Escape the Debt Trap

It seems like only yesterday that debt was in vogue and saving for any purchase, big or small, was strictly optional. You could buy a home with no money down and watch the equity grow before your eyes. Credit card debt? Just pay it off with a home-equity line of credit made possible by magically expanding real estate values. Student loans? No worries—that’s “good” debt.

The recession and plummeting home prices put the kibosh on debt indulgence. Consumers, with prodding from credit-stingy lenders, have put themselves on a debt diet. Even so, debt levels, at about 115% of disposable income, are almost as high today as they were during the debt-crazed aughts. Many families are still trapped in a cycle of paying the minimum on credit cards without making a dent in principal. One-fifth of U.S. homeowners are underwater on their mortgage—meaning the value of their home is less than the amount they owe. And for many families, job loss, which often means a loss of health insurance, has led to a mountain of medical bills or a spike in credit card debt.

If you have too much debt—or you simply want to whittle down what you owe—try these strategies.

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Credit cards

Just over a year ago, Sue and Jerry Bailey of Jackson, Mich., accomplished a daunting mission: paying off $92,000 in credit card debt. The Baileys had amassed the debt using 17 cards over a few years. “We bought things for the house. Our two daughters had weddings, and I like to buy things for my grandkids. We had a car with engine problems. Things piled up,” says Sue.

“It was so easy to get credit cards at the time,” adds Jerry. “It was spread out over so many cards that no one card was overwhelming. But together, they were staggering.”

The Baileys signed up for a debt-management program in 2005 with GreenPath, a nonprofit debt-counseling serv­ice, which worked with their card companies to lower their interest rates and eliminate late and overlimit fees. The couple cut their expenses dramatically, including by selling a car, and took on additional work to boost their income. Finally, in October 2010, they paid off the last of their balances.

The best way to tackle crushing credit card debt is to lower your interest rate while you search for ways to boost your income and reduce expenses, then use the extra cash to accelerate the payoff. If you have balances on several cards, attack the highest-rate debt first. Or, you could get a psychological boost by starting with the smallest balance.

Credit card companies have stepped up offers for 0% interest on balance transfers for people with the best credit records. Eliminating the interest, even for a limited time, can help you pay off the debt much faster. For example, if you have a $10,000 balance at 18% and pay $350 a month, it will take 38 months to pay off the debt and cost $3,200 in interest. At 0% interest, you’ll pay off the balance almost one year earlier. Note that balance-transfer fees typically range from 3% to 5%.

Sheila Amparano of Lomita, Cal., ran up a $17,000 credit card balance in 2008 because of medical bills and new-home expenses. She started digging out when she jumped at a balance-transfer offer that reduced her interest rate from 14% to 3.99%. After her husband picked up extra work, they boosted their payments and finally paid off the card balance in September 2011. “Being free of credit card debt is very liberating,” she says. Now they’re using the $350 they had been paying on their card each month to increase their car payments.

Need extra help? A good credit-counseling agency can give you a free budget review and help you find ways to save. You can also sign up for a debt-management program to reduce your interest rates and eliminate late fees and over-limit charges. You can find a credit-counseling agency through the National Foundation for Credit Counseling or the Association of Independent Credit Counseling Agencies.

Mortgage

Many Americans are still house-poor—stuck with an outsize mortgage that seemed to make sense when home values were headed nowhere but up. To make the payments more manageable, refinancing to take advantage of the lowest rates ever is a good start.

If you owe more on your mortgage than you could sell your home for, refinancing may seem out of reach. But with the relaunch of the Home Affordable Refinance Program (HARP) in late 2011, you might qualify to trade in your mortgage. The new rules eliminate the 125% ceiling on the loan-to-value ratio (the amount of your mortgage divided by the market value of your home) for fixed-rate loans owned by Fannie Mae and Freddie Mac.

Before you throw everything you have at your mortgage, determine whether your situation will improve in six months to a year, says financial planner Cheryl Krueger, in Schaumburg, Ill. If not, consider other options. A nonprofit, full-service housing counseling agency approved by the Department of Housing and Urban Development can help sort out your situation and create a plan, says Mechel Glass, director of education for CredAbility, in Atlanta (find other agencies).

