverzagt paid off about $28,000 in credit card debt with a home-equity loan. “That was a huge mistake,” he said. Soon enough, he resumed his old habits and racked up new debt.

Nonprofit credit counseling

Nonprofit credit counseling firms work out a payment plan for strapped consumers, negotiating with creditors on their behalf. These negotiations involve reducing interest rates — for example, a 29% rate could become 7% or 8%. Consumers can find a program near them through the National Foundation for Credit Counseling .

Under these debt management programs, debtors typically pay off their debts in full over a period of five years. Many advisers said their average client has $10,000 in debt. Participants make one payment to the credit-counseling agency each month, instead of payments to their individual creditors.

Most debt management programs require participants to be employed, since a regular income is key to making the monthly payments. Agencies charge a modest monthly fee, usually between $15 and $50, for their services.

Unverzagt turned to a debt management firm for help tackling his debt. He paid to the agency some $650 a month for nearly 5 years, rounding that amount up by an additional $10 or more whenever possible. He agreed to cut up his credit cards for the duration of the program.

Unverzagt asked to receive a portion of his paycheck in cash and used that to pay for groceries, gas and other necessities. Cash payments help the spending feel more real and are also easier to track than debit-card purchases. His family stopped eating out, carpooled, and bartered services with friends and neighbors.

The approach required discipline but didn’t feel like a huge sacrifice, Unverzagt said. “I had to learn how not to go into Best Buy all the time,” he said. He also learned to plow his annual tax refund into an emergency savings fund, instead of spending it on vacations and other fun purchases. He put the emergency fund into a separate savings account so he wouldn’t feel tempted to tap it for everyday needs.

At the end of the five years, the family celebrated their achievement by making jambalaya with shrimp, a small luxury they never allowed themselves in their lean times. Unverzagt does not use credit cards now. “I never want to go back to that,” he said.

Debt settlement

Debt settlement firms are for-profit operations that offer to help consumers settle their debts for less than they owe. Their process is essentially a high-stakes game of chicken: debt settlement programs generally require consumers to stop paying their bills and allow their debt to go into delinquency and then eventually default.

Instead of paying their creditors, consumers pay the debt settlement firm a monthly amount that gets put into an escrow account. The idea is to make creditors think they’ll wind up with nothing, so that when the debt settlement firm offers them something, they’re more likely to accept it.

The Federal Trade Commission has brought numerous enforcement actions against debt settlement firms and has warned consumers to be wary when selecting one. Beware: Some debt settlement firms will ask for upfront fees before settling any debts, a practice that is against the law.

What’s more, the commission warned that many consumers don’t complete these programs, thus paying fees without reaping any rewards. Even for those who had one or more debts settled, they saved $58.1 million in aggregate but paid $55.6 million in fees, nearly canceling out their savings, according to an analysis of industry data by the New York City Bar Association.

To the extent that consumers eliminate debt through a debt settlement firm, they may owe Uncle Sam on the amount. The IRS usually considers forgiven, canceled and discharged debt to be taxable income. Consumers will receive a 1099-C form in the mail for all applicable debt and will have to report the amount in their gross income unless they meet strict criteria for an exclusion or exception such as being insolvent.

Debt settlement firms often sell themselves as a less-traumatic alternative to bankruptcy, but they make no guarantees.

Debt settlement firms don’t require participants to be employed, so they are an option for those who wouldn’t qualify for a nonprofit debt management. To research firms, consumers can check with their state attorney general to see if there have been any complaints brought against the company and also consult the Better Business Bureau. A simple Google or Yelp search will also turn up reviews.

Members of the American Fair Credit Council, a trade organization representing debt settlement firms, must agree to the council’s code of conduct, which include complying with all applicable state and federal laws, conducting services in good faith, and charging “fair and reasonable” fees.

Bankruptcy

Bankruptcy is the end of the line when it comes to debt elimination, but it’s not the end of the world for consumers who file. Those who end up filing for bankruptcy often would have benefited from doing so earlier, bankruptcy attorneys say.

It’s best to consult a lawyer after just a few months of struggling to pay for basic expenses, said Ike Shulman, an attorney in San Jose, Calif. and the co-founder and first president of the National Association of Consumer Bankruptcy Attorneys.

Many lawyers offer a free initial consultation, so consumers can use that to learn more about the option. Ideally, you should investigate bankruptcy at the same time as you’re exploring other debt-reduction options, such as a debt management program, Shulman said.

This doesn’t mean that you should necessarily proceed directly to bankruptcy. It just means that you’ll understand your range of options upfront and the impact each will have on your life and finances.

Consumers who ultimately file for bankruptcy have often been struggling and juggling debts for at least six months to a year, Shulman said. Many have liquidated their retirement accounts in an effort to honor their obligations and stay above water. Generally, 401(k) and IRA assets are protected in bankruptcy, so those who file having already dipped into or depleted their account have unnecessarily compromised their future security.

There are two different types of personal bankruptcy, Chapter 13 and Chapter 7, and each has pros and cons. Chapter 13 allows those with regular income to repay debts over three to five years. This process allows debtors behind on their mortgage to keep the house and catch up on payments over time.

Conversely, Chapter 7 wipes out all eligible debt, such as credit card balances. (Generally, alimony, child support and student loans cannot be discharged.) Those without regular income must file Chapter 7, which typically takes about three months to complete, Shulman said. Unlike Chapter 13, which allows debtors to catch up on their late mortgage payments, filing for Chapter 7 doesn’t stop a foreclosure.

Filing for both kinds of bankruptcy stops collections calls, lawsuits and wage garnishments that creditors might have established. The process provides a court-supervised way for debtors to get a handle on an overwhelming situation.

That said, filing for bankruptcy shouldn’t be taken lightly. Bankruptcy stays on filers’ credit report for up to 10 years, and this black mark can hinder your ability to secure a home lease or a job. On the upside, your credit score can recover quicker than that, often within just a few years.

The bankruptcy process itself can cost thousands of dollars in attorneys’ fees and hundreds of dollars in court filing fees. Lawyers generally ask for payment upfront in Chapter 7 filings, whereas in Chapter 13 attorney’s fees are built into the payment plan.

Practical and financial costs aside, sometimes bankruptcy represents the best way for strapped consumers to achieve a fresh start after years of stress and struggle. “The emotional release is enormous,” Shulman said. “It’s almost tangible.”