Ask Liz Weston

Dear Liz: My son recently learned that he likely will lose his job April 1. He is a fireman and there is a chance the layoff might be temporary, depending on city budget negotiations.

If he loses his job he will not have the income to keep his house, where he is upside-down. He owes $300,000 and the house is valued at $190,000.

He just paid the February payment and is now unsure what to do next. He doesn’t want to lose his house but he is currently living paycheck to paycheck and certainly can’t afford the payments without a job.

Should he stop making payments and let it go into foreclosure, which will ruin his good credit rating that he has worked so hard to maintain? Will the bank work with him to modify his mortgage before he loses his job? Could I buy the home in a short sale to keep the home in the family?

Answer: To answer your last question first, probably not. To get a short sale approved, lenders typically want an “arm’s length” transaction to avoid the possibility of fraud.

Your son should talk to a housing counselor approved by the U.S. Department of Housing and Urban Development. He can find referrals at www.hud.gov. The counselor can review his situation, discuss his options and help him navigate the loan modification process, if that’s the route he chooses.

If his unemployment is indeed temporary, he may only need mortgage forbearance (a temporary suspension of payments) or a short-term modification to keep his home. Either could negatively affect his credit, but the consequences would be less severe than the damage done by foreclosure.

Even a single skipped payment can knock 100 points off his credit scores, so he should avoid missing payments until he’s decided on a course of action.

Dear Liz: I lost my job 18 months ago. I am 61 and have back pain that keeps me from standing more than 15 minutes or sitting more than two hours before I have to lie down, which limits my job prospects. I arranged a short sale of my home a year ago to avoid a foreclosure, and recently received a 1099-C form from the lender for $99,000 of forgiven debt. Please warn others about this!

Answer: Don’t panic just yet.

Normally when a lender cancels or forgives debt, you have to include the forgiven amount in your income for tax purposes, which can result in a whopping tax bill.

But the federal Mortgage Forgiveness Debt Relief Act of 2007 provides an exception for homeowners who lose a home to foreclosure, sell it for less than they owe in a short sale or have their debt reduced through a mortgage modification.

You still have to report the forgiven debt on IRS Form 982, but it’s typically not included in your income for federal tax purposes if:

• The home was your primary residence (second homes, vacation property and rentals don’t qualify).
• The forgiven debt was $2 million or less ($1 million for a married person filing separately).
• The debt was forgiven in calendar years 2007 through 2012.

For more information, visit the IRS’ website at http://tinyurl.com/5pe43f. Details can also be found in IRS Publication 4681, Canceled Debts, Foreclosures, Repossessions, and Abandonments.

You’ll have to do a little research to see what you might owe under your state’s income tax laws, which could differ. California, for example, hasn’t updated its law to conform with the federal law for mortgage forgiveness occurring on or after Jan. 1, 2009, although there are several bills pending in the Legislature to do so.

If you’re in California, you might want to bookmark this Franchise Tax Board page at http://tinyurl.com /yhx89zw and check back before filing your taxes April 15 to see if you get any relief.

Dear Liz: What is the best source for a free credit report with no strings attached (that is, you’re not required to sign up for credit monitoring or other offers)?

Answer: The one and only site to get your free, federally mandated look at your credit reports is AnnualCreditReport.com. There are plenty of look-alike sites that try to fool you, so make sure you get to the right one.

Also, be aware that you’re entitled only to free credit reports, not free credit scores. If you want to see the FICO scores that lenders use, you will have to buy those at the MyFICO site. If you want to see free credit scores that aren’t FICOs but that give you some idea of where you stand with lenders, visit the Credit Karma site.

Dear Liz: Lots of “credit card remedies” are being marketed now. Is debt settlement a reasonable way to reduce debt? I have a good track record of payments and good credit scores (my median FICO score is 745). I’m concerned I’ll damage my creditworthiness for years to come.

Answer: Debt settlement means you’re paying less than you owe — and creditors really don’t like that. Debt settlement can trash your credit, which is why it isn’t a good option if you can find other ways of dealing with your debt.

If your interest rates are relatively low and you can easily make your minimum payments, your best bet is to simply pay off the debt on your own, throwing as much money as possible at your highest-rate card while paying the minimums on your other debt. Once your highest-rate debt has been retired, you can apply that payment to your next highest-rate debt, and so on until you’re debt free.

