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Video: Jean Chatzky’s guide to financial fitness

TODAY books
updated 1/4/2010 9:15:07 AM ET 2010-01-04T14:15:07

In her new book, “Money 911,” financial expert Jean Chatzky answers common money questions. In this excerpt, she writes about how to proceed with debt settlement and how it affects your credit score.

Chapter one: Debt

1. What is a debt settlement company? How do these companies work? How much do they charge? Should I use one to get rid of my credit card debt?

A: Debt settlement companies work as a middleman between you and your creditor. If all goes well (and that’s a big if), you should be able to settle your debts for cents on the dollar. You’ll also pay a fee to the debt settlement company, usually either a percentage of the total debt you have or a percentage of the total amount forgiven.

If you’d asked me a few years ago about debt settlement companies, I probably would have told you to avoid them. But things have changed a bit. The Bankruptcy Reform Act of 2005 made it harder for individuals to file bankruptcy, which is always the last resort. Unfortunately, simultaneously consumers racked up so much debt that counseling companies — which are higher up on my list if you need help managing your debt — are sometimes unable to help. So if you fall into this camp, debt settlement may be something to consider.

Here’s how it works: The debt settlement company will direct you to stop paying your creditor and instead send the money directly to them each month. The company’s goal is to demonstrate to your creditor that you don’t have the money to pay up — that’s your leverage. After a few months, the company will typically go to the creditor and say, “I’m holding X dollars on behalf of your customer. He doesn’t have the money to pay you, so you should take this amount as a settlement or you’ll end up with nothing.” If the creditor wants to get paid badly enough, it will take the money.

All of this sounds great, but there are negatives. For starters, during the three- to four-month stretch that you’re not paying your creditor, your account will accrue late fees and possibly even “over the limit” fees. Both of those fees add to the total debt and to the debt settlement company’s fee. Not paying your creditors can do a serious number on your credit score, and having a settlement on your credit history drags it down even further. If you start out in the high 600s, for example, your credit score could be well into the 400s by the time you’ve gone through debt settlement, especially if you settle more than one account.

And besides: You really don’t need to hire a debt settlement company to negotiate with your creditors. Unless you have multiple accounts that you need to negotiate and you think the project is just too big to tackle on your own, you’re better off just calling your creditors directly. For what to say, see the script included with the next question.

I also need to know ...

Q: How much is working with a debt settlement company likely to cost me?

A: To be honest, you might have trouble getting a straight-up answer to this question even from the debt settlement company itself, and if you do, that’s a reason to walk away. The best companies will charge a percentage, usually about 15%, of the amount of debt that they’re able to settle for you. Others may charge 15% of the total debt you have when you enter the program. If the fee is calculated this way, not only are you paying too much but you’re also not holding the company accountable to get you the best results.

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But if you are able to settle, you’ll be getting off rather easy. Debt settlement companies can sometimes get you off the hook for a large percentage of your debt — in many cases, up to 50% will be written off.

Q: How long will the settlement stay on my credit report?

A: That you settled a debt instead of paying in full will stay on your credit report for as long as the individual accounts are reported, which is typically seven years from the date that the account was settled. Unlike with bankruptcy, there isn’t a separate line on your credit report dedicated to debt settlement, so each account settled will be listed as a charge-off. If a debt has gone into collection, it will be on your report for 7 1/2 years from the date you fell behind with your creditor.

Q: How can I check a debt settlement company’s credibility?

A: For starters, make sure that the company is a member of The Association of Settlement Companies (TASC), a trade association that represents debt settlement firms and outlines standards that they agree to meet. The association has a search tool on its Web site that allows you to find a registered member in your area. Once you’ve pinpointed a few viable choices, ask for an initial consultation. You should also make sure the company has a clean record with the Better Business Bureau (BBB), which you can do at www.bbb.org/us/.

Q: Do I need a lawyer?

