Episode 255: February 21, 2012
Debt Loans Credit
by Laura Adams
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This is the second in a two-part series about how to get out of debt faster. Part one gave you 5 tactics to reduce the interest rates on your debt so you can make lower monthly payments and use the savings to pay down balances ahead of schedule.
In this segment, I’ll cover another major strategy: Reducing your principal, or the actual amount of debt that you owe.
Use Assets to Pay Down Debt
The easiest way to reduce your debt is to pay it down using cash savings. I realize that most people don’t have a big stash of excess cash lying around. But think about what assets you own—like investments, cars, boats, equipment, or jewelry—that you could sell to raise cash.
Paying off a debt that’s charging you 20% interest is just like finding an investment with a guaranteed 20% rate of return that’s tax free! In other words, parting with your cash to get rid of expensive debt is a smart financial move.
However, don’t use every penny of your cash to eliminate debt. It’s still important to keep a reasonable cash cushion that would keep you safe in an emergency. Additionally, never take an early withdrawal or borrow from a 401(k) or IRA to pay off debt. The benefits you give up and the penalties you have to pay when you tinker with a retirement account are just too high.
Use Biweekly Payments to Pay Down Debt
Many people want to know if it’s smart to get rid of their home mortgage as soon as possible. Since mortgages have relatively low interest rates and come with a tax deduction, they’re the last debt you should pay off. For more on this topic be sure to read or listen to Whether to Invest or Pay Down Debt.
However, if you want to whittle down your mortgage balance faster, here’s a clever way to do it: Pay one half of your monthly mortgage payment every other week or biweekly. There are 52 weeks in a year, so you’d make 26 half payments. That’s the equivalent of making 13 full payments in a year, instead of 12. Making biweekly payments is a really easy way to get one extra monthly payment made each year, especially if you get paid every other week.
If you have a 30-year, $200,000 mortgage with a 5% interest rate, making biweekly payments could save you close to $35,000 and allow you to pay it off 5 years ahead of schedule! Enter your loan information into the BiWeekly Payment Calculator at dinkytown.com to see the difference biweekly payments could make for you.
By the way, this tactic works for any kind of installment loan, not just mortgages. Just make sure that your loan doesn’t include a prepayment penalty for paying it down early. And watch your statements carefully to make sure that the lender applies your biweekly payments correctly.
How to Settle Debt for Less
Another way to reduce your debt is to settle it for a lower amount. This is a common tactic if you’re already behind on unsecured debts, like credit cards or medical bills.
To settle a debt, contact the lender or collections agency and ask to speak to the accounts receivable or collections department. Never hide from a creditor when you’re having financial troubles. You’ll get much more favorable treatment if you’re honest about your situation and express a willingness to find win-win solutions.
If you have cash to pay a lump sum amount, that’s a powerful negotiating tool. Offer to pay 25% of the full debt—perhaps they’ll meet you in the middle at 50% of what you currently owe. Many creditors would rather get half your debt in cash, rather than risk getting nothing down the road—especially if your debt is old.
Should You Use an Attorney?
Many creditors would rather get half your debt in cash, rather than risk getting nothing down the road—especially if your debt is old.
If you don’t feel comfortable negotiating a debt settlement on your own, there are professionals who can help. An attorney can facilitate a negotiation, help you understand the best options for dealing with debt in the state where you live, and keep a creditor from harassing you or engaging in illegal collections practices.
Should You Use a Credit Counselor?
Some credit counseling agencies can reduce your debts through a formal agreement with your creditors called a debt management plan. The idea is that the agency negotiates lower payments on your behalf and then you send the agency one monthly payment that they distribute to your creditors according to the prearranged schedule.
There have been scams and fraud associated with some credit and debt organizations, so don’t send any money to an agency until you know they’re legit. To find one that’s reputable, do your homework and make sure they’re approved or certified by one or more of the following organizations:
To further protect yourself, always confirm a debt management plan directly with your creditors. Also, track the balances on your bills carefully so you know if the agency is sending the right amounts to your debts each month.
The fees charged by attorneys, credit counselors, and debt arbitrators vary widely, so always ask to see a written list of their services and prices. In many cases you can do exactly what they do for free—but you have to be the judge.
Is Cancelled Debt Taxable?
If you or a professional is successful in settling any amount of your debt, remember that cancelled or forgiven debt is generally considered taxable income. Expect to receive a Form 1099-C at the end of the year to use when filing your tax return.
However, you can avoid paying the tax if you were insolvent at the time of the debt cancellation. Insolvency means that your total debts are more than the fair market value of your total assets. Many people who are likely to meet an insolvency exemption don’t know it and they end up paying too much tax.
If you’re not sure if you qualify for insolvency or think you overpaid tax on canceled debt in any of the 3 previous tax years and may qualify for a refund, be sure to consult with a tax accountant.
There’s also a temporary exception for mortgage debt that’s forgiven from 2007 through 2012. Read What You Need to Know About Forgiven Debt and Taxes for more information.
Who Will Benefit from the Mortgage Settlement?
If you’re struggling to pay a mortgage or have had your home foreclosed, you may qualify for relief under the new $25 billion national mortgage settlement. The money will help borrowers who suffered a wrongful foreclosure or who have existing loans with participating banks.
This is the largest multistate settlement since the tobacco deal back in 1998. To find out if you’re eligible for a payout or if your existing home loan will be affected, visit nationalmortgagesettlement.com.
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