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  • The Pros and Cons of Settling Your Debts

    This is a guest post from John Ulzheimer, credit blogger for Mint.com, and a contributor for the National Foundation for Credit Counseling. If you would like to guest post at Chief Family Officer, please review the CFO Guest Post Policy.

    Over the past four years we’ve unfortunately had to become familiar with the term “short sale,” which is actually a settlement accepted by your mortgage lender. And while mortgage settlements have become a common practice over the past few years, the process of settling other debts, such as credit card debt and debts being worked by collection agencies is a much more established process.

    Debt settlement works like this: You owe someone a large or not so large sum of money. For whatever reason you are unwilling or are otherwise unable to pay the creditor the entire amount. You approach the creditor or the creditor approaches you with an offer in compromise, which is a fancy way of saying that they are willing to take less than the full amount due and call it even. If you take advantage of their offer then you have “settled” the debt.

    Settled in Full Versus Paid in Full

    There is considerable confusion of the final status of a debt that has been settled. Some people suggest that it has been paid in full. Others suggest that it has been settled in full. Neither is actually true.

    Paid in full is reserved for consumers who did, in fact, pay the entire amount due to the creditor resulting in a fully exhausted debt, or a $0 balance. Settled in full is a contradiction of terms. Settlement, by definition, means to pay less than the full amount so a debt cannot be settled in full, ever. But, a debt can certainly be settled and left with no monies due. The appropriate and unnecessarily formal way to refer to a settled debt is that it has been settled and now has a $0 balance.

    Self Help or Third Party Settlements

    A settlement can be negotiated a variety of ways. Consumers can hire 3rd party debt settlement companies, that will charge a fee, to facilitate the settlement process or, they can attempt to negotiate a settlement on their own. And, there’s even a chance that the lender will reach out to the consumer and begin the settlement discussions proactively.

    Using a 3rd party debt settlement company can cause some problems with your creditor. First, the settlement company will likely instruct you to stop paying your lender and to start paying them directly. This accomplishes a couple of things. First, your payments to the debt settlement company will begin to build a war chest of money that the settlement company will eventually use to make settlement offers to your lenders. Second, some people would suggest that by not paying your lender for several months that they are getting desperate for payment and will be more flexible when considering your settlement offer.

    Of course consumers can negotiate with their lenders on their own. This not only saves the cost of the debt settlement company’s fee but it also might yield a settlement as good as one negotiated via a 3rd party.

    Impact To Credit Reports and Credit Scores

    Settlements are considered to be “major derogatory” items by all credit risk scoring systems, including FICO and VantageScores’ credit scoring models. And, when you choose to settle a debt the lender will almost certainly report that disposition to all of the credit bureaus. On a credit report, the debt will include language such as “Settlement accepted on this account”, “Partial payment plan”, or “Settled for less than full amount.” Regardless of how it’s reported to the credit bureaus, the impact is still the same.

    Just because a settlement appears on your credit reports doesn’t mean that it’s going to automatically have a severe negative impact to your credit scores. For example, if the debt already shows as being in default on your credit reports, it likely already has a negative impact. The fact that it is eventually updated to show as being a settled debt doesn’t add to the already negative impact.

    However, if you have clean credit reports and solid credit scores and you settle a debt that is not already in default and has no late payments associated with it, then the reporting of the settlement will likely result in a significant reduction in your credit scores. The length of time the settlement will be reported is seven years from the default date. Depending on what your scores were before you settled the debt, you could expect to see your scores drop over 100 points.

    Settling a Collection Agency Debt

    When you settle a debt with your original creditor, like a credit card issuer, you really are causing them to lose a considerable amount of money. However, when you settle a debt with a collection agency or a debt buyer you are not at all causing them to lose money. To the contrary, when you settle a debt with a collection agency, they are likely making a large profit on the debt.

    When collection agencies or debt buyers purchase a defaulted debt from a creditor or service provider they do so for pennies on the dollar. They are able to purchase your defaulted debt for so little because they are likely purchasing hundreds of millions of dollars of defaulted debt at one time and can command a very low “per dollar” price. When they purchase the debt, they become your creditor. You no longer have a relationship with the original creditor and any payments must be made to the collection agency.

