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How to Get Out of Debt With Bad Credit

Christy Bieber, The Motley Fool

How can you get out of debt if you don’t have a good credit score? Here are some approaches.

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Getting out of debt is always tricky. But it's especially hard when you have bad credit. It can be even harder with bad credit and a low balance than it would be with better credit and a higher balance.

Balance transfer credit cards and personal loans are popular methods for getting out of debt. But they likely aren’t accessible to you if you have bad credit. You’ll need to look into other alternatives to make debt repayment affordable or to pay what you owe ASAP.

Are you ready to resolve your debt issues, but aren’t sure how to get out of debt with bad credit? Here are some options to consider:

  • Refinancing debt to make payoff easier: It's not easy to refinance with bad credit, but you do have some options.
  • Aggressively paying what you owe: Use the debt avalanche or debt snowball method to pay what you owe over time.
  • Negotiating a debt settlement offer or payment plan: You may be able to pay back less than the full amount. But that isn’t always possible and it could damage your credit.
  • Filing for bankruptcy: Bankruptcy can make eligible debt uncollectible, but also does damage to your credit. It’s sometimes still the right answer, though.

Let’s take a closer look at each of these options so you can decide which approach is best for you.

Refinancing debt to make payoff easier

If you have a lot of high-interest debt like credit cards or payday loans, payment is difficult. Much of your monthly payment goes to interest instead of paying your balance. In some cases, so much of what you pay goes to interest that your principal balance doesn’t even go down.

Refinancing to a loan at a lower rate could make it easier to repay your balance. More money goes towards bringing your balance down each month. But, with bad credit, a low-interest personal loan or balance transfer probably isn’t an option unless someone with better credit cosigns and agrees to share legal responsibility for what you owe.

Do you have a friend or family member willing to cosign? Are you confident you’ll be able to make payments and not hurt your cosigner’s credit score? If so, this could be a good approach.

You could also potentially qualify for some types of loans with bad credit. A 401(k) loan is a good example. If you have money in a workplace 401(k) and your plan allows borrowing, you don’t need good credit to get a loan. You’re borrowing from yourself.

There are big risks to this approach, like getting hit with a 10% penalty on borrowed funds if you don’t pay the loan back. But taking this risk might be worth it if you can use a 401(k) loan to pay off all you owe and pay back this loan to yourself.

Aggressively paying what you owe

If you can’t reduce your interest rate with a balance transfer, personal loan, or 401(k) loan, you can work on paying off what you owe as quickly as possible. This approach works if you can make big extra payments to your debt and bring your balance down over a reasonable period of time.

Living on a budget that dedicates a lot of money to debt repayment helps reduce your principal balance as long as you make extra payments. You could also free up money for debt repayment by downsizing your home, driving a cheaper used vehicle, or getting a side job to earn extra money.

Focus on paying off one debt at a time. The debt avalanche method pays off the highest-interest loan first, while the debt snowball targets the lowest-balance debt. As debt is paid off, redirect the money you were paying towards it to the next debt on your list. Keep going until all debt is paid off.

As an added bonus, paying what you owe can significantly improve your credit score over time. After you’ve made payments for a while and brought your balance down, your credit may be good enough that you can qualify for a personal loan or balance transfer to reduce your interest rate.

Negotiating a debt settlement offer or payoff plan

If you cannot afford to pay back what you owe, a debt payoff plan won’t work for you. But you could negotiate a debt settlement or payoff plan with your creditors. This involves contacting your creditors, letting them know you cannot pay, and working out an agreement.

If you can pay a lump sum amount towards your debt, creditors may agree to accept this as full payment even if it’s less than the balance due. This is called debt settlement. It damages your credit because the debt is reported as settled rather than paid in full. But you won’t owe any more and you can work on rebuilding your credit score. Creditors will only agree if they believe you can’t pay and want to collect at least something from you.

If you can’t make a lump sum payment and can’t afford your bills, you could also propose a payment plan. This might involve the creditor lowering your interest rate or freezing your account. Hopefully, they'll no longer charge over-the-limit fees and other penalties. You’ll typically have to pay a set amount per month according to a schedule agreed to with your creditors. Sometimes the creditor will accept repayment of less than the full balance due if they think you otherwise won’t pay.

With both debt settlement and a payoff plan, you typically have to stop using your credit card. Be aware of that before you contact your creditors to find out your options. Debt settlement companies will help negotiate an agreement with your creditor for a fee, but you can call creditors yourself to talk about a plan. Be sure to get everything in writing before you start making payments.

Filing for bankruptcy

If you can’t get creditors to agree to a payment plan and your debt is truly unaffordable, bankruptcy may be your best answer.

While bankruptcy severely damages your credit, it can also help you stop negative information from being posted on your report every month when you miss payments and max out cards. Because bankruptcy can give you a way to solve your debt problems, it’s often the first step to rebuilding credit. Even though it does send your score plummeting.

There are two different types of bankruptcy you can file, and both provide relief in different ways.

Chapter 7 involves selling some of your assets to pay off creditors. The remaining balance of eligible debt is forgiven.

Chapter 13 lets you keep your property, but you have to pay something to creditors in a three- to five-year payment plan.

At the end of the Chapter 7 liquidation or the Chapter 13 repayment plan, the remaining balance of any eligible debt is erased.

If you want to file bankruptcy, talk to a lawyer to make sure your debt is dischargeable. They'll help you through the entire process. Credit card debt, medical loan debt, personal loan debt, payday loan debt, and most types of unsecured debt can usually be discharged.

But child support debt, some types of tax debt, student loan debt, and certain other kinds of debts cannot be wiped away in bankruptcy. Your lawyer will help you determine if bankruptcy is an option.

Which approach to getting out of debt is best for you?

There’s no one right way to get out of debt with bad credit.

You could attempt to refinance if you’re able, making payoff more affordable. You could use a debt payoff plan and work on paying down your debt. You could negotiate a settlement agreement with your creditors. Or you could file for bankruptcy.

Consider how much money you have available as well as the impact on your credit with each approach to decide what’s right for you.

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