Ask Liz Weston

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.

Debt settlement is the real Wild West–lots of bad guys and no sheriff in sight. Even the companies that aren’t outright scams might charge you thousands of dollars and not resolve your debt problems.

Federal regulation may be on its way, but until then (and probably even afterward), it’s buyer beware.

Here are three signs that indicate you’re dealing with one of the bad guys:

• They refer to a “new law” or “federal bailout package” that allows consumers to cut their debt “legally.” There’s no such animal.
• They say or imply you can settle debt without affecting your credit. Debt settlement trashes your credit scores.
• They use “as seen on CNN” or other media outlets, but when you click on the link it simply brings you to another debt settlement advertisement.

Anyone who is considering debt settlement should first talk to an experienced bankruptcy attorney about his or her options. If you truly can’t pay your bills, you may be better off getting them erased through bankruptcy than throwing money at debt settlement.

For more, read:

Debt settlement: a costly escape

When debt settlement makes sense

Damned by debt consolidation: settlement could be a trap

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.

U.S. consumer bankruptcies rose by about one third in 2009, to 1. 4 million–nailing the number predicted earlier that year by American Bankruptcy Institute’s Sam Gerdano. He cited job losses, high debt burdens and “unsustainable mortgage burdens” as the leading factors in the 32 percent increase in filings.

It’s fair to say at this point that Congress’ effort to reform the bankruptcy system is a big old failure. The 2005 law’s most significant effects were to drive up filing costs and filings themselves in the months before the law took effect. After a brief lull following the law’s inception, cases started marching upward again.

The law failed because it addressed only one side of the equation, borrowers, without regard to the excesses of lenders. Those excesses have been temporarily trimmed by the Great Recession and to a smaller but perhaps more permanent extent by the credit card reform act. The only thing that’s clear at this point is that the great wave of bankruptcy filings is unlikely to crest any time soon: filings in December were up 33% compared to a year earlier.

Dear Liz: Is there a point at which the time required to repay credit card debt exceeds the period that settling the debt will adversely affect your credit scores? Is there something else that should be considered?

Answer: You can’t predict how much credit card settlements would hurt your credit scores (other than “a lot”) or how long it would take your scores to recover.

But anyone who is struggling to pay debt and considering debt settlement should research whether bankruptcy might be the better choice. If you can’t repay this debt within five years, a Chapter 7 liquidation filing could let you erase it.

Dear Liz: It looks as if I will have to file for personal bankruptcy because of a business failure. (I guaranteed the debts personally, and there are two I know I can never repay.)

I could possibly keep the business open a few more months if I stopped paying a few of the other creditors, thus keeping my workers employed a little longer.

I know my FICO score will drop when I file, but will it drop more if I stop paying bills before I file, or is the FICO drop the same no matter what?

Answer: The end result will be about the same.

If you stop paying some bills, those skipped payments will lower your score substantially. Once you file for bankruptcy, your score will drop some more.

But the effect of bankruptcy on your scores is so profound that you’ll end up in about the same place as you’d be if you had filed without ever having missed a payment. Either way, your scores will be in the basement.

If you believe bankruptcy is inevitable, consult a bankruptcy attorney now. It’s easy to make mistakes that could endanger your bankruptcy filing.

You don’t want to wind up with shattered scores but still owing these impossible-to-pay debts.

FICO finally parted the curtains enough to show us how much effect certain actions–late pays, maxing out, debt settlement, bankruptcy and foreclosure–can have on credit scores. You can see my column about this at MSN Money (CLICK HERE), but here’s a taste:

Dear Liz: I have reunited with the love of my life. There is one problem: She has a bankruptcy on her record. If I have very strong credit scores and we marry, how will her credit affect my chances of buying a house?

Answer: You each will retain your individual credit reports when you marry. They won’t be combined.

If you plan to use her income to help qualify for a home purchase, though, her credit scores will be used to determine the rate and terms you get. If the bankruptcy is recent or if she hasn’t taken steps to rehabilitate her credit, that means you could pay more interest or have more trouble finding a loan.

If you don’t need her income to qualify, on the other hand, her credit troubles don’t need to affect your loan.

Dear Liz: I’m 59 and unemployed. My husband, who is turning 65 in July, recently lost his job as well. We’ve saved about $12,000 for emergencies and have a couple of 401(k) accounts totaling about $110,000. My husband receives about $1,800 a month from Social Security and a pension. We’re not too hopeful about finding jobs at our ages and in our area.

Should we begin drawing on the 401(k)s for income to pay our bills after the savings run out, or should we seek credit counseling to reduce our consumer debt? I’m scared of what our future holds and worried about losing my insurance coverage through COBRA after the subsidy runs out.

Answer: You didn’t say how much consumer debt you have or what your monthly expenses are, but the fact that you’re thinking of tapping your relatively small retirement stash indicates you’re probably in deep trouble.

A debt management plan through credit counseling will work only if you have the extra income to pay off your credit cards over the next five years. If you don’t, bankruptcy may be the better option. Even if you think credit counseling will help, consult a bankruptcy attorney so you understand all your options.

In fact, you should talk to a bankruptcy attorney any time you’re considering tapping a retirement fund early to pay off debt. Retirement funds are typically protected in Bankruptcy Court, while most unsecured debt can be wiped out.

And you don’t have that big a nest egg, anyway. At your age, you can draw only $3,000 to $4,000 a year from your retirement funds without dramatically increasing the risk of running out of money before you run out of years.

Dear Liz: I just received rate increases on two of my credit cards that are together going to send me into bankruptcy. I didn’t think it could happen to someone who has perfect credit, has not maxed out the card and has been steadily reducing the balance and not charging anything, but obviously it can. I had every intention of repaying my debt, but these arbitrary increases — which will add $600 a month to my payments — have made it impossible.

I feel foolish for having this debt at all, but I lost my mortgage business and my husband is in construction. We have had a really bad four years. If they had just allowed me to continue making the payments per our original agreement, I would have been able to continue reducing the balance and they would get their money. This way, they won’t receive any money at all. How does this make sense?

Answer: Credit card issuers know full well that their latest rate increases will send some of their borrowers to Bankruptcy Court. What they’re hoping is that they’ll get enough interest from those who can still pay to offset the losses from those that can’t.

All may not be lost. Many issuers who have instituted these rate hikes offer an “opt out” provision that would allow you to keep your original rate if you agree to close the account. You should contact your issuers to see if this option is available. Closing accounts can ding your credit scores but will cause far less damage than a bankruptcy.

Be realistic about your financial situation, however. The amount of the proposed payment increase indicates you’re carrying substantial debt on those cards. Unless your financial situation improves dramatically, it’s probably only a matter of time until a misstep or another change in terms causes you to fall behind.

If that’s the case, bankruptcy may be a better option than continuing to struggle with debt you’ll never repay.