Borrowing money from a bank or another financial institution is a double-edged sword. On the one hand, it can be an effective way to begin building personal wealth. Borrowing to invest in either a new house or property or your children’s education will most likely pay dividends of different kinds down the line. On the other hand, using credit cards (you’re actually ‘borrowing’ from Visa, for example) to purchase anything and everything that tickles your fancy will most likely lead you down a financial road with few turns. 

While credit cards can be practical tools if used properly, they also have the potential to drive people who have an enthusiasm for spending into enormous debt.

When you reach the point at which monthly accounting is a mess (several credit card bills, utilities, etc.) and can only manage the minimum payments on your credit cards, it’s probably time to look into several different types of debt relief options.

Each has its pros and cons - some more cons than pros - but if you choose the route that best fits your finances, stick to the program, and do the time to eliminate the debt, you can pull yourself out of your situation.

Let’s look at each, from best option to the ‘nuclear’ option - the option of last resort.

Consolidation

When you first consider trying to consolidate all of your debt into a single monthly payment, you may find yourself in a strange situation: you want to take out a personal loan so that you can consolidate, manage, and pay off your debt, but banks aren’t approving you for a loan.

Why? 

The very thing that you’re trying to pay off - your debt - is warning the banks away from you as a bad financial risk.

In a way, it doesn’t seem very fair.

That said, you should still consider consolidation your first, best option. It has more advantages than disadvantages if you stick to your payment schedule.

The first two things to bear in mind are that consolidation requires you to 1) pay back your entire debt and 2) have a manageable credit score - most likely resulting from a decent debt-to-income ratio. If a bank deems that your income stream cannot handle the total amount of your debts, they’re probably going to back away from you.

The benefits of debt consolidation are obvious:

• You can transfer all your debts to a single lump sum. You pay off all your debt immediately.

• Your credit rating skyrockets, since you’ve paid all your creditors.

• You pay a much lower interest rate on the bank loan than you would on the various credit cards.

Should you have a poor credit score or a poor debt-to-income ratio, a bank may still approve your application. You’ll probably pay a very high interest rate - somewhere closer to the credit card rates, maybe even a bit higher.

In the relative short term, then, this is the most effective option. If you can stick to the monthly payment schedule from anywhere between 2-5 years, you’ll be debt-free and have a much-improved credit rating and a clean credit report.

Settlement

At first glance, this will undoubtedly strike you as an attractive option.

Negotiating with your creditors to pay a one-time, lump-sum amount that is significantly less than what you owe seems like a pretty good way of getting yourself out of trouble quickly and completely.

Always, remember, though, that there’s no such thing as a free lunch. There are still strings to consider - not the least of which is that your creditors are under no legal obligation to settle with you for anything less than the total amount. They have to be willing to work with you.

Debt Settlement Companies

While you certainly have the option to try to work with your creditors on your own, most people hire professionals in the field to negotiate on their behalf. There are some things to consider here:

• These companies also want to make money, and their take is usually about 20-25% of the amount that you’ll save, which could be significant.

• Debt settlement companies will most likely instruct you to stop making your regular monthly payments, which can be problematic. While you’re waiting for your representatives to settle, you’re accruing more interest and late fees, which only adds to the total amount of your debt.

• The payments you’ve skipped are intended to build a sum of money that you can offer to your creditor(s). Remember, though, that the longer it takes and the more your debt increases, the more you may be forgiven - which will probably end up in a more significant payment to the debt settlement company.

Credit Score and Credit Report

Since you won’t be paying the total amount for which you’re responsible, and since you’ll most likely miss an extended number of monthly payments while you’re waiting for negotiations to settle, your credit score and credit report are going to take a significant hit. This information will affect both for seven years, during which time it will be tough for you to borrow money from any financial institution.

Tax Consequences

The IRS considers any amount of forgiven debt to be ‘income’, since it’s less money than you have to pay out and therefore technically more cash in your pocket. You’re required to claim it as income on your taxes.

Is settlement worth it? It’s certainly less attractive than consolidation, but if you’re trying to avoid declaring bankruptcy, it’s probably the short-term answer.

The ‘Nuclear Option’ - Bankruptcy

Nobody wants to declare bankruptcy.

Not only does it effectively destroy your financial reputation for several years, but sometimes it can be uncomfortable. 

Sometimes, however, it may be the only way out of trouble.

Declaring bankruptcy allows a person to have a fresh start. It clears away all of your unsecured debt, and it’s also a way for some people to deal with unfortunate life circumstances: a significant illness, having been laid off from a job, or possibly a divorce.

Think carefully before pulling that lever, though, because you won’t be able to put your financial reputation back together for a long time. 

Clearing the Accounts

Before you choose a choose the route that you’re going to take, do some research and try to have the following information at your fingertips:

• The approximate cost to get yourself out of debt

• How long will it take? (consider your stage of life - young? middle-aged?)

• The impact on your financial reputation (short-term and long-term)

As the expression goes, ‘your reputation precedes you’. If you want to borrow money for productive reasons, you have to take care of your credit score and credit report.

Consolidating your debt is the first step to securing your financial future. If you would like to speak to a professional about how to navigate this essential move, click here.