Ask Liz Weston

Get smart with your money

Credit & Debt

Huge debts? Where to find help

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Dear Liz: My husband and I are in a huge amount of debt. I understand that there are nonprofit agencies that can sit down with us and help us develop repayment plans and strategies. How do I find a reputable one?

Answer: Contact the National Foundation for Credit Counseling at (800) 388-2227 for a referral to a legitimate, accredited, nonprofit credit counseling agency in your area. A counselor can review your financial situation, help you with budgeting and see whether you’re a candidate for a debt management plan, which would allow you to pay off your credit card debt over time, perhaps at a lower interest rate.

You also should consider making an appointment with an experienced bankruptcy attorney. You can get referrals from the National Assn. of Consumer Bankruptcy Attorneys at http://www.nacba.org. A credit counselor may try to steer you away from bankruptcy, whereas an attorney can let you know if it might be a better option.

Unfortunately, many people wait too long before they contact a credit counselor. They may be approved for a debt management plan but find themselves unable to stick with the plan long enough to pay off their debt. In other words, they continue to struggle with debt that they ultimately can’t pay. Understanding all your options, including bankruptcy, can help you make a better choice about what to do next.

“Compassionate review” may lead to student loan discharge

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Dear Liz: We have a family member who recently was approved by Social Security for a complete disability claim. This person will never work again but has an outstanding student loan. The lender has a formal mechanism to apply for loan forgiveness, but is refusing to accept medical documentation of the disability. What appeal process is there and how can we force them to act? Do we need to retain legal counsel and incur additional expense to enforce a legal process and achieve loan forgiveness?

Answer: Federal student loans offer a “total and permanent disability discharge” that forgives outstanding education debt. You can find the rules and an application at DisabilityDischarge.com.

The rules for private student loans, however, vary by lender. Four lenders — Sallie Mae, New York Higher Education Services Corp., Discover and Wells Fargo — offer a discharge for total and permanent disability that is similar to the federal one, said Mark Kantrowitz, publisher of the FinAid.org and FastWeb.com financial aid sites. The Sallie Mae discharge is also provided on loans made through lenders that market the Sallie Mae loans, such as Commerce Bank, Fifth Third Bank and Regions Bank, Kantrowitz said.

Other lenders do not offer such a discharge, but all have a compassionate review process for their private student loans, he said.

“Borrowers in a difficult financial situation, or their family or other representatives, should contact the lender that holds the loan directly,” Kantrowitz said. “The call center staff are not always familiar with the compassionate review process.”

Lenders are generally more likely to cancel some or all of the debt, or at least reduce the interest rate, in a situation that permanently affects the borrower’s ability to repay, Kantrowitz said. They are less likely to make an adjustment when the loan was cosigned and the cosigner is capable of repaying the debt.

“But it varies,” Kantrowitz said. “I’ve seen some cases in which the borrower was military and killed in action where the lender forgave the loans even though the cosigners were capable of repaying the debt. Another example involved a mother whose daughter dropped dead on an athletic field and the mother’s anguish was palpable in the letter to the lender.”

Debt cancellation comes with another issue: taxes. Forgiven debt is typically treated as taxable income by the IRS. Your family member may be able to avoid the taxes if he or she is insolvent, but a tax professional should be consulted.

Soon-to-be ex wants cash-out refinance

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Dear Liz: My soon-to-be ex wants to refinance our mortgage to pay for renovations so we can sell it for more money. He also wants to take out some cash to pay off unsecured loans. (I have $11,000 in credit card debt, and he has over $50,000.) The house recently appraised for $310,000 and we owe $158,000 on it. Is it wise to refinance in this circumstance?

Answer: A cash-out refinance would be a risky maneuver even if you intended to stay married. Renovations rarely boost a home sale price enough to cover their cost. Also, home equity that’s used to pay off credit card bills is often wasted, since the borrower never fixes the problem that led to overspending in the first place and simply runs up more debt. Since he would be getting the bulk of the benefit by having more of his debt paid off, you also would need to adjust the rest of your property settlement.

Often, the best and easiest solution in a divorce is to simply sell the house. You certainly wouldn’t want to remain on a mortgage with an ex after the divorce was final, if you could possibly avoid it. A good divorce attorney can give you advice about how to proceed from here.

