All debt is not the same. Some debt, like car and mortgage payments, can actually improve your credit score, as long as you can keep up with the monthly payments. But then there are other types of debt that just make your financial situation worse. Here's a closer look at four of the worst types of debts and what you can do to get rid of them once and for all.
1. Debt that you've defaulted on
When you default on a debt, your lender reports this information to the credit bureaus, and it can sink your credit score, especially if the default comes on the heels of numerous late payments. You may start getting calls from a collections agency, and worse still, the default will stay on your credit report for seven years, making it difficult to get new loans and lines of credit. Your lender may also tack additional late fees onto your balance.
Image source: Getty Images.
Ideally, you can stop this situation before it starts by reaching out to your creditor as soon as you begin to have trouble making the payments. The company may be willing to work with you to set up a payment plan so that you can avoid going into default. Even if you've already defaulted, it's still a good idea to reach out. See if you can come up with some kind of payment plan or settlement agreement. Settling a loan won't look as good to lenders as paying the balance in full, but it's better than continuing to run from the debt. If you're not having any luck negotiating on your own, consider enlisting the help of a reputable credit counseling service.
You'll also want to begin taking steps to rebuild your credit. Think about signing up for a secured credit card, and make at least the minimum payment on all of your other bills to avoid further late-payment penalties and defaulted loans.
2. Credit card or payday loan debt
The average credit card interest rate is about 17%. If you don't carry a balance from month to month, you don't have to worry about paying any interest at all. But if you do carry a balance, it can get expensive quickly. If you charge $1,000 to your card but you can only afford to pay $50 at the end of the month, it will take you two years to pay back, and you'll end up paying an extra $200 in interest, assuming a 17% interest rate.
Payday loans are even worse. The average payday loan interest rate is 391%, assuming you treat the various fees and charges that most payday lenders charge as part of the interest cost of getting the loan. If you borrow $500 at that rate and pay it off over the course of a year, you'll spend $2,024, with $1,524 of that being interest. If money is tight for you, it can be difficult to get out of this cycle once you get into it.
Defaulting will only make your situation worse, so you need to find a way to secure a more affordable interest rate. Your credit card lender may be willing to negotiate a lower interest rate, but another option is to transfer a balance to a new credit card with a 0% introductory APR. This is generally only a good idea if you feel you can pay off the full balance in that introductory period. Otherwise, you'll end up in the same position as before. Also keep in mind that there may be fees associated with transferring a balance.
A personal loan is also worth considering. Depending on your credit score, the interest rate may be more affordable than your credit cards. Even if it's not, the advantage is that you're locked into a single, predictable monthly payment instead of your balance continuing to accrue interest. This could solve your problems, provided you don't go out and accumulate more credit card debt.
3. Tax debt
Most creditors are not allowed to garnish your retirement accounts to recoup what you owe them, but the IRS is an exception. If you owe back taxes and you have made no effort to set up a payment plan, expect the government to come at you with everything it's got. It can also place a lien on your property or revoke your passport. However, it is not allowed to take money from need-based retirement benefits, like Supplemental Security Income.
If you find yourself with taxes that you're unable to pay, the worst thing you could do is not file a return or not pay at all. Instead, file your tax return like normal and file an extension if you need more time to pay. The government will grant you an extra six months, but you'll have to pay a penalty of 0.5% on any outstanding balance.
You can also try applying for a payment plan if you owe $50,000 or less. Some individuals may qualify for an Offer In Compromise, which enables them to settle their taxes for less than the full amount. You can find out if you're eligible by filling out the Pre-Qualifier form on the IRS website.
4. Student loan debt
Many young adults graduate from college and then find themselves struggling to pay their living expenses and their student loans at the same time. Falling behind on the student loan payments will cause you to incur more penalties, and the real kicker is that you can't even get rid of them by declaring bankruptcy. But there are still ways to get out from under student loan debt.
You may qualify for student loan forgiveness, depending on what you do for a living. If you work for the government or a nonprofit for a certain number of years, your student loan debt may be reduced or eliminated entirely, though you'll still have to keep making payments during this time.
If your credit is good, you may also be able to refinance your loan to get a more affordable monthly payment. You could try switching to an income-based payment plan as well. These plans typically have longer terms and limit your bill to a fixed percentage of your monthly income.
Make being debt-free your goal
Dealing with these four types of debt is challenging, but if you're committed to becoming debt free, it is possible. Following the suggestions listed above and making a commitment to handling your money responsibly will set you off on the right path.
