Live Debt-Free

Steve and Lucille Martin's personal finances looked immaculate. They carried no credit-card debt, had just five years left on their 30-year fixed-rate mortgage and invested the maximum in their retirement-savings plans. If they wanted something, they saved for it.

The Middlebury, Ind., couple covered daughter Erica's first two years of college and felt financially secure enough for Lucille to quit work temporarily to attend grad school for ten months.

But they weren't prepared for what happened next. As a senior vice-president of a financial-services company, Steve was on the executive committee that created his company's downsizing plan. Then he learned he was one of the downsized, out of a job at age 54. Now the family must deal with what they least expected: a growing pile of debt.

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The squeeze is on. About four in five middle-class Americans say maintaining their standard of living is tougher than it was five years ago, according to a Pew Research Center survey. AARP reports that one-fourth of baby-boomers are taking money out of their 401(k)s and other retirement investments before they had planned to.

And debt problems have started dragging down families, like the Martins, who thought they were crisis-proof. Says Suzanne Boas, president of the Consumer Credit Counseling Service of Atlanta: "We are hearing now from more people with higher incomes who want budget and credit counseling -- people solidly in the middle class."

Often it takes just one misfortune to trigger a debt crisis, such as the loss of a job, an unexpected medical bill or a mortgage issue. Here's how these increasingly common events pushed families into debt, what they're doing to climb out and how you can prepare in case it happens to you.

Losing a Job

The Martins' family finances suffered another blow that's become all-too-common recently: tightening of home-equity lines of credit. For ten years they'd had a $25,000 line that they rarely tapped and always paid off quickly.

With Erica and Lucille both going to school, they asked to raise the borrowing limit, but their lender refused because the value of their home had dropped by 20%. After closing that credit line and reapplying (and paying about $1,000 in fees), they finally got their line of credit bumped up to $36,000. But that is a lot less than they were expecting, and the Martins had to scramble to find student loans.

While he's considered an expert on the serious financial issues facing the average American, Steve says he's now experiencing "what many are facing in these difficult economic times. It's been very humbling to go from teacher to student."

What could they have done differently? While their retirement savings are impressive, they can't tap them now without penalty until they're 59. By channeling some of those savings into an emergency fund, they could have built a bigger cushion to get them through tough times.

In the short term, Steve is trying to stretch his eight months of severance pay as far as it will go. "We immediately thought about where we can cut back," he says. They stopped eating out and carefully plan trips and errands from their small town in northern Indiana to minimize gas costs.

Long term, Steve expects that he and Lucille may need to work past age 65 to catch up on retirement savings. But they're taking this opportunity to switch to their dream jobs. He's thinking about starting his own management-consulting business. She'll be a landscape designer when her year of schooling is finished. In their new careers, they think work will be a pleasure. "We could easily work for another 15 to 20 years, especially if we retool into careers with time flexibility," says Steve.

But he wishes he had planned for more contingencies. "So many people leave no margin for error," he says. "I recommend having a plan for living on 30% less income. That, hopefully, will help you prepare for uncertainty."

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Medical Emergencies

Even a minor emergency can send you over the financial edge if you're already spending most of your earnings.

Jennifer and Brooke Raser, now 36 and 42, had a harder time paying the bills when Jennifer took unpaid maternity leave from her job as a special-education teacher to care for son Lee in 2006. But complications from the birth of another son, Kenny, just one year later, are what landed them in trouble. The Rasers incurred a big hospital bill their insurance didn't cover, in addition to losing Jennifer's income during a second maternity leave.

And soon after Jennifer returned to work, Brooke needed back surgery. A commission-based car salesman, Brooke didn't get paid while he was recovering. Even after he returned to work at an auto dealership in Wheatland, Wyo., his paycheck wasn't what it used to be. The shop has been hurt by high gas prices, which discourage customers from driving to a rural town for service.

The Rasers charged everyday expenses on their credit cards, ending up with $9,500 in debt on four cards. After racking up late fees and interest charges as high as 24%, they finally went to ClearPoint Financial Solutions, a credit-counseling agency, for help. They should have gone sooner, they admit, but "it's a pride thing," says Jennifer. "It's not easy to call someone and say you can't make your payments."

The agency brought them relief. It negotiated with the card companies to drop the Rasers' late fees, lower their interest rates to about 9% and stop hounding them for payments. Now, the Rasers make one fixed payment every month, which ClearPoint distributes to the lenders. The agency also helped the Rasers create a budget.

You can call your lenders and ask for reduced interest rates yourself, which may be effective if you have a good credit history. (See www.debtsmart.com for advice on how to go about lowering your own rate.)

The Rasers also picked up extra income and slashed their expenses. Jennifer taught summer school this year, and Brooke started an auto-glass side business. And they found a new day-care provider, which saves them $600 a month. They cut their gasoline expenses by shopping online rather than driving 70 miles to Cheyenne, the nearest major town.

The couple say they feel as if they've turned a big corner. Says Jennifer: "It's gotten better, but those two years were harrowing." In another two years, they'll finally finish paying off their credit cards, they won't have to pay for diapers, and their day-care expenses will disappear when the boys start school. "A lot of it is just because of the time in our lives," says Jennifer, who wishes they had saved more money in advance for those extra expenses that come with the baby years.

And the future looks bright. She's about to finish grad school, paid for by the school system, which will boost her income. Also, Brooke's auto-glass business has grown large enough that he works at it full-time, a move made possible by having their debt under control. They hope to earn more money from his business, but they also value the flexibility Brooke's self-employment provides. "Ultimately, it's more family time that you can't put a price on," Jennifer says.