Or you can transfer your debts to a fixed-rate personal loan and pay that off over time. Many credit unions offer three-year personal loans at rates of 10% to 15% to people with good credit.

If you’re struggling to make your minimum payments, you should arrange two appointments: one with a legitimate credit counselor (you can get referrals from the National Foundation for Credit Counseling at www.nfcc.org) and another with a bankruptcy attorney.

The credit counselor may be able to put you on a debt management program to pay off your debt at lower interest rates. Credit counseling is a neutral factor in credit scoring formulas — neither helping nor hurting — but your creditors may report you as late, which could hurt your scores.

Bankruptcy would really trash your scores, driving them down into the 500s. But it could wipe out your debt and give you a fresh start if you aren’t able to pay your bills.

What you want to avoid, if possible, is raiding retirement funds or home equity to pay credit card debt, particularly if bankruptcy may be an option. Retirement funds are protected in Bankruptcy Court and so, in many cases, is home equity.

Dear Liz: I have almost $250,000 in my retirement accounts. I also have almost $50,000 in credit card debt. Should I take $50,000 from my 401(k) to pay off the debt?

Answer: No, no, no.

In case that wasn’t clear: No.

Of all the dumb financial moves you can make, raiding retirement funds to pay off credit card debt ranks near the top. You’ll pay penalties and taxes that typically equal one-quarter to one-half of any withdrawal, plus you lose the future tax-deferred returns that money could make. If you’re 30 years from retirement, that $50,000 withdrawal would cost you $500,000 in lost retirement income, assuming an 8% average annual return.

The fact that you have that much debt puts you at high risk of bankruptcy. In bankruptcy, your unsecured debt can be wiped out or reduced, while your retirement funds would be protected from creditors.

If you can’t figure a way to pay off your debt without raiding your retirement, you need to make two appointments: one with a legitimate credit counselor (visit the National Foundation for Credit Counseling at www.nfcc.org) and another with a bankruptcy attorney.

Dear Liz: I am a single woman with a base salary of $101,000 plus bonuses, which so far have been significant. I divorced three years ago, and I am still digging out of debt. Last year I put all of my bonus toward debt but still have about $20,000 remaining. I will soon get another bonus of $38,000 before taxes and 401(k) contributions.

Is it wise to just pay off all the debt, or should I target the higher-interest-rate loans and put some in savings? I am thinking that I would have just enough to eliminate all my debt except my mortgage.

Answer: Debt comes in three basic flavors: toxic, good and neutral. Toxic debt includes credit card debt, payday loans and other high- or variable-rate borrowing. Good debt includes borrowing that can help you build wealth, such as a moderate amount of mortgage or student loan debt. Neutral debt includes everything that’s not actually toxic but that isn’t helping you build wealth, such as fixed-rate car or personal loans.

You should get rid of toxic debt as quickly as possible, so use your bonus to pay off any that you have. Then consider any neutral debt you owe. If you already have substantial emergency savings, you could pay off that neutral debt. If, however, you don’t have an emergency stash equal to at least three months’ worth of expenses, and your neutral debt has low rates, consider building up your savings instead.

Finally, make sure to review your spending and saving plans to make sure you’re living within your base salary. Bonuses are great but are variable by their nature, and you don’t want to count on them to pay your bills or bail you out of a jam.

Dear Liz: We are fortunate to be debt free with a nice cash reserve. We typically pay our bills in cash, by check or by a credit card that’s connected to our brokerage account. Imagine our surprise when we applied for credit at two retail stores to get a discount on items we wanted and were turned down on the spot at both places. We have asked for, and received, the government-required reports from the three major credit bureaus, and the information provided seems correct, to the best of our interpretation. Short of a significant effort to get more credit, which we can survive without, what do you recommend we do?

Answer: Under the Equal Credit Opportunity Act, you have a right to know why you were turned down for credit. Simply referring you to the credit bureaus isn’t sufficient — the retailers should have given you the reasons your applications were refused. If you haven’t received letters by now explaining their rationale, write each retailer’s credit-granting department and point out that they’re required by law to give you an explanation.

It could be that your scores weren’t high enough. Even though your finances are in good shape, the fact that you have only one active credit account might be damping your scores. If that’s the case, simply adding another credit card could boost your scores and make you eligible for instant credit offers.

