You don’t have to be in debt to have good scores

Dear Liz: How deep in debt must a person get before he or she is able to get a mortgage on a home? My grandson, age 26, has been steadily employed by the same company for nearly six years. He rents a place he can afford, buys used cars for cash, has a nice savings account and basically avoids debt by not buying things he can’t afford with cash. Now he would like to begin investing in a home. When applying, however, all he hears is that because he doesn’t have a credit rating, he can’t get a loan. Does he really have to create debt in order to get a loan?

Answer: The idea that you have to be in debt to have a good credit score is a persistent and destructive myth. It’s just as wrong as the idea that all you have to do to have good scores is manage your finances responsibly.

To have good credit scores, you must have and use credit accounts. This does not mean you have to be in debt or carry credit card balances. Simply using a couple of credit cards lightly but regularly and paying them off in full is enough to build good scores over time.

Your grandson may need to start by getting a secured card, which offers a line of credit equal to the amount of cash the applicant deposits at the issuing bank. Websites such as NerdWallet, CreditCards.com, CardRatings.com and LowCards.com highlight current secured card deals.

He also could consider “piggybacking” onto someone else’s good credit by being added as an authorized user to that person’s credit card. In some cases, the other person’s history with the card can be imported to your grandson’s credit bureau files. The person considering adding your grandson should check with the issuer to see whether such an import is possible.

Huge debts? Where to find help

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.

Don’t use your 401(k) to pay debt

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.

Parents trapped by huge student loan debt

Dear Liz: My husband and I took out more than $200,000 in federal parent PLUS loans to pay for our two daughters’ college educations. My husband earned over $300,000 when the loans were made. Since then, he lost his job and now makes $100,000. I went back to work and earn $35,000. We finally succeeded in getting a more affordable mortgage, but we are taking about $3,000 out of our savings each month to pay the bills.

My husband handles the finances and says that even if we could lower our loan payments, it wouldn’t matter because we still have to pay forever. He can’t even think about retiring. We do have a financial advisor, but I’m very concerned and wonder whether we should be using our savings this way. What are our options?

(P.S. Our girls both graduated, although one doesn’t have a great job and the other is still looking for work.)

Answer: Parent PLUS loans can, in moderation, help families pay for their children’s college educations. The key phrase there is “in moderation.” Even at your former income level, taking on so much debt for your children’s educations was ill-advised.

You don’t have a lot of options, unfortunately. As you probably know, this debt typically can’t be erased in Bankruptcy Court. If you stop paying, the government can take your federal and state tax refunds, garnish up to 15% of any Social Security benefit payments and ruin your credit, said Mark Kantrowitz, publisher of the FinAid and Fastweb financial aid sites.

“The government can also sue defaulted borrowers to recover the debt if they believe the borrower has sufficient funds to repay,” Kantrowitz said.

Ideally, you wouldn’t have borrowed more than you could have paid off before retirement (while still being able to contribute to your retirement savings). Since that’s not the case, your best strategy may be to simply get the payments as low as you can and resign yourself to paying this bill, perhaps until you die. (PLUS loans are canceled when the borrower dies and are not charged against the borrower’s estate, Kantrowitz said.)

As you suspect, it’s not a good idea to dip into savings to pay your monthly bills, especially when you’re doing so in the vague hope that things will get better rather than in the face of concrete evidence that they will.

There are several ways of stretching out the term of the loan to reduce your payments. One is using all available deferments and forbearances to suspend repayment for a few years. Then you could use an extended repayment plan to stretch out the loan term to 30 years.

Normally you wouldn’t want to take deferments and forbearances because interest continues to accrue, digging you into a deeper hole, Kantrowitz said. “But if the goal is to reduce the burden of the monthly payments and not ever fully repay the debt, it can be a workable strategy,” he said.

Another possible option for some families is an income-contingent repayment plan. Parent PLUS loans aren’t eligible for the more favorable income-based repayment plan, but income-contingent plans could lower your payments to 20% of your discretionary income, with the balance of the loans forgiven after 25 years of repayment. Discretionary income in this case is the amount of your income over the poverty line.

