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Dig Yourself out of Debt.

Posted on: May 23, 2005

Fidelity Investments

How to Dig Out of Debt

By Neil Rhein

Would you pay $1,500 for a high-definition TV that’s on sale for $1,000? That’s exactly what you may be doing when you charge purchases with a credit card and take months or even years to pay off your balance in full.

While borrowing money to pay for your college education or a home usually pays off in the form of a higher income or a valuable real estate asset, credit card debt rarely pays such dividends. In fact, for some consumers the temptation to buy whatever they want whenever they want can lead to financial disaster. Here are some pointers on managing your credit card debt.

The average card balance rose 14.5% last year to $2,627, according to Myvesta.org. And Americans are now carrying more credit cards than ever, with an average of 2.9 credit cards per consumer.

"When people are pulling out the plastic to make everyday purchases such as hamburgers and groceries, it’s no surprise that the average amount of debt has gone up," says Jim Tehan, a spokesperson for MyVesta.org.

Over the past few years, millions of Americans have refinanced their mortgages, often repeatedly, to take advantage of falling interest rates and to lower their monthly mortgage payments. Yet at the same time, millions are still carrying credit card balances with annual percentage rates (APR) of 18% and higher.

When you don’t pay off your credit card balances in full at the end of each month, you’re robbing your ability to save and invest for your future. In a recent report on the credit card industry for PBS, Elizabeth Warren, the Leo Gotlieb Professor of Law at Harvard Law School, argued that credit card debt makes it difficult for anyone to build a solid financial foundation.

"When someone is carrying credit card debt, it means they are falling behind instead of getting ahead," says Warren. "When people ask how much credit card debt is OK, it’s a little like asking how much dynamite can you keep in the basement. You probably could keep some and get along OK. But the smartest move is not to keep any."

Warning Signs
There is a severe lack of understanding about debt and personal finances today, according to New York Law School Professor Karen Gross, who also serves as president of the Coalition for Consumer Bankruptcy Debtor Education. "We have equal opportunity ignorance — it cuts across all levels of society," she says.

For a quick assessment of your situation, ask yourself these questions:

  • Am I making only the minimum payments on my credit cards?
  • Do I live from paycheck to paycheck with no savings?
  • Do I sometimes skip payments on one credit card in order to pay off others?
  • Have I reached the credit limit on one or more credit cards?

If you answered yes to any of these questions, you may need to take action to get back on track.

Stepping in the Right Direction
"It’s essential to pause, take a deep breath, and look carefully at possible solutions," explains Gross. "The last thing you want to do is to try to relieve your financial headache with a solution that will be worse than the hangover itself." Like a New Year’s diet resolution, quick fixes rarely work. What does work, according to Gross, is a simple four-step formula for financial H.E.L.P.:

  • Hold your horses, stay calm, and don’t rush into any impulsive arrangements. "Don’t panic," advises Gross.
  • Examine your situation. While your debt problems may be serious and appear urgent, first get an accurate sense of the extent of your problem. "Lots of organizations offer help, but don’t take the first solution that comes along. Take time to assess, compare, and contrast multiple solutions," she says.
  • List your options and the pros and cons of each. For example, while a home equity loan may seem like an appropriate solution, it’s not always the best course of action because it can put your home at risk.
  • Pay at least the minimum amounts due on all of your credit cards. This last step is critical due to a new clause that has worked its way into the fine print of many credit card agreements. It’s called the "universal default" clause and it permits a credit card company to raise your interest rate if you’re late on another company’s credit card or any other outstanding loan. Banks argue that it’s logical to raise rates for a consumer who has shown evidence of becoming a higher risk.

Don’t Make Matters Worse
Virtually every American with a functioning mailbox has received an offer to consolidate his or her debt onto a new credit card with a low introductory interest rate. While switching to a card with a lower interest rate makes sense in many cases, consolidating your loans onto a single card can adversely affect your credit score.

Credit service agencies such as Experian and Transamerica use your credit score to assess the risk of loaning you money. The lower your score, the higher your interest rate. One factor that they consider is your credit utilization rate. According to Gross, you should avoid using more than 30% of the available credit line on a single card, because doing so can lower your credit score. When you consolidate all your debts onto a single card, it’s likely that you’ll exceed a 30% utilization rate.

As a last resort, some consumers turn to one of the many organizations offering help to the overextended. But be careful who you look to for help, warns Gross. "Different debt relief options have varying degrees of legitimacy," she says. "Learn the differences between these approaches and whether the people helping you are reputable."

Many credit-counseling organizations are organized as nonprofits, which helps create an image of altruism and benevolence. In practice, however, many of these firms pay their principal officers hefty salaries, and some do more harm than good. According to the Better Business Bureau, complaints against credit-counseling agencies have risen 467% over the past four years.1 "If they promise you the moon, they probably can’t deliver," says Gross.

Action Step: Visit the National Foundation for Credit Counseling to investigate credit-counseling agencies.

One common arrangement that some firms offer is a debt management plan (DMP). These plans allow the credit-counseling agency to intervene with creditors on your behalf. You send a single payment each month to the credit agency; it negotiates with and pays off your creditors, and attempts to obtain lower interest rates on your credit lines and eliminate late fees.

Most DMPs charge a setup fee and a monthly fee in exchange for these services. If you decide to enroll in one of these plans, be sure to ask for a detailed breakout of the fees and confirmation that the firm is licensed to operate in your state. You may also want to confirm that it is a member of the National Foundation for Credit Counseling and see if it is accredited by the Council on Accreditation for Children and Family Services (COA), an international, not-for-profit, independent accrediting body.

Some credit-counseling agencies may also ask for a lien on your house as a condition of the DMP. But it’s a risky proposition. "While turning to home equity can provide temporary relief, eventually the equity will dry up and the debts will need to be paid off. If you find yourself charging everyday purchases and relying on debt to make ends meet, act quickly before the situation gets out of control," says MyVesta.org’s Tehan. Most lenders are willing to work out a payment plan, so using your home as collateral should only be a last resort.

1 Source: CBS MarketWatch, Feb. 1, 2005, Discrediting Credit Counseling

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