Once you start thinking about getting rid of debt, you are on the right track to being financially responsible. Debt settlement and debt reduction are two different ways of getting rid of debt. Debt settlement involves trying to get your lender to settle your debt for less than what you owe. Debt reduction consists of taking planned steps to reduce your debt. You might save more money in the short-term if you get your lender to agree to debt settlement, but you will pay in the long run. Debt reduction is the better way to go.
You typically need to have missed payments to get your lender to settle your debt. If that happens, your lender will probably report the delinquency and settlement to the credit reporting agencies. That will hurt you for the next seven years when you want to apply for new credit. Not many lenders will jump at the chance to lend to someone who missed making payments and settled debt. In addition, the money you don’t pay to your lender will count as income, for which you will be taxed.
Beware of Debt Settlement Firms
If you decide to take the debt settlement route, be careful of debt settlement firms that tell you they can settle your debt for you for a fee. Many of these places take your money and never even contact your lender. Or, if they do negotiate a deal for you, it could be months after you paid them. The Federal Trade Commission issued a Final Rule that prohibits debt settlement telemarketers from collecting upfront fees. This reinforces the importance of never giving these companies money before they deliver. The way debt settlement companies go about negotiating is often bad for you as well. Debt settlement companies typically tell you to stop paying your debt and give the money to them instead. In turn, they will open an account for you, and when they feel enough money is in the account, they will offer that lump sum to your creditor. You might as well go to Las Vegas because your odds of winning are about the same. Your creditor might not agree to a settlement. Meanwhile, you have accumulated late fees and interest and have shot your credit rating.
Snowball Debt Reduction
Debt reduction is a process to which you need to commit, but it will help your credit score and will leave you debt-free when you are done. Debt snowball and debt avalanche are the two most common methods. Financial guru Dave Ramsey prefers the debt snowball method because you get faster wins that way. The concept involves paying off your smallest debt first. Continue to pay the minimum on all other debts while paying extra on the smallest debt. After you have paid off the smallest debt, you feel a sense of accomplishment, and you are ready to tackle your next largest debt the same way. This method is called a snowball because of its cumulative nature: Once you pay off the first debt, you take the money you were using for it and add it to the minimum you were paying for the next debt. You tackle your biggest debt when the snowball is biggest.
Avalanche Debt Reduction
The debt avalanche method involves paying the debt with the highest interest rate first. This makes the most sense mathematically. As with the debt snowball method, you would make minimum payments on all your bills except the one with the highest interest rate. When that is paid off, you go to the bill with the next highest rate. You pay off debts faster and pay less interest with the avalanche method than the snowball method.
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