How to get out from under credit card debt

It’s the single most common question these days in the Answer Desk Inbox: I’m drowning in debt! What can I do?

I am a 77 year old person with a limited income and have used credit cards to the maximum and now find myself in a position ($18,000) unable to pay.  What are the consequences for me if I just STOP making any payments to the six credit card companies? 
— Nicholas C., address withheld

What should you do if the accounts are already delinquent, past due, charged-off, and not necessarily due to neglect? Paying these accounts will still show negligence, so what can we do, those already drowning in bad credit?
— Letina, Tallahassee, Fla.

Here’s our seven-step plan for getting the credit card monkey off your back:

Step 1: Reality check
Over the years, with the blessing of Congress and federal regulators, the credit card industry has created a repayment system that was skillfully engineered to put its customers deeper and deeper into hock. By keeping credit limits high and monthly payments artificially low, the financial services industry created a dangerous sense of well-being among borrowers.

Billions of marketing dollars have been spent to create this false reality. The first step to getting control of credit card debt is to remove yourself from the fantasy mindset that as long as you can make the minimum monthly payment, your debt is under control.

Step 2: Make a plan
If you haven’t already done so, make a budget. You really have no idea if you’re truly broke until you understand where your money is going. Gather three months' worth of bills and make a list of where it goes. If you’re a heavy ATM user, keep a “cash journal” for a month or make your best guess about where you spend. Include all family members to make sure they get the same reality check.

If your monthly expenses are bigger than your income, you have to make some tough choices.  There are no right or wrong choices as long as you can get your budget to balance. Try to classify as many budget items as you can as "non-essential." Consider a list of things you can sell.

You may not have to make all these cuts, but look for as many as you can. Your goal is to find enough savings to make a meaningful dent in your credit card and other debts, not just the minimum payment.

Depending on the outcome of this exercise, you have (roughly) two courses of action.

Step 3: Pay it down
You’ll have to come up with more than the minimum to make a serious dent in your debt pile. But let's look at the impact of increasing your monthly payment.

If you added $300 to the monthly payment on that $18,000 balance, you’d save $47,600 in interest. And you’d be debt-free in just three years. If you can’t afford that much, a $460 monthly payment (just $100 more than your minimum) would save you $42,400 in interest and get you out from under in five years. (Our numbers are based on the Federal Reserve’s Web calculator. Try it out for your debt.) 

You‘ve got to stick with the plan month in, month out. Put your new monthly payment at the top of your pile of bills, along with rent, utilities, food and other “essentials.” Your credit card is now a “first of the month” bill and not something you try to chip away at when you have “spare” cash.

Have your paycheck direct deposited to your bank account and then set up an automatic bill payment for your credit card. These automatic payments will help impose a discipline to your plan: the money’s gone before you can find other “discretionary” ways to spend it. If you’re trying to go on a diet, it’s easier if you don’t stock the freezer with ice cream.

Step 4: Get help — carefully
If your budget won’t balance no matter how much you sharpen your pencil, you need to move to Plan B. The sooner you acknowledge the problem and get help, the sooner you’ll be able to resolve it.

If you're falling behind, you have a fairly limited window to act. Most card companies will move an unpaid debt to “delinquent” status after 90 days. That doesn’t mean you should wait that long if you know you have a problem. But your lender may not want to discuss other options before then.

Once you’re delinquent, you need to work out a plan as quickly as possible. After 180 days of non-payment, lenders typically “charge off” the loan from their books. They may sell your unpaid debt to another company at a big loss. Once your lender has decided to take the hit and move on, it’s a lot harder to work out a solution.

So don’t wait to ask for help. Call your lender (more on this in a minute). If that doesn’t work, contact one of the many legitimate, non-profit, nationally accredited credit counseling agencies that are available in most areas of the country. If you can’t get to a counselor's office, you may be able to work with them by phone. (To find a counselor, check out the Web site for the National Foundation for Credit Counseling.)

Step 5: Don’t get scammed
With so many people in credit trouble these days, there is no shortage of people offering solutions. Unfortunately, many of them will only get you deeper into trouble. Start by ignoring all the e-mail and Internet pitches for “debt consolidation,” “credit repair” and any other “get out of debt free” schemes. Most of these are scams.

