Yes, you may not have to pay all your debt, but you may regret it
By Sally Herigstad
To Her Credit
Sally Herigstad is a certified public accountant and the author of "Help! I Can't Pay My Bills: Surviving a Financial Crisis" (St. Martin's Press, 2006).
Dear To Her Credit,
My husband owes Lowe's $10,800, mostly from building our
deck and remodeling the bathroom. Because of some recent setbacks, we've been
falling behind on our credit card payments. As of next month we'll be two
months behind on our Lowe's card.
We just received a large sum of money. We hope to use it to clear
as many of our debts as possible.
My husband called Lowe's to see what the bottom line for
payoff would be, and they easily offered that on our payment due date next
month it will be $7,600. If we settle for that, how will it affect our credit? We sure like the savings as it will allow us to pay another
creditor as well. -- Bonnie
Dear Bonnie,
Before you jump at the chance to save $3,200, think about
what settling your debt for less than what you owe will end up costing you.
Your credit score will certainly take a hit if your credit
report shows your Lowe's account as "settled" instead of "paid."
The more creditors it shows you settled with, the worse it looks.
It only makes sense -- you spent $10,000, you get to keep
the new deck and remodeled bathroom, but Lowe's gets to take a $3,000 loss. The
purpose of a credit history is so potential creditors have some idea what to
expect when they deal with you. It's like a Better Business Bureau in reverse.
Imagine you are thinking about buying something from a local
business, but you check it out with the Better Business Bureau and notice --
whoa -- this business has a history of not keeping its promises! You'd probably
go elsewhere.
Banks do the same thing with credit applications. The
difference is they may still extend credit to you after they see you settled a
debt in the past. You just won't get the preferred interest rate. You'll pay
more -- possibly much more. You could spend a lot more in higher interest
expense than you saved by settling with Lowe's.
Even worse, if you buy or refinance a house in the near
future, having a settlement on your credit history could cause banks to offer
you a higher rate on your mortgage. Every additional percentage point
dramatically increases the amount of interest you pay over the life of the
loan.
You could ask Lowe's to mark the account as "paid"
instead of "settled" on your credit report. You should be aware,
however, that you are asking them to lie on your behalf. Lowe's is under no
obligation to put anything but the truth on your report.
I see one more problem with taking 100 percent of the money
your husband received and using it to pay off debts. You apparently don't have
a financial cushion, or you wouldn't be behind in your payments. If you use all
the money to settle your debts, you still have nothing to fall back on. The
next unexpected expense or dip in income that comes along, and you go into debt
to pay bills again. It's a frustrating cycle of going deeper into debt and
trying to get back out again and again.
The only way to break that cycle is to start planning ahead.
Try to build up a reserve equal to six or nine months' living expenses, as well
as a savings plan for future projects, trips or luxuries.
Lastly, you'll get an unpleasant surprise at tax time if you
settle your debt. That $3,200 is likely taxable income that could bump up your taxes
due by $800 or more.
Here's what I recommend:
Skip the settlement.
Instead, take about half of the money you've received and start paying down
your debts. Put the most money on the accounts with the highest interest rates
first. If two accounts have the same rate, pay the smallest account off first.
With the accounts paid down considerably, your monthly minimum payments will be
smaller, making life easier.
Put the rest of the
money into savings. Add to it faithfully. Even putting $25 into savings
every month gives you a sense of control.
Beware of short-term fixes. The money you and your husband
have received can help you get a new
start by lowering your debt and giving your savings plan a head start. That may
not be as immediately gratifying as wiping all your debt out at once. But if it
helps you and your husband start practicing good financial habits, it will help
put you in control of your finances for the rest of your life.
Sally Herigstad writes about women and credit every week for CreditCards.com. Herigstad is a writer and finance consultant for MSN Money, a personal finance software product. She is also a member of the Washington Society of Certified Public Accountants and the American Institute of Certified Public Accountants. Her Web site is http://helpicantpaymybills.net. Sally Herigstad lives in Kent, Wash., with her husband Gary. They have two grown children, Valia and Grant.
To Her Credit answers a question about a debt or credit issue from a CreditCards.com reader each week.
Send your question to Sally.
Best use for inheritance: pay debt or create savings? – A reader inherited some money and is on a mission to be debt free, but wonders whether it wouldn't be smarter to put that cash toward retirement instead ...
Protecting the elderly from credit card collectors – Credit cards and their associated terms and conditions can get very confusing for the elderly who also suffer from dementia. Here's what you can do to help ...
Did you like this story? Then sign up for CreditCards.com’s weekly e-newsletter for the latest news, advice, articles and tips. It's FREE. Once a week you will receive the top credit card industry news in your inbox. Sign up now!
RSS news feeds