To qualify, you’d need to consolidate your Parental PLUS loans into a Direct Loan consolidation loan. You can find out more at http://www.loanconsolidation.ed.gov. Given your current income, though, you may be better off with the extended repayment plan.

 

How to help a friend with big debts

Dear Liz: I have a friend who owes $30,000 in credit card debt. I suggested he see a financial advisor who can help him to get out of this situation, but he never finds the time to do it. He pays all his bills on time, but only the minimum required, and there’s nothing left for him to save for his old age. He has a good-paying job but still struggles financially. How can we help him?

Answer: If your friend can pay only the minimum on his debt and can’t save for retirement, he’s in a deeper hole than he probably realizes. Many people in his situation wind up filing for bankruptcy, often after years of throwing money at impossible-to-pay debt.

Your friend should make two appointments: one with a legitimate credit counselor (referrals from the National Foundation for Credit Counseling at www.nfcc.org) and another with an experienced bankruptcy attorney (referrals from the National Assn. of Consumer Bankruptcy Attorneys at www.nacba.org).

The credit counselor will review his financial situation and see whether he qualifies for a low-interest repayment program that would allow him to pay off his debt within five years. The bankruptcy attorney will let him know whether bankruptcy might be the better option.

As a friend, you can pass these suggestions along to him, and even offer to go with him to one or both appointments if he’s comfortable with that idea. But you can’t force him to face reality or take any action until he’s ready to do so. One thing you definitely shouldn’t do is lend him money. He’s not managing the debt he has, and you don’t want your loan winding up with the rest of his bills in Bankruptcy Court.

Botched remodel holding up refinancing

Dear Liz: My husband and I are wondering whether it is time to file for bankruptcy. We have about $20,000 in credit card debt, largely because of a home addition and remodeling project my husband began five years ago. It has been much more costly and time consuming than he anticipated and is not even close to being finished. That prevents us from being able to refinance, which would free up money to pay our debt.

A mortgage broker recently suggested we apply for a home equity line to get enough cash for materials and labor to finish this project. We pay our mortgage and two car loans on time and make at least minimum payments on the cards.

My husband’s health has been declining, making it very difficult for him to do physical work on this project, and one of our kids has had two surgeries in the last few years, so there have been a lot of medical bills as well. How should we proceed?

Answer: You’re having trouble managing the debt you already have, so it’s definitely risky take on more. On the other hand, if you have enough home equity to get a line of credit, that could be a path out of this mess.

First, though, make 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 card balance of $20,000 isn’t by itself insurmountable, depending on your income, but the fact that you’re not paying much more than the minimums on your cards is a huge red flag — as are those medical bills.

The lawyer can review your situation and let you know whether bankruptcy is even a reasonable option. Each state’s laws differ, so you need to consult an expert.

If you decide instead to take out the home equity line, make sure you hire a competent and well-recommended contractor to finish what your husband started. The last thing you need is for someone else to botch the job.

Old debts don’t disappear

Dear Liz: I am astonished you would counsel someone to try to negotiate a settlement of credit card debts from 2003 that were written off in 2007. Why? The statute of limitations is no more than six years in California and can be much shorter in many other states. If a reader of your column begins to negotiate over debts that are that old, they risk creating a new debt or resurrecting the old one, thereby becoming liable for repayment of a debt that is not collectible. When there is a stale claim, the response to the collection agency needs to be: “This is a stale claim, the statute of limitations has expired. I do not owe this debt to you or to my original creditor. Please stop contacting me.”

Answer: Statutes of limitations limit how long a creditor is supposed to be able to sue a borrower in court. The statutes vary by state and the type of debt, but range from three to 15 years. The expiration of that limit doesn’t make the debt somehow disappear or prohibit a creditor from continuing collection efforts.