    Still, this is not always bad news. If they purchased a $10,000 defaulted debt from your credit card issuer, they likely did so for a few hundred dollars or less. That means even if they can collect a few thousand dollars from you, they’ll make a huge profit by purchasing your debt. Clearly this means they’ll be more open to settling for considerably less than the original loan amount.

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    Why Saving is Less Rewarding than Paying Off Debt & How to Motivate Yourself to Save

    It took us nearly ten years to pay off our non-mortgage debt and become otherwise debt-free, but towards the end, our debt snowball had become so big that we were able to pay off a lot very quickly.

    Since then, our financial goals have changed as our lives have changed. At first, I wanted to pay off the mortgage. But then I wanted to build up a cash cushion so I could quit my full-time job as a lawyer. I did that two years ago, and the first year was really about learning to live on one income plus the substantially smaller amount I bring in blogging.

    The wonderful thing is that even now, we are able to build up our savings. In fact, I have a savings goal that is so outlandish, I’ve given us until mid-2016 to reach it. Each month, I add up our account totals and calculate how much more we have to save to reach our goal. We’ve made progress toward our goal every month except one (when we used savings to pay cash for our bathroom remodel). But I’ve noticed the last few months especially that I’m feeling dissatisfied with the relatively slow progress we’re making – just a few percentage points at best. At this rate, we may reach our goal by 2016, but we’re unlikely to get there early.

    I don’t remember feeling that way very often when we were paying off debt, but I realized it’s because there were smaller, tangible goals when we were paying off loans. We started with multiple loans and gradually paid off one after the other. So it was easy to see the balance of the targeted loan go down toward zero. We knocked off one loan, then another, so that felt like progress too. And even when the last, biggest loan was left, I approached it eagerly because of the momentum from paying off the other loans.

    So the current savings goal feels different because it’s this one big number waaay down the line that we’re not close to yet.

    The obvious solution is to break the big goal down to smaller goals and create mental milestones that will be rewarding. Since we keep our savings in different accounts, one way of doing this would be to establish a savings goal for each account, giving me a very reachable number to aim for. Another way would be to set a target for the end of the year and then have fun getting there. Just thinking about these strategies makes me feel more positive and optimistic about how far we’ve come and where we’re going – it’s going to be fun!

    Saving Money vs. Being Debt-Free

    Our public school district is in serious dire straits, so I’ve been thinking about life five years from now. While I feel reasonably confident our current elementary school will be okay, in five years, our oldest will be heading into sixth grade and off to a middle school. The problem is that I’m finding it difficult to find a really desirable public middle school. I’ve had my eye on the Sherman Oaks Center for Enriched Studies, which has a great academic reputation and goes from fourth through twelfth grade, but it’s incredibly difficult to get into. Even if I did everything possible to maximize priority magnet points, our odds of getting in will still be slim because of the lottery system.

    So we would really like to have private school on the table as an option in five years. But that will require money, and a lot of it.

    At the beginning of the year, I said that I wouldn’t have any financial resolutions for this year and that I just wanted to get used to living on one income. But we seem to have done that, and I couldn’t help taking a closer look at our mortgage, which is our only remaining debt.

    Ever since we became otherwise debt-free in 2009, I’ve toyed with the idea of paying off the mortgage. We pay a little extra every month, but only enough to accelerate the payoff by a couple of years. But. We could pay off the mortgage in five years if we save aggressively.

    Unfortunately, it’s hard to predict the future. Is it better to pay off the mortgage and free up the mortgage payment in our cash flow in five years? Or would we be better off saving the money and having a huge cash cushion that we can use to pay for tuition?

    I don’t think there’s a right answer, at least not at the moment when there are so many unknowns, like how much tuition would be. My projected calculations show that if tuition at the top schools continues to rise at the same rate it has been, it’s going to be in the neighborhood of $40,000 per year at the most expensive schools. I’m not sure we would opt for a school like that, even assuming we got in, because it’s so expensive. But even a moderately priced school is going to be around $20,000 per year, and we’ll have to pay twice that for two kids for five years (and then there’s college).

    So for now, we’re going to play it safe. It’ll be like last year, when we were aggressively saving so I could quit my job, only we’ll be saving for five years instead of one now. I’ve got a spreadsheet set up to track our progress, just as I did last year. And just like last year, we’ll have to be diligent about doing all of the things I recommend in the Ways to Make & Save Money series. My goal last year was ambitious but we did it – hopefully, we can do it again!