A: You don’t. If you’re filing bankruptcy, you will likely want to hire an attorney. But for debt settlement, a company is sufficient, or as I said, you can often do the legwork on your own.

Four things you need to know about any debt settlement company
The fee: It should be based on the amount of debt that the company is able to settle for you.

Red flag: If the company charges a percentage of your total debt upfront, walk away.

The return policy: There should be a money-back guarantee in place of at least 30 days.

Red flag: If the company doesn’t offer a guarantee, find one that does.

The timeline: No company can promise an end date, but if you have multiple debts, the first one should be settled within a year.

Red flag: If a company promises a faster return, it may be spinning the truth.

Where is my money? Once you send it to the debt settlement company, it should be kept in an FDIC-insured bank account. (The FDIC, or Federal Deposit Insurance Corporation, insures bank deposits, among other duties.)

Red flag: If the company asks you to hold on to the money or doesn’t keep it in an insured account, the company isn’t doing its job.

An example
You have $35,000 in credit card debt that is settled through a debt settlement company. Forty percent of your debt, or $14,000, is forgiven, and you pay $21,000 in full upfront. The debt settlement company charges you 15% of the amount of debt that is forgiven, or $2,100.

• Total paid: $23,100

• Total forgiven: $14,000

• Total saved: $9,000

• Total damage to your credit score: –150 points

2. How do you negotiate with a credit card company? What happens when you settle your debts for less than you owe?

A: I’ve been seeing this question more with every passing week. You fall a bit behind on a credit card bill, your interest rate soars, your minimum payment rises, and you start falling more and more behind every month. You don’t see an end. But you don’t want to file bankruptcy either. What you can do — and should do — is negotiate. Here are the steps.

Prepare your case. Why are you in this situation? You need a clear, legitimate excuse for why you’re behind, such as a layoff, divorce, or medical emergency. Be prepared to back up the circumstances with supporting documents. Anything you have to substantiate your story — including proof that you have, for instance, been actively looking for a new job — will help.

Call your creditor directly. In most cases, if you’ve gotten to this point, you’ve already received a letter or phone message from your creditor with the name and extension of a representative. If you haven’t, you can call the toll-free number on your bill, but keep in mind that the person who answers may not have the power to negotiate a settlement. Ask to speak to someone who is either a supervisor or in the settlement department, if the creditor has one (as many do).

Make an offer. After explaining why you’re in trouble, ask the creditor if the company would be willing to accept a smaller amount. Start negotiations at about 30% of the total amount due, with the end goal of paying 50%.

Ask the creditor to report to all three major credit bureaus — TransUnion, Experian, and Equifax — that the debt has been paid in full. Sometimes a creditor is willingto do this as a bargaining point — you give the creditor cash in hand, it gives you a positive listing on your credit report — even though you haven’t paid the full amount. Get this agreement in writing.

Write the check. The creditor will want to see the money immediately.

One thing I want to make clear: You never want to hide from your debts. It doesn’t work. You’ll get much better results by being upfront, answering their calls, and responding to their letters. Delaying the inevitable only digs a deeper hole.

I also need to know ...

Q: Does negotiating a settlement hurt my credit score?

A: It will. Once the settlement is completed, the credit card company will report it to the credit bureaus, which will then make a notation on your credit report that that account was paid by settlement. That’s going to signal to future lenders that you left the last guy hanging. That’s why, as with bankruptcy, debt settlement is an extreme option, one you shouldn’t take lightly. It’s not just an easy, cheap way to eliminate debt.

Q: Are there tax liabilities?

A: In many cases, yes. Most people don’t know this, but if you settle a debt for less than the amount you owed, you are potentially responsible for taxes on the forgiven debt. Look at it this way: You received goods and services for the full amount of debt, but you’re only paying for a portion of it — sometimes less than 50%. Anything more than $600 is generally considered taxable, but the IRS will sometimes waive the tax if you can prove that your assets were less than your liabilities when the debt was settled.