Many people feel a moral obligation to pay their debts when they can. Others want to negotiate to remove collections from their credit reports in return for payment. (Time limits for reporting negative items on credit reports are different from state statutes of limitations; in most cases, the limit is seven years and 180 days from the time the account first went delinquent.) If someone wants to get a mortgage, for example, a lender may require payment of an open collections account regardless of the state statute of limitations.

You’re correct that anyone who wants to negotiate a settlement of an old debt should be aware of the statute of limitations affecting that debt. If the limitation hasn’t passed, the borrower needs to be aware of the danger of getting sued. If the limitation has passed, the borrower needs to avoid restarting it by making a small payment. Instead, the best approach is to settle for a lump sum and to get the collector’s assurance, in advance and in writing, that the remaining debt will be forgiven rather than resold.

Don’t pay grandson’s credit card bills

Dear Liz: I hope you can offer me some advice regarding a large credit card debt. My 28-year-old grandson is currently enrolled in college part-time and is employed. Over the last few years, he was not in school and unable to find work. He has, consequently, accumulated a total debt of $7,000 on his three credit cards. What would you advise him to do? He is paying the interest only on his debts as that is all he can afford.

Answer: Today’s minimum payments require credit card borrowers to repay a portion of principal along with the interest owed that month. If he truly is paying only interest, then he’s paying less than the minimum required and his credit scores have probably taken a big hit.

Let’s assume that he’s actually paying the minimums on his cards. He needs to increase his payments if he wants to work his way out of debt faster. That will require earning more income (by working more hours or taking a second job), cutting expenses or both.

Seven thousand dollars is not an insurmountable amount of debt, and certainly not something he should file bankruptcy over. But he may want to talk to a legitimate credit counselor about budgeting strategies or, if he’s really in a bind, a debt management plan that would allow him to pay the debt off over time at lower interest rates. He can get referrals from the National Foundation for Credit Counseling at http://www.nfcc.org.

What you shouldn’t do is offer to pay this debt, even if you can. Struggling to repay this debt could teach him not to carry balances in the future. If you pay the debt, the only thing he learns is that he can count on Grandma to bail him out of his own messes.

There’s more than one way out of credit card debt

Dear Liz: In your book “Your Credit Score,” you note that one of the best ways to improve your credit score and lighten your credit card load is to get a personal loan with a credit union and pay it off in installments.

I have two high-interest credit card balances that are hovering right near my credit limits (a little over $15,000 total) that comprise the vast majority of my debt. I’d love to get an installment loan to pay them off, but I’ve applied several times and several places for personal loans — including my credit union — and have either been denied or not given a sufficient loan to cover the total amount. I also don’t have $15,000 in cash sitting around in a savings account to secure a loan of that size.

In this situation, what would you recommend? The minimum payments on these two cards are roughly $190 and $160 each, and I’d love to be able to combine them and maybe even save a few bucks too.

Answer: What you seem to be talking about is a secured personal loan, rather than one that’s unsecured. Secured personal loans typically require that you have an equivalent amount in a bank account or certificate of deposit as collateral for the loan. If you have the cash, though, you wouldn’t need the loan — you could use the money to pay off your debt.

Unsecured personal loans don’t have collateral. The bank or credit union is relying on your word that you’ll repay the loan. Not surprisingly, lenders can be pretty picky about whose word they will trust. Few will take a risk on borrowers with poor credit scores — and those maxed-out cards, accompanied by all those loan applications, aren’t helping yours.

For now, give up the idea of getting a loan. Instead, take whatever cash you have to pay down the cards as far as you can. Retain $500 or so as an emergency fund, but put the rest to use in eliminating this high-rate debt.

Next, start cutting expenses so you can free up more money to repay your debt. Do you eat out? Cut back. Pay for TV? Ditch the cable. Take vacations? Stay home for a while. None of these sacrifices has to be more than temporary, as long as you’re willing to stop adding to your debt.

Paying credit card debt is a lot like losing weight. If you don’t make much effort, you won’t get much result. But sending in big payments each month will help you see progress pretty quickly, which can inspire you to keep going.

Once you’ve got the debt paid off, don’t charge more on the cards than you can afford to pay off each month.