    The Effects of Becoming a Work-At-Home Mom: Refinancing Our Mortgage Again

    Early last year, we refinanced our mortgage because rates had gone down enough that we were able to get a rate that was 7/8% lower. This time, we will get a rate that’s another 2/3% lower, so we’ll be at 4.125% (I’m hoping that it will be even lower by the time we close, though I don’t think that’s going to happen).

    The last time we refinanced, I was all about saving money and lowering our overall payments. But back then, I didn’t foresee myself no longer working at this point in our lives.

    This time, I am all about the lower monthly payment. After all, I’ve quit my job and make a miniscule fraction of what I used to make.

    We can certainly continue to make our monthly payment now, but I like the wiggle room that a lower monthly payment will give us. And we’ll continue to pay extra on the mortgage, just not as much as we used to. We may, in the long run, end up paying more for the house than we would have if we hadn’t refinanced. But we’re confident it will be worth it – I am so much happier now than I was when I was working full-time, and I think that as the kids get older, I’ll be even happier that I am around a lot. I’ve always wanted to have the house that the kids hang out at after school, so I know what my kids are doing.

    I have to admit though, that I’d forgotten how much paperwork is involved in a refi. And, I’m waiting for the appraiser to arrive right now!

    Is a law degree worth the cost and risk?

    As a lawyer, I follow the legal industry, and my favorite legal blog, Above the Law, actually bills itself as a “legal tabloid.” One constant theme is how much it sucks to be a lawyer right now, especially an unemployed one. And another recurring theme is how much it sucks to be a law student right now, with worse employment prospects than the fourth-year associate who just got laid off. Here’s a recent example: UCLA School of Law (arguably the most prestigious law school in LA) recently sent around a job listing to students that was for the position of chauffeur to an entertainment lawyer, the pitch being that you could talk to him about his job while you were driving him around to his various appointments. At least when I was a student, the law school tried to help students get hired as law clerks or externs doing real legal work.

    Last week, Above the Law discussed whether a student entering his second year should quit before incurring more loans. (The gender of the student isn’t disclosed so for simplicity, I’m going to assume he’s male.) The student in question goes to a top eight school, has decent but not stellar grades, thinks he would enjoy public interest law, already has $70,000 in student loans, and is convinced he would graduate with $170,000 in debt. The editors gave the pros and cons of staying in school, but I thought what was really interesting was what was missing from the discussion: deciding whether you really want to be a lawyer and if so, how to make it happen.

    For example, if the student really wants to be a prosecutor or legal legislative work, then continuing with law school is the only way to make that happen. Or maybe he really wants to be an entertainment lawyer – he’s still going to need that law degree. The fact that he is at a top law school indicates that he is bright and is likely to pass the bar exam, be considered for interviews, etc. Especially if the student is willing to relocate for his dream job, then I think someone bright enough to go to a top law school would be able to get the position. At the very least, he will be able to get some position in his chosen field.

    That leaves the money question. Crystal at Money Saving Mom often writes about how her husband was able to make it through law school without incurring any debt, but I don’t think that’s realistic for most people. Tuition and fees at the law schools in Los Angeles is about $40,000 per year. I don’t know if it’s even possible to come out completely debt-free if you go to a relatively respectable school and don’t have a whole lot of money coming from somewhere other than loans, such as savings, a spouse, or a job.

    Speaking of a job . . . that’s something most law students don’t have, and understandably so. I didn’t, for the first two years of law school. First year grades in particular are so important that most students don’t want to have distractions from studying. But the student we were discussing is already a second-year, and could conceivably hold down a job if he was serious about limiting the amount of debt he graduates with. Even ten hours a week would bring in some income.

    And of course, there’s the big one – lifestyle. To be honest, back when I was in law school, I didn’t have a full grasp of what it means to live within one’s means. And most of my peers seemed to be the same. But a frugal lifestyle could significantly reduce the total amount of loans at graduation.

    Just as important, a frugal lifestyle after graduation will ensure those loans are paid off relatively quickly. Most loan programs allow for 20 to 25 years to pay off your student loans. But if you follow the proven debt-reduction techniques like the debt snowball, you can cut that time by half or more. These are all things that should be taken into consideration when deciding on a future career path, whether it’s the law or something else.

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