3. Should I consolidate my debts?

A: Rolling all of your debts into a single loan is a good idea — in theory. In fact, it can be a great idea. But before you move forward, you need to be certain of two things: (1) that this consolidation makes sense financially and (2) that it makes sense for you personally.

A consolidation makes sense only if you can lower your overall interest rate. Many people consolidate by taking out a home equity line loan or home equity line of credit (HELOC), refinancing a mortgage, or taking out a personal loan. They then use this cheaper debt to pay off more expensive debt, most frequently credit card loans, but also auto loans, private student loans, or other debt.

You also need to understand that when you consolidate credit card debt into mortgage debt — like a home equity loan or a HELOC — you’re taking an unsecured debt and turning it into a secured debt. If you default on an unsecured debt, you won’t lose anything (except points on your credit score). When you default on a secured debt, the creditor takes the asset that backs up that debt. When you convert credit card debt to mortgage debt, you are securing that credit card debt with your home. That’s a risky proposition.

Personally, can you handle it? In about one-third of credit card consolidations, within a short period of time, the cards come back out of the wallet, and in no time at all, they’re charged back up. Then you’re in an even worse position, because you have the credit card debt and the consolidation loan to worry about. You’re in a hole that’s twice as deep — and twice as steep.

Debt
If you have even a smidgen of doubt that you’ll be able to stay away from racking up additional debt, don’t do it. You must be sure — and I mean absolutely positive — that you have the willpower to pay off those credit cards and not use them again. If you are, consolidating at a lower interest rate can help you pay off your debt faster. But if there’s even a small chance that you’ll spiral back into debt, it’s not for you.

The math
If you have $20,000 on a card with an 18% interest rate and you put $300 toward paying it off each month, it will be more than 24 years before you’re debt free. If, however, you transfer the debt to a $30,000 HELOC at an interest rate of 5.37%,* you’ll be able to pay your debt off in a little more than six years.

I also need to know ...

Q: In this tighter credit market, what sort of a credit score do I need to qualify?

A: Even in the days of the tightest credit in 2008, HELOCs and home equity loans were being made. The interest rate you receive, however, is contingent on your credit score. For example, according to myFICO .com, the consumer Web site of Fair Isaac Corporation, the primary creator of credit scores in the United States, the monthly payments on a 15-year, $50,000 home equity loan vary widely, depending on credit score. As you can see, borrowers with the best credit score pay 28% less each month than borrowers with the worst — and $23,940 less over the life of the loan.

* Bankrate.com: national overnight average on October 19, 2008.

Q: Do you have any tips for staying out of debt once I’ve consolidated?

A: I do, and in fact, even if you’re sure you have the strength to keep from backsliding, it will help to put some of these safeguards in place:

• Turn down offers for new cards or credit line increases on your current cards. Credit’s tight, and chances are, you’re not getting many offers anyway. But if you do, remember that the less credit you have available, the less trouble you can get into.

• Take the cards out of your wallet. A debit card is accepted just about everywhere that credit cards are, and you’ll be spending money you have — always a good thing.

• Pay cash. For some reason, it’s harder for people psychologically to part with their cash than it is to swipe a card. Maybe it’s the act of physically seeing the money change hands, or maybe it’s because you don’t want to break a $20 for a $2 cup of coffee. In fact, the bigger the bill, the less likely you are to spend it. If you want to really save money, spend only cash and carry only fifty-dollar bills.

• Save for your goals. Take note of what’s coming your way — vacations, the holidays, what ever is going to cost you money — and start saving ahead of time so that you have a stash when the time comes. That way, you won’t be caught off guard and you won’t feel guilty, because you’ll be spending money that you’ve allocated for the occasion.

• Get your friends involved. Let your shopping buddies know that you’re on a tight budget, and they can help you out when your willpower starts to weaken at the mall.

Excerpted from "Money 911" by Jean Chatzky. Copyright (c) 2009, reprinted with permission from HarperCollins.

© 2012 MSNBC Interactive

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