Government recoups defaulted student loan debt

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Dear Liz: I read your response to the person questioning the rationale behind taxpayer-supported federal student loans. Your response was well written, but do you have any information about how much money is owed to the government for student loans and what percentage of all the loans are actually paid back in full? You mentioned that the government can garnish wages and Social Security checks and seize tax refunds, but does the government follow through and hold these people accountable? Does the government have personnel to do this or is this just a threat?

Answer: Millions of unhappy student loan borrowers can assure you the government’s considerable powers to collect defaulted student loans are much more than a threat. In addition to its own collection activities, the U.S. Department of Education also hires a number of private collection agencies to help recoup what’s owed.

As a result, the government collects more than 100 cents on every defaulted dollar once accumulated interest and penalties are included, according to the Education Department’s most recent report. On a net present value basis — when future collections are discounted back to today’s dollars — the government recovers about 80% of the defaulted debt.

Decades ago, it was possible to skip out on federal student loan debt without serious consequences. Public outrage over that fact led to much stronger collection efforts. That has resulted in the federal government recovering about $10 billion in defaulted student loan debt every year, said Mark Kantrowitz, publisher of the FinAid.org and FastWeb financial aid sites.

Low car loan rate could have been lower

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Dear Liz: I recently bought a new car, and the dealer, after running a credit check, told me my Experian score was 783. I have had only credit cards and no loans. This is my first auto loan. They gave me a 3.5% interest rate and I took it reluctantly. I do not like the rate and the need to pay huge interest over time, and am considering paying off the loan as soon as possible as there are no pre-payment penalties. If I am able to pay off my loan in a couple of months (instead of the original five-year loan term), will this improve or adversely affect my credit score? How will this look in the eyes of future lenders?

Answer: Paying off debt is a good thing, both for your credit scores and your wallet. The leading FICO credit scoring formula likes to see a big gap between your available credit and the amount you’re using. This is particularly true with revolving accounts, such as credit cards, but your scores also get a boost from paying down installment debt, such as auto loans and mortgages.

By the way, a 3.5% rate isn’t bad and wouldn’t cause you to pay “huge” interest. But you probably would have gotten a better rate had you arranged your financing in advance, say with a local credit union. If the dealership then offered you a better deal, you could cancel your application with the credit union. As it was, you left yourself at the mercy of the dealer — not a good idea.

Once you get this loan paid off, consider making the same-sized payments to a savings account so you can pay cash for your next car. If you do decide to finance again, try to keep your loan term to three or four years. That will help ensure you don’t buy more car than you can afford and could prevent you from being “upside down” (owing more than the car is worth) for much of the loan term, as is often the case with longer loans.

Don’t use your 401(k) to pay debt

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Dear Liz: I will be 61 in December. I have $15,000 in credit card debt at 9.9% and $41,000 in a certificate of deposit earning 3% per year. I have $590,000 in my 401(k) account. I want to pay off the credit card balance to redirect my income to paying off my $26,000 mortgage by the end of 2013. Which near-term option for paying off the credit card is better: close the CD and buy a new, lower-paying CD with the balance after paying the card off, or take a 401(k) distribution, leaving the $41,000 emergency fund untouched?

Answer: Since you’re older than 591/2, you would not have to pay penalties on any withdrawal from your 401(k). But a withdrawal would still be a bad idea for a number of reasons.

The most obvious is that you would have to pay taxes on any amount you take out. Typically 20% is withheld from any distribution, but your bill could well be higher depending on your federal and state tax brackets. In the 25% federal and 8% state brackets, you’d owe $3,750 in federal and $1,200 in state taxes on a $15,000 withdrawal. So even without penalties, you’d lose one-third of a withdrawal to taxes.

The money you take out also wouldn’t be able to earn any future tax-deferred returns for you. At 60, you have a life expectancy of a couple more decades. The money you plan to withdraw potentially could grow to more than $70,000, assuming 8% average annual returns, if you leave it alone.

So using 401(k) money to pay debt is almost as dumb for you as it would be for a younger person who would pay penalties and incur an even bigger potential loss of future tax-deferred money.

Use the CD money instead, and change your spending habits so you don’t incur any future credit card debt.