Debt Settlement

Should You Pay Off Debt or Settle It? What’s Better?

What should you do if you find yourself in the red? Pay off debt or settle it? The answer to that depends on your circumstances. Consider the following scenarios:

Barbara carries a credit card balance of about $4000. She cannot afford to put any money into savings each month, but she is slowly chipping away at her credit card balance.

John and Mary have a credit card balance of $10,000, which is spread over 3 credit cards. Though they pay more than the minimum payment on each of their cards, they cannot seem to make any headway with reducing their principle credit card balance.

Jillian carries a small balance on her credit card each month. It varies from $100 to $500 and has never been more than that. She is able to put some money aside each month into a savings account, and she dabbles a bit with investing.

Looking at each of these scenarios, it is clear that debt and its consequences vary. For this reason, appropriate ways to handle debt can vary as well.

When should you pay off your debt?

The answer to this question depends on the type of debt you are carrying. For instance, if you have purchased a home and are making regular mortgage payments, that is considered to be “good debt”. Why? Because home values typically appreciate in time, your current debt is actually an investment in your future financial well-being. Similarly, student loan debt may fall into the good debt category because it can represent an investment in your future.

However, not all debt can be considered “good”. For instance, carrying a large credit card balance is considered bad debt, especially when the interest rates are high. Additionally, things like gambling debt, payday loan debt, and rent-to-own debt are all considered bad debt because they do nothing to improve your financial standing. Rather, they tend to put a real ding in your credit score. What does all this mean? Simply put, when you are thinking about whether to pay off debt, take into account the type of debt you have. Whenever possible, pay off anything that can be considered as bad debt and then start chipping away at any other debt you have.

Should you pay off debt, save for an emergency fund or retirement, or pursue investments?

In a perfect world, you would have enough income each month to handle all your necessities, and pay off any outstanding debts. However, the world is far from perfect for most consumers.

Research indicates that 42 percent of American credit card holders carry a balance (source), meaning that they do not pay off their credit card amount in full each month. In total, American revolving debt currently amounts to $953.3 billion (source). That is a lot of debt.

So, should you be concentrating on paying debt or building up savings? Both goals are noble and both goals can lead to financial success.

The advantages of paying off your debts include:

    • Saving on interest costs.
    • Building a solid credit score.
  • Eliminating constant anxiety about burdensome bills.

On the other hand, building up a savings fund results in other advantages, including:

    • Having readily available funds for emergencies.
    • Reaching long-term financial goals like buying a home or retiring.
  • Protection from the prospect of debt.

To make the most of your financial opportunities, it is a wise course to work on both paying off debt and putting some money away for the future. Determining when to funnel your money to paying debt and when to start saving depends on which course of action will net the most benefit for your personal situation.

For instance, if the interest rate you are paying on outstanding debt exceeds the interest rate you can earn on money you save, the better option may be to pay off your debt first. Then, set aside some savings.

Even if you decide to pay off your debts before investing strongly in savings, you might want to consider building up a small emergency fund of $500 to $1,000 first.

What are some debt payment strategies?

Once you commit to paying off your debts, there are several strategies to help you get to a debt-free status. Here are some of the more popular ways to reduce or eliminate your debt:

Pay more than the minimum amount due

If your credit card debt is not exceedingly high, you might find that simply paying more each month reduces your debt more quickly than you might think. To illustrate, consider this scenario:

Suppose you owe $5,000 on a card with a 15 percent interest rate. Paying a minimum payment of $112.50 per month, it will take you over 22 years to pay off your debt and cost you over $5,700 in interest alone. However, if you make payments of $225.00 per month instead, you will shave off 12 years and over $3,500.00 in interest. If you can pay $300 per month, you can cut that time to a little over 6 years and reduce your interest to just a little over $1,200. By paying a bit extra, you can save a lot of time and money.

Create an avalanche

If you have a number of credit cards with different interest rates, you can prioritize the way you pay them from highest rate to lowest rate. For this method, you pay the minimum payment due on each of your cards and put any extra payments you have toward the card with the highest rate. When that card is completely paid, you proceed to the next card and so on, until all cards are paid. This method works because by the end of process, you will have paid a lesser amount of interest overall.