A short sale—selling your home with the lender’s approval for less than you owe on the mortgage—is another option. That’s what Angela Angelovic did. In 2005, near the peak of the real estate boom, Angelovic and her husband sold their home in California and moved the family to Destin, Fla. They used the proceeds of their home sale to buy a primary home as well as two rental properties and land. Until then, Angelovic says, they had perfect credit and paid cash for everything.

Then the real estate bubble burst and the economy tanked. The couple couldn’t command the rent they needed to cover the payments on their rentals, and the home-equity line of credit they tapped to cover the difference was frozen because of declining home values. They drew down their kids’ college funds. By the time the couple divorced, they had lost the land to foreclosure and the two rental properties to short sales. In September 2011, Angelovic and her ex agreed to a short sale of their family home, too, for $252,000—far less than the $455,000 they owed on their first mortgage and home-equity line of credit. Angelovic now lives in a rented cottage. She can’t get a credit card because the short sales and foreclosure torpedoed her credit, but she feels free and relieved.

If you pursue a short sale, look for an experienced real estate agent who knows local market values, is familiar with lenders and their short-sale process, and can zero in on patient buyers. Depending on your state’s law and your financial situation, lenders may try to continue collecting the balance of the mortgage left after the sale (a deficiency judgment), although most now realize that’s like trying to squeeze blood from a stone. In most cases, says Wendy Rulnick, an agent in Destin, Fla., who specializes in short sales, she has negotiated away the judgment. Mechel Glass of CredAbility says that you must get that agreement in writing.

Like a foreclosure, a short sale will adversely impact your credit record for seven years, but it may hit your credit score less hard than if you go through a lengthy period of late payments that ends in foreclosure. If the lender accepts the short sale proceeds to satisfy what you owe, the amount of canceled debt will be reported as taxable income to you (you’ll receive IRS Form 1099-C). However, special legislation in effect through 2012 waives the tax bill on up to $2 million of canceled debt if the mortgage was on your principal residence (you claim the exclusion on IRS Form 982). On the upside, you can get another mortgage (backed by Fannie Mae or Freddie Mac) within two to four years.

Student loans

Newly launched college grads in 2010 towed in their wake an average of $25,250 in student loans, according to the Project on Student Debt. The goal, ideally, is to repay the debt in the least amount of time to reduce the interest. How you do that depends on what you can afford and whether your loans are federal or private.

Many graduates with federal loans can’t afford the standard repayment plan of 120 equal payments over ten years, says Deanne Loonin, director of the Student Loan Borrower Assistance Project with the National Consumer Law Center, but you have other repayment options (see The Dark Side of Student Debt). Use the Department of Education’s online calculators to test various scenarios. If you have a Federal Family Education loan, you can switch your plan once a year; you can switch anytime with a Federal Direct loan.

You have much less flexibility with private loans, which often make up the largest portion of student-loan debt (because they have no loan limits) and carry higher, sometimes variable, interest rates. One strategy: Choose a payment plan to minimize your federal payments, then pay extra on your private loans (assuming your contract doesn’t impose a prepayment penalty) or your other debts, such as credit cards. Once you’ve conquered the more onerous debt, you can increase the payments on your federal loans (there’s no prepayment penalty).

Medical bills

The top reason cited for consumer bankruptcy is medical debt, which can leave you with thousands of dollars in unexpected expenses at the same time you’re worrying about your health.

Before you pay a medical bill, check for errors. Match your bill with your insurance company’s explanation of benefits to make sure you’re getting all the credit you should. With large hospital bills, you could shave thousands of dollars off the charges.

Next, try to negotiate. If you’re able to pay a lump sum right away, ask the provider or hospital for a break. Pat Pane, a medical claims specialist in Wilmington, N.C., usually starts by offering about 50%. If that doesn’t work, try to set up an interest-free monthly payment plan. Don’t wait too long to call the provider—many send bills to collection agencies after 90 days, which makes it much more difficult to negotiate.

Ask the hospital whether it offers any financial-aid programs. Also find out about other consumer-assistance programs available in your state. “Try to do this as quickly as possible,” says Cheryl Fish-Parcham, deputy director of health policy for Families USA, which offers a helpful publication titled Your Medical Bills: A Consumer Guide for Coping with Medical Debt.

When you file your taxes, you can deduct out-of-pocket medical expenses that exceed 7.5% of your adjusted gross income, and you may be able to take a particularly large deduction if you were unemployed or your income was cut during the year. See IRS Publication 502, Medical and Dental Expenses, for details.