Miss Simplee Sufficient

Bad debt is a term used to refer to a loan that you have failed to pay off.  Bad debt can result in a judgment, repossession, or foreclosure – or a combination of these.  Bad debt will remain on your credit report until you take care of it.  You have three options for taking care of bad debt:  paying it off, declaring bankruptcy, or ignoring it.

Paying it off
Paying off your debt, in general, is the best option.  If you have one or more bad debts, the first thing you’ll want to do is to contact the creditor and negotiate a payment plan.  The process can be complicated, stressful, and scary, so read our article about how to deal with creditors.

The creditor should work with you to set up a payment plan.  In many cases, the creditor will renegotiate the amount you owe to make it more likely you will complete the payment plan.  Sometimes creditors will require that you pay the full amount you owe.  If you need help negotiating with creditors, contact a credit counseling agency.  Most cities have non-profit organizations that will help you manage your debt.  These organizations don’t charge for their services.  Do not get involved with a pay-for-service company that charges you negotiate with your creditors.  You can do this yourself for free or use a no-cost debt management organization.

Bankruptcy
If you are in a situation where you have bad debt that you are relatively sure you will never be able to repay, bankruptcy may be your best option.  You should consider this option carefully though, because it causes a great deal of damage to your credit. 

Most people consider one of two bankruptcy options: Chapter 7 and Chapter 13.  In Chapter 13 bankruptcy, you petition the court to help you set up a payment plan to repay all or part of your existing debt.  Using this option, you will probably be able to keep things like cars and houses, but you have to pay for them.  The bankruptcy court will require regular payments and will probably deduct them right from your paycheck.  As long as you are making your bankruptcy payments as dictated, your creditors can’t call or harass you, and they can’t take further steps to collect the debt or repossess property.  Chapter 13 is the most common type of bankruptcy.

Chapter 7 bankruptcy happens when someone petitions the court to eliminate all of their debt.  This might sound like a piece of heaven, but it comes with serious consequences.  First, not everyone qualifies for Chapter 7.  In recent years, laws have been passed to keep people from taking advantage of Chapter 7.  You now have to prove that you will never, in the foreseeable future, be able to pay what you owe.  For instance, you may qualify for Chapter 7 if you have been injured and can no longer work.  Additionally, in Chapter 7, you may lose everything you own.  Houses, cars, and other possessions may be auctioned off, and the proceeds used to pay your creditors.

Ignoring Debt
Ignoring your creditors should never be viewed as an option, but far too many people do it.  Debt doesn’t ever go away unless you pay it off.  Ignoring your debt will result in late fees and penalties, a decreased credit rating, annoying and/or harassing creditor calls, and the inability to get more credit when you need it.  You should always work with your creditors to pay what you owe.

Defaulting on Debt – Secured Debt
Large-item debt reflects the biggest debt you will likely ever have.  It’s important that you know exactly how to manage large-item debt before you encounter it.

Large item debt is generally “secured” debt.  Secured debt means that the amount of the debt itself is backed up by the item purchased.  So, if you buy a car, the amount you owe on the car is secured by the car itself.  If you don’t pay what you owe, you can’t keep the car. 

The tricky thing about secured debt, especially in relation to cars and houses, is that, even if you don’t pay off what you owe, and the creditor takes back the item you bought, called “repossession,” but you may still have to pay the rest of the debt.  This is because, in the contract you sign for the debt, you promise to pay the full amount of the contract. 

If you don’t make the payments, the creditor will repossess the item and try to sell it to someone else, usually at an auction.  You will probably have to pay the difference between what you still owe on the item and what they were able to sell it for. 

Here’s an example:
You buy a car for $10,000.00.  With interest, the total payments on the car will add up to $15,000.00 by the time you’ve finished paying for it.  You pay for the car for a year, but then lose your job and can’t pay for the rest.  After missing three payments, the car credit company repossesses the car and sells it at auction.  At this point, let’s say you owed a total of $12,500.00 on the car (principal plus interest).  The finance company was able to sell the car for $5,000.00. 

That means that you will still owe $7,500.00 on the car.  A car you no longer have!  And, to top it all off, your credit rating will be trashed!  A bad credit rating will make it harder, if not impossible, to buy another car.  It’s like a few missed payments snowball into an impossible financial situation. 

From this scenario, it’s easy to see why it’s so important to make sure that you make all your payments on time.  Managing debt is not difficult, but it does take planning, budgeting, and, above all, personal and fiscal responsibility.  Manage your debt properly from the very beginning and you will find that your stellar credit rating will pay off years down the road.

Defaulting on Debt – Unsecured Debt
Most large debt is secured debt, but some debt that you will incur will be unsecured debt.  Unsecured debt means that what you owe isn’t backed by any particular item, but is rather backed by your promise to pay. 

The best example of large unsecured debt is a student loan.  Student loans can total, literally, tens of thousands of dollars, or more.  Medical students may leave school with more than $100,000.00 in student loan debt.  As a matter of fact, the average student loan debt for class of 2009 medical students is $156,456.  That’s a huge financial responsibility.

Student loan debt has one advantage over non-student unsecured debt; if the loans are backed by the government, payment plans are often very reasonable.  Unsecured loans from banks tend to carry traditional payment terms and interest charges, resulting in larger payments and fewer options for refinancing.