Try for a snowball

Another method that works if you like to see more immediate results is the snowball method. With this strategy, you choose to pay off the card with the smallest balance and pay only the minimum amount due to your other cards. Once the small balance card is paid off, you proceed to the next card in order until all cards are paid in full. This method works because achieving small successes encourages you to stick with your repayment plan over time.

Negotiate for a better rate

If your credit is good and you are not currently delinquent with your payments, it may be possible to negotiate a better interest rate with your credit card company. Sometimes a simple phone call explaining your situation will yield surprising results. Many credit card companies are willing to reduce your rate in hopes that this accommodation will keep you from defaulting on your debt.

Can you consolidate your debt with a balance transfer credit card?

If you have good credit, you may find it possible to consolidate your debt onto one credit card with a lower interest rate. If you choose this option, look for a card with a 0-percent introductory interest rate that is valid for at least 12 months. During the introductory period, make payments of as much as you can afford in order to maximize the benefit of a no-interest card.

Consider this before consolidating your debt with a loan.

  • First, there is typically a balance transfer fee. So, even a 0-percent interest rate is not truly free.
  • Second, applying for a new credit card may reduce your credit score a bit. If you can find a credit card company that uses a “prequalified offer”, it is less likely that your credit score will be affected.
  • Third, applying for a new card may tempt you to overspend. For a balance transfer card to really work, you need to commit to using it only to consolidate other higher interest rate cards and end any spending habits that make you accumulate new debt.

Should you consolidate your debt with a debt consolidation loan?

In some cases, you may find that a debt consolidation loan is a reasonable option for getting out of debt. For instance, if you find that you are not making much headway with increasing your monthly credit card payments, a debt consolidation loan can put you on a more level playing field. Or, if you have several different kinds of unsecured debt like medical bills, unsecured personal loans, and credit card debt, a debt consolidation loan may make it easier by allowing you to pay one bill per month rather than several.

There are a few factors to consider before you get a debt consolidation loan.

First, you must decide whether you are willing to put up collateral for your loan or whether you prefer an unsecured loan option. Putting up collateral like your home may help you get a lower interest rate, but it can also put your home at risk.

On the other hand, an unsecured personal debt consolidation loan may have a higher interest rate than you want to pay. Before making a final decision, it is important to crunch the numbers and be sure that a loan will get you out of debt more quickly and easily than simply paying your bills as they are now.

When should you consider debt settlement and what are the pros and cons of debt settlement?

Take an honest look at your current level of debt. If you determine you won’t be able to repay your debt within a reasonable amount of time, consider debt settlement as an option.

Debt settlement is a process in which you offer your creditor less than what you owe to pay your debt in full. In many cases, working with a debt settlement company helps you to negotiate with your creditors to reduce the principal balance that you owe.

Here are a couple of things to consider when looking for a debt settlement company.

Do they have minimum and maximum limits on the amount of debt you can enroll?

Most companies require you to have a minimum amount of debt, which is usually around $10,000. Some lenders, such as Freedom Debt Relief, accept lower amounts. Other companies also have a maximum amount of debt you can enroll, such as $100,000. You will need to find a company with requirements that match your needs.

What is their customer service like?

We typically don’t care about the customer service of a company until we run into problems or have questions. It is important to find out ahead of time about the level and quality of support provided by a company. You can do so by researching the support channels they offer (phone, email, live chat, etc.) and by reading reviews from past customers. Look for companies like Debtmerica Relief and Rescue One Financial which are recommended by our community of users. Other debt settlement firms to consider are Pacific Debt and National Debt Relief.

Benefits of a debt settlement

Advantages of debt settlement are clear. If your creditors agree to negotiate, you may end up reducing the amount you owe by 30 to 50 percent. This means that you will get out of debt faster. In the meantime, your single payment will be easier to manage and your budget will appreciate the extra wiggle room.

Disadvantages of a debt settlement

However, there are disadvantages as well. Debt settlement can have a significant effect on your credit score. When you settle a debt, your creditors will likely report that account to the credit bureaus as “settled for less than agreed” or “settlement accepted”. This drops your credit score like a stone, and the effects of debt settlement on your credit score can last up to seven years.

For this reason, debt settlement is to be considered as an option only for people with overwhelming debt who cannot qualify for reasonable loan rates or re-negotiate more favorable terms with their creditors.

If that is your situation, it is important to find a reputable debt settlement company to handle the matter. You can check out SuperMoney’s unbiased reviews here.