4 Common Ways to Clean Up Debt

erasing debtConsolidation of debts is often one of the most common routes to take when cleaning up money owed to creditors, but there are also many other popular options available. Any of these can be used as an alternative to conventional debt consolidation or as a supplement, depending on your needs and budget.

Here are four of the most common choices when cleaning up debt:

  1. Rearranging credit cards
  2. Refinancing auto loan
  3. Tapping into 401k
  4. Borrowing from friends and family

Let’s take a closer look at each debt clean up option.

Rearranging Credit Cards to Clean Up Debt

When it comes to credit cards, not all are the same. In a time of financial distress, not all should be kept or managed in the same way. An important step in debt management is eliminating the cards which are keeping you the furthest in the red.

When starting to look over your current credit card situation, keep the following points in mind:

  • Which card has the lowest interest rate? The highest?
  • Do any of the cards charge an annual fee?
  • Do you have any cards you never use?

Once these questions have been answered, follow these steps:

  1. Pay off any cards with low balances to help gain momentum.
  2. Transfer the rest of the balances to the card with the best interest rate through a balance transfer offer if possible. Be sure to check on the balance transfer fees.
  3. Don’t use the new card for new spending until it has is paid off.
  4. Determine which two or three cards to keep and repeat this process until only those remain.

Things to watch for when consolidating credit cards:

  • Canceling a card with a balance can cause your rate to increase dramatically, as issuers often raise rates on the balance if they know you will close the account.
  • Continue making minimum payments on all cards until transfers are complete. Assuming the transfer went through and missing a payment can be costly.
  • Closing accounts can have a negative impact on your credit score. Try to keep accounts open so long as they are affordable (no significant annual fee or other charges) but make them unavailable for use.

Refinancing Auto Loan to Clean Up Debt

Another point to consider when rearranging your debts is your car loan. Often, there are ways to reduce your monthly payment, interest rate, or loan term, all potentially saving you money.

The first and easiest step involves contacting your current lender and inquiring about a rate modification. If you have been regularly paying on time, there is a chance a simple phone call could land you at a lower rate.

If you have not been paying on time, or the lender is not budging on the rate, it is time to look into refinancing.

  • Obtain your credit report and score to determine where you stand.
  • Determine if your current loan has any prepayment penalties.
  • Estimate the current value of your car and compare that to the amount owed.
  • Use this knowledge to shop for a better rate.

There are many routes to take here, and speaking with lenders is the best way to find out if a refinance is the right move. However, if you owe more than your car is worth, it will be difficult to find a lower rate. A lender will not have enough collateral to replace funds loaned if things go south, so they won’t likely even approve your refinance request. Be sure to do your homework beforehand.

Tapping Into a 401k to Clean Up Debt

A last resort option may be to use your 401k or other retirement savings plan. To determine if this is a viable option for you, first, speak with your company’s 401k administrator. This person will likely work in accounting or human resources. Also, there is often a toll-free number on your plan’s statements. Explain what you would like to do, and they should be able to help if a loan or distribution option is available. Take note that not all plans offer this option.

Prior to making that phone call, it is important to understand some of the pros and cons of taking money out of your 401k.

Pros

  • You are borrowing from (and paying interest back) to yourself, not a credit card company or lender.
  • The rate is usually low, 1 or 2 percent above the prime rate.
  • There is no credit check.
  • Repayment is through payroll deductions, which is easy for most people.
  • There are often low transaction costs compared to other loans options.

In most 401(k) plans, you can borrow up to 50 percent of your vested balance, but not more than $50,000. You have to pay the money back with interest over five years.

Cons

  • Plan management companies may charge fees up to $400 for an application or processing fee.
  • Money removed does not appreciate as it would if left in the account if it is invested.
  • Once repayment begins, your overall paycheck deductions could double if you are to maintain your current contribution schedule.
  • If you leave the job, the loan accelerates and must usually be paid within 60 days to avoid it being viewed as a distribution.
  • If the loan is not repaid, it is considered an early withdrawal and taxed, and a 10% early withdrawal penalty applies.

Of course, if you’re already retired that could change things slightly. You won’t have access to a 401(k) loan if you no longer work for that company, but you can look to your individual retirement savings (IRAs) as an alternative. However, a distribution from an IRA is not a loan, so there may be tax consequences, and most importantly, a reduction in your overall retirement savings balances.

Retirement savings should be earmarked for retirement first and foremost. However, if rearranging your debt is a dire need, you can look to retirement savings as a back-up. It is crucial to understand the nuances to this route before deciding if it is the right option for you.

Borrowing from Friends and Family to Clean Up Debt

Borrowing from friends and family will always depend on the relationships. As often stated, mixing finances with family and friends is an easy way to hurt feelings and ruin relationships.

However, if you decide this is the route for you, it is important to put things in writing first. Although we all assume nothing bad will happen, it is a prudent step to put the following down on paper:

  • The names of the lender and borrower
  • The date of the loan initiation
  • The amount
  • The date by which the loan is to be repaid
  • The interest rate, if one is applied
  • The number of payments
  • How often payments are to be made (weekly, biweekly, monthly)
  • The minimum amount to be paid
  • Each party’s signature

Another step to ensure comfort on both sides would be to put up some type of collateral. Many lenders would require this, and it should be no different with friends and family.

If these options are not available to you or will not work to clear up debt with your current financial situation, be sure to read our next section covering credit counseling services.

Borrow up to $50,000 with low fixed rates!

Posted on June 11, 2021 by in Debt Management

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