Unsecured debt can be just as damaging as secured debt if you default on your payments.  Although a creditor who has extended unsecured debt can’t necessarily repossess a tangible item, that creditor can file for a judgment against you in court and cause serious damage to your credit.  This might not sound like a big deal now, but, in the long run, having a healthy credit rating is less expensive and easier to deal with.

If you default on unsecured debt, a creditor can go to court and file for what is called a “judgment.”  A judgment occurs when a creditor explains to the court that you have not made your payments as promised and the court issues a legal proclamation indicating that you owe a certain amount to that creditor (plus interest in most cases).  The judgment will remain in force until you pay the amount you owe or renegotiate the debt with the creditor.  It will remain on your credit report for several years after you pay it off. 

Try getting credit with a judgment in force.  It can be impossible.  It’s not easy to get an unsecured loan in the first place (other than student loans).  If you default on an unsecured loan, you may never be able to get another one.  And, most other creditors won’t extend credit to you if you have not yet paid off the judgment.  Any credit that does extend credit regardless of the judgment will likely charge higher interest rates and require higher payments and a shorter loan term.

Dealing With Creditors

If you always pay your bills on time, you may never actually speak to or hear from any of your creditors.  But, if you fall behind on payments or default on a loan, you may hear from your creditors, or their cohorts the collection agency, far more than you ever dreamed.

Most creditors have their own in-house collection department.  You may begin receiving calls as soon as the day after a payment is due.  The person calling will want to know when you will make your payment and why you were late.  They may also ask if you anticipate being late again.

You can avoid most calls, by contacting your creditor as soon as you know you will be late on a payment.  They will appreciate being notified.  Explain your situation and ask if the payment can be skipped.

Creditors can call you every day and leave a message if you don’t call them to explain why your payment is late.  Creditors are not permitted to be abusive or vulgar to anyone.  Most in-house collectors are more than happy to work with you to reschedule your debt.  Outside collection agencies, however, are known to be harder to work with and many people complain that their practices are abusive.  Since abusive credit collection is illegal, you can report such practices to the Federal Trade Commission at http://www.ftc.gov/.

Falling behind on payments can cause a great deal of stress.  Many people try to avoid this stress by ignoring their creditors.  This is never a good option.  If you ignore your creditors, they may assume that you don’t want to pay what you owe.  If you find that dealing with your creditors is too stressful, get help.

Most cities have free debt management agencies that can help you get a handle on your debt, create a budget, and pay your creditors.  If you find that you are drowning in debt, contact one of these agencies and set up an appointment to discuss your situation.  Bring all of your financial information to your appointment, including all of your bills (even the ones you are not behind on) and all of your income information (pay stubs, etc.). 

Your financial counselor will look over what you owe and what you make.  The counselor will call all of your creditors and set up a payment plan that fits within your budget.  He will then help you set a budget.  This budget will have to be very strict.  The theory is that, once you get into debt, it’s time to stop thinking about spending and start thinking about paying.  You’ll not have much, if any, money for entertainment or extras.  You’ll be very limited as to what you can spend.

You will pay the credit counseling agency an agreed upon amount every week and they will send the funds to your creditors directly.  This arrangement should stop all creditor calls and let you breathe easier, but you have to follow through!

Remember, credit counseling is free in most areas.  You don’t need to pay a credit recovery agency to help you “fix” your credit.  As a matter of fact, you can negotiate with your creditors if you like, but credit counselors generally have more experience and more clout.  Since the service is free, there’s no reason not to let them handle it.

Terminology

Understanding the terminology that surrounds debt can be difficult.  Here, we have explained a few terms in easy-to-understand language.

Principal – Principal is the actual amount of the loan. 

Interest – Interest is the amount you pay each month to carry a loan. 

Collateral – Collateral is something that you offer to a creditor to secure a debt.  The creditor may or may not retain ownership of the collateral until you pay off what you owe.

Secured debt – Secured debt is a loan that uses a tangible item as collateral.  The creditor may retain ownership of the collateral until you pay off what you owe, even though you may have actual possession of the item.  For instance, a car is collateral for a car loan.  Although you have possession of the car, the lender actually owns it until you pay it off.

Unsecured debt – Unsecured debt is a loan that is not backed by collateral.  Unsecured debt is not easy to get (except for student loans) unless you have a stellar credit rating.

Judgment – A judgment is a legal motion that says that you have not honored your commitment to pay off a loan.  A judgment remains in force until you pay it off but it will remain on your credit report for several years after you finish paying.  Paying off a judgment is called “satisfying” it.

Default – Default happens when you don’t pay what you owe as you agreed. 

Collection – When you are late on a payment or default on a loan agreement, your creditors will try to contact you to collect what you owe.  After a period of time, most creditors will “write off” bad debt and sell your debt to a collection agency.   Collection agencies can be very aggressive in their collection practices.

Repossession – Repossession happens when you don’t pay for an item you used as collateral for a loan.  For instance, if you don’t make your car payments as agreed, the finance company can take the car back and sell it at auction.

Foreclosure – Foreclosure is like repossession of a house.  If you don’t make your house payments as agreed, the finance company can take the house back and sell it to someone else.  You will most often owe the difference between what you owe on the house and what the bank is able to sell it for.

Bankruptcy – Bankruptcy happens when someone goes to court and explains that they can’t pay their debt as agreed.  They can either enter into a payment plant to repay their debt under the court’s supervision (called Chapter 13 bankruptcy) or they can eliminate their debt entirely (called Chapter 7 bankruptcy).  Bankruptcy damages your credit and remains on your credit report for several years after the bankruptcy has been discharged (ended).