One of the most common pitches these days comes from swindlers who offer to get your lender to settle for less than you owe. (You maybe able to do this on your own: more on that in a minute.)

The scam works like this: for a big upfront fee, your “settlement counselor” collects your information, tells you they'll contact your lender and then claims they've reached an agreement on your behalf with your lender. They'll insist on collecting payments from you to forward to the lender, cutting off all communication between you and your lender.

By the time you find out you’ve been scammed, your debt has been charged off or sent to collection agencies, you still owe the debt, your credit is ruined and the "settlement counselor" has pocketed your upfront fee and any payments you made.

Step 6: Consider alternate payment plans
Contrary to the claims made by the credit repair scammers, there’s no magic to taming a large pile of debt. When you meet with your legitimate, nationally accredited counselor, they'll need to review your budget to determine what your options are. If you haven’t made a budget, gather up all the bills, bank statements, cash spending diary and other documents you’ll need to work out a budget.

If you and your counselor can’t figure out budget items to free up cash to increase your monthly payments, the next step may be to consider approaching the credit card company to try to negotiate an alternative payment plan.

Negotiating a plan isn’t easy, and it’s not without consequences. You can do this on your own, but you may do a lot better with the help of a professional who does this for a living and knows who to contact and what to ask for. The credit counselor can also advise you on the impact various plans will have on your finances and credit down the road.

Step 7: Choose your best option
Debt Management Program: If your budget can afford it, your credit counselor will work out a five-year plan to consolidate all your credit cards and other debts and roll them up into a single monthly payment, using guidelines established by the lending industry for approved credit counselors. You'll have to show you can come up with a workable budget.

As part of the plan, your lenders may agree to waive late or over-limit fees and cut your interest rate. You won’t be able to use your cards, and your credit score may get dinged a bit, but the impact on your future credit will be better than your other options.

If the plan is approved by your lenders, you’ll be debt free in five years, as long as you keep up with the new monthly payment. You’ll pay a small fee to the counseling agency (typically $15 a month), and your counselor can help you stay on track.

If your counselor determines that a Debt Management Plan won’t work for you, they can help you discuss alternatives. But you’re going to have to deal directly with your lender to try to negotiate another option.

That means finding the right person in the right department who has the authority to change the terms of your debt. This is not something handled by the front-line customer service agent. Ask for the department that handles settlements, workouts or “loss mitigation.”  Expect to make more than one call.

Forbearance: With this option, your lender essentially agrees to stop the clock, but you’ll still owe the full balance and, usually, any outstanding interest and fees. Lenders will typically only offer this under very specific circumstances. You’ve lost your job but you’ve just found another one, or you lost income due a short-term setback like an illness. When the clock starts up again, you’ll have to make up missed payments, so unless your financial setback was truly temporary, and now behind you, this option probably won’t work.

Workout: This is similar to a Debt Management Program, but may not follow the same guidelines used by credit counselors. The bank may eliminate fees and cut your interest rate (temporarily or permanently) to help you get your finances back under control. You’ll probably also end up with a lower credit limit; you may have to agree to stop using the card.  

Settlement: Short of bankruptcy, this will have the most drastic effect on cutting your debt, but it will ruin your credit. With this option, your lender agrees to take less that your full balance to settle your debt. You’ll typically make three lump-sum payments. 

But this option comes with a price. Your credit score takes the same hit as you’d get from filing for bankruptcy. And you may owe taxes on the debt balance you didn’t pay off.

If you choose this option, make sure to get the settlement terms in writing. Read them and make sure you understand them before agreeing to move forward. Your credit counselor can help.

Bankruptcy: This is a last resort, butifyou’ve gotten this far you probably need to seriously consider it. It’s a terrible process to go through, it’s expensive, and it will leave your credit impaired for years. (Don’t believe any of the claims you may hear about “repairing” your credit score after a bankruptcy. It’s another scam.)

Though it’s the worst option, bankruptcy court is there for a reason. The law acknowledges that life is full of uncertainty. Perfectly responsible people can and do suffer financial setbacks through no fault of their own. The bankruptcy process is designed to give those people a fresh start.

If you’ve explored every other option and come up empty, seek a good bankruptcy lawyer and find out what your options are. The first visit should be free.