Shrinking Home Values

Homeowners who can't afford their rising adjustable-rate mortgages may be the biggest headline of the housing crisis. But another issue is people who are falling further into debt because they can't sell a house.

A San Diego family in that situation recently came to June Walbert, a financial planner for USAA. The family had bought a bigger house in the midst of the housing boom because they worried that they'd never be able to afford a larger house if they waited. Instead of selling their old house, they rented it out in hopes it would continue to appreciate. The rent arrived on time for two years, but then hard times hit their tenant, and the payments stopped a few months ago.

Housing values in San Diego had already plummeted by that time, flooding the rental market with other homes and making it tough to earn the same rental income, which they'd been counting on to afford their bigger house. The family put the small house on the market but had no luck selling it. So Walbert recommended a switcheroo: "My advice was to go back to the house they knew they could afford, and that they were quite comfortable in, and sell the bigger house."

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Walbert says that building an emergency fund for their original house before they started renting it would have been a smart move. Then, if it wasn't rented out 100% of the time, "they could still afford its mortgage payment without throwing their finances into a tailspin."

Home-sale troubles can become much worse after you've retired and don't have an income to pay your way out of problems. Many seniors took out a mortgage in retirement and moved to their dream home at exactly the same time that their investments took a hit and inflation ratcheted up everyday expenses. "We are seeing more retirees and seniors with considerable debt," says Todd Mark, of the Consumer Credit Counseling Service of Dallas. Some even start charging day-to-day expenses on their credit cards, which creates a dangerous debt spiral.

Kirk and Judy Lauter, ages 70 and 65, landed in debt because of the housing slump. But because they planned carefully for the potential problem, they've minimized the impact on their retirement savings.

The Lauters had spent the past several years splitting their time between two homes: a house in Stuart, Fla., and a duplex in Brevard, N.C. They got tired of the double life and met with financial planners Steven Swindler and Stephen Schramm to talk about their options. The advisers recommended that they sell their Florida house in June 2007 rather than wait. The market hadn't tanked yet, and even though they had to drop the price once, they ended up making a profit on the sale.

Because they'd be living in North Carolina for the full year, the Lauters wanted to move out of their duplex and into a larger, stand-alone house. After eight months on the market, their duplex still hadn't sold. In August, the Lauters went ahead and bought a new house, which they could afford because they had paid off the mortgage on their duplex -- a move that gives retirees a lot more flexibility.

The Lauters then faced a decision common to people who own a home that won't sell and who are looking to buy another: how to finance the purchase. The Lauters, for example, didn't want a long-term mortgage on their new house, but they couldn't afford to pay the full amount until their duplex sold.

Schramm and Swindler looked into several sources for a bridge loan. Two options were getting a home-equity line of credit on their old home or taking a margin loan on their investments. The margin loan had a slightly lower interest rate but would have created too much risk for the retirees. Instead, their high credit scores and equity in their house made them eligible for a low-interest home-equity line of credit, which they'll pay off when they finally sell the old house.

This worked for the Lauters, but don't count on a home-equity line of credit for a down payment these days. That strategy has left some home buyers scrambling over the past few months, as lenders have cut back credit lines even for borrowers with the best credit.

Even though they have the credit line and hope their duplex sells eventually, the Lauters know the housing market may not recover soon. They also know that maintaining a house is about more than just making loan payments; it includes insurance, taxes and maintenance costs, which eat into savings. "You have to face reality," says Judy, even if it means selling your house for less than you think it's worth.

Divorce

Failing to downsize after divorce often means falling into debt. Says Stacy Francis, a New York financial planner who specializes in divorce situations: "Many people don't have a good grasp of what their expenses will be after a divorce, and with less money coming in, they turn to credit cards."

Stan Lloyd of Fair Oaks, Cal., fell into that trap. During his separation and after his divorce in 2005, Lloyd racked up $23,000 in credit-card debt. He admits his former wife was the frugal one and that his bad money habits were masked when they were together. Not only did they reveal themselves when he was on his own, but he also took a hit when he changed careers and traded in his pastor's salary to manage a Starbucks.

With less income and the same lifestyle, trouble was inevitable. But Lloyd, 53, admits he was in denial and couldn't keep up with payments. "Creditors were calling me and I dreaded answering my phone," he says. "I needed help."

He turned to ClearPoint, which negotiated the rates on six of his seven accounts, bringing them down by more than half in some cases. He's chipped away $7,600 in a little over a year, and in four years, he'll be out of debt completely.

Downsizing after a divorce often means biting the bullet and making some big lifestyle changes. If you got the house in the settlement and you're struggling with the mortgage, rent out a room or sell the house. When it comes to spending, recognize that living your old lifestyle may not be possible on one salary.

But what if the debt isn't just your own? A lot of couples have shared debt when they break up, and untangling it can be difficult. Francis cautions, "A lot of people think that because they've called it quits with a spouse, the credit-card companies see it the same way." But your credit will be tied to your ex-spouse until you close all of those joint accounts. Be sure to transfer the balances to new credit cards to avoid being on the hook for new debts your ex incurs.

Canceling joint cards is even more important if the solution to dividing the debt in a settlement is that one party will take the debt, but also more of the assets. "If you gave up assets and end up responsible for debt the other person didn't pay, you come up the loser twice," says John Ventura, coauthor of Divorce for Dummies (For Dummies, $20).

Housing debt works the same way. If your ex is keeping the home and giving you assets in exchange for equity, don't let your name be taken off the title without getting it off the mortgage. The person staying in the home should refinance in his or her name, so you're not responsible if the former spouse becomes delinquent.