Or it could be your scores are fine and the problem is your income, or what the retailers think your income might be. Credit card lenders are under regulatory pressure to consider borrowers’ incomes, and some are using various services that purport to estimate incomes based on other information in your credit reports, such as the size of your mortgage or your credit limits. If you have no mortgage and only one card with a low limit or no limit reported, that estimate could be way off.

But you don’t have to guess. The retailers should tell you. If they don’t, you can report them to the Federal Trade Commission.

Dear Liz: I am trying to rebuild my credit and am following many of the tips I’ve read in your articles. I recently obtained a secured credit card and an auto loan just to help with rebuilding my credit. Can I increase my credit score even if I pay off the entire credit card balance due each month before any finance and interest charges are incurred? And can I increase my credit scores over time even though I currently have a tax lien and judgment on my credit report?

Answer: Let’s tackle your last question first. You can mitigate the effect of serious negative marks such as tax liens, judgments, bankruptcies, foreclosures or repossessions by being responsible with your other credit accounts, but these missteps will still drag down your score as long as they’re on your credit reports. Most negative marks will drop off after seven years, although bankruptcies can be reported for up to 10 years and there’s no limit to how long unpaid tax liens can remain on your report — which should be a good incentive to pay those off.

Being responsible with your credit accounts means paying them on time and using only a fraction of your available credit card limit. (Using less than 30% is good, and using less than 10% is even better.) It does not mean you have to carry a balance. Credit reports and credit scores typically don’t distinguish between balances that are carried month to month and those that are paid off, so you might as well save the finance charges and pay your bill in full each month.

Dear Liz: I am a divorced 49-year-old man who has a lot of debt. I recently (and shamefully) turned in the keys on my ridiculously upside-down home in Arizona. My credit scores have plummeted and all my credit cards have raised their rates to 28% and above.

I am remarried to a wonderful woman who is more fiscally responsible and wants to buy a home. I’d like a quick fix, but that seems unlikely. I’ve avoided commingling our assets and credit so far, but recently I asked my wife to cosign a personal loan to consolidate my debt. I’ve also requested to be an authorized user on some of her high-limit, low-balance credit cards.

I fear this may be a break point for our relationship. She has worked hard to be responsible and I — well, I have not. My strategy seems sound. What do you think?

Answer: Your plan could dramatically lower your interest costs, allowing you to repay your debt more quickly. It also could help rehabilitate your battered credit scores.

But the cosigned loan would put your new wife’s credit in your hands. If you missed a single payment, her hard-won credit scores could plunge overnight. If you failed to pay the debt, she would be responsible for it.

That’s a huge risk for her to take, so you shouldn’t hold it against her if she declines. Adding you as an authorized user of her cards involves much less risk, since she wouldn’t have to actually give you access to those cards, but she’s under no obligation to do that either.

If she turns you down, you might want to consider a visit with a legitimate credit counselor (one affiliated with the National Foundation for Credit Counseling) as well as a session with a bankruptcy attorney so you can be apprised of all your options regarding your debt.

Dear Liz: The day before my son got married, he proudly had a long-term 800-plus FICO credit score. The day after he got married, his FICO score became 600. It seems his new wife had many outstanding major debts incurred before the marriage. They live in a non-community-property state. How can he rebuild his credit either with or without a divorce?

Answer: Unless your son filed for bankruptcy the day after his wedding, the scenario you describe is pretty much impossible.

Our credit reports don’t get merged or combined when we marry. And it’s highly unlikely that any of the debts his wife incurred before marriage would be added to his credit reports unless he agreed to be added as a joint account holder or an authorized user.

As a practical matter, of course, he’ll want to help his new wife address these debts, since they’ll affect the couple’s life together.

But he’s not legally responsible for them. Because she incurred these bills before the wedding, they’re her separate responsibility in every state — community-property states included.

An appointment with a marriage counselor might be in order if she actively concealed these debts from him. But they needn’t contact divorce attorneys to fix this problem.

They should probably make two more appointments, however: one with a legitimate credit counselor affiliated with the National Foundation for Consumer Credit (www.nfcc.org) and another with an experienced bankruptcy attorney. The counselor and the attorney together will provide a complete picture of her options.

By the way, just as there’s no such thing as a combined credit report, there’s also no such thing as a “long-term” credit score. Each score is a snapshot of your credit situation and changes as the underlying information in your credit reports changes — which is basically all the time.