Credit repair: What's the smart plan for clearing out debts?

Credit repair (Question #1) and recovering from bankruptcy (Question #10) let you erase old debt and improve your credit score – in the long run. But be careful about short-term implications.

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Feeling squished by your debt load? You can clear out old debts (Question #1) and rebound from bankruptcy (Question #10), if you're one of the increasing number of Americans worried about credit repair. If you're financially solid, check out employer matching in Question #6 or Roth vs IRA advice in Question #9, from today's Reader Mailbag.

Q1: Clearing off old debts
All my creditors write to me each year and offer greatly reduced settlement figures to clear the debt but, as yet, I haven’t had to money to settle any of them so would it be a good idea to implement a version of the snowball effect by saving fixed amount that I can afford each month and put it into an account to earn some interest, no matter how small, and then when I have a couple of thousand saved up contact the smallest debt creditor and offer an amount, say 30% of the balance owed to clear the debt? I am sure they would agree in order to clear the debt. Then carry on saving as before and add the amount I used to pay the creditor … and so on.

I don’t want to increase the amount I pay each creditor on the current agreement because they might think I can afford more and therefore increase the likely amount they would accept in the future as a settlement.

I do want to pay off my debts and so far I have done a fairly good job of working towards this goal. I want the best possible deal but I am unsure of the best strategy.
- Tom

Since these debts are in collections and thus not accruing more interest, I’d say your strategy is a relatively good one assuming that your goal is to actually be honest with your debts and pay them off now that you have your life in order.

It’s important to note that when you pay off the debts, the act of paying them will have an immediate negative impact on your credit rating which will be somewhat mitigated by an improved debt-to-credit ratio. It’s crazy, I know, but when you pay a debt that’s been in collections, you take an old debt and make it current, and your credit score pays much more attention to recent debts than to old ones.

Why am I mentioning this to you? If you’re about to take out debt for some other reason, wait until after you take out the new loan before paying off an old loan. You need your credit score as high as possible in the moment in which you’re getting a car loan or a home loan.

Q2: Life insurance and suicide
Is it true that life insurance does not pay out if you commit suicide?
- Fred

I excised a good deal of Fred’s note for obvious reasons. I sent him a personal note directly encouraging him to rethink some of the things going on in his life.

Nevertheless, Fred’s question is a good one. The truth is that most life insurance policies have some sort of suicide clause in them stating that there are either no benefits or reduced benefits in the event of suicide. This is obviously to protect a life insurance company from someone signing up for a big policy just to off themselves and give their family a big payout.

In short, if you’re considering some sort of misbegotten “I’ll get life insurance and then kill myself” plan, not only is it a dangerous and painful idea, it won’t work, either. Instead, you should spend your energy seeking out someone to talk through your problems with, whether it’s a trusted friend or a psychology professional.

Q3: Handling three child seats
My husband and I are expecting our third child. Our kids are currently 3 and 18 mos., and of course both are in car seats. By the time the next one arrives, the oldest will be in a booster, I think…but of course we’re contemplating the car question.

Our current fleet consists of three old, paid-for cars. We don’t travel much, and this works for us financially, as we’re paying off student loan debt and can’t fathom a car payment…Our cars are a 1993 Saturn wagon (220K+ miles), a 1999 Buick Regal (208K miles), and a 1999 VW GTI (78K miles). If one breaks down, we have an extra. So far we’ve been able to manage the occasional repair ourselves, by troubleshooting, talking with a knowledgeable parent, and networking for affordable repairs.

My question: with three in child seats, we may need to rethink a “family” vehicle soon. All three vehicles manage two child seats handily (the little VW is actually our favorite, as it’s deceptively roomy), but three seems like a real stretch.

If we need to think about a car purchase, we want to avoid a payment if at all possible. We have about $8K, optimistically, to use for a car. We just want to be reasonable and safe. Any thoughts on a bigger car?
- Kathryn

I’ll tell you right now that you don’t need to worry about fitting three car seats into your vehicles. We have three car seats in the back of a Toyota Prius – your station wagon will be just fine.

Based on what I could find, I’m sure that your station wagon and your Regal will be able to fit three seats in the back. I’m not 100% sure when it comes to the VW GTI, but I suspect that three seats will fit in there, too.

If it turns out that the GTI doesn’t quite fit three seats, put the GTI at the top of your trade list.

Q4: Various health insurance plans
Have you ever researched the cost of private insurance vs. employer provided plans? My wife and I are both Registered Nurses and were shocked by the cost of our “employer provided health care” for next year. In order to keep our current medical plan it will be $497.00 every two weeks (per pay period) which is $12922 per year. The only other option was $390.00 every two weeks and would have required that we change all of our MDs. We are both in good health in our early 30′s, have no significant health history or any medications and rarely see our MD unless it is for our kids (ages 4 and 2). This policy also comes with the standard co-pays and deductables for usage. Basically, I am wondering if this $12922 could be put to a better use? We are planning to get pregnant this year (so it makes sense to stick with this plan this year and keep our OB doc) but I am wondering about the years ahead. Why not purchase a quality plan for the family that has a higher deductable and invest the difference in a Health savings account (that could be tapped when needed) year after year? Why do we shop around for car insurance but never look at alternatives for health insurance? I guess it never occurred to me until it reached $12922.00/ per year out of pocket. Any thoughts would be appreciated.
- Andy

This is an impossible question to answer for several reasons.

One, not all health insurance plans are created the same. Different deductibles, different premiums, different policies, different levels of customer service… the variables go on and on and on.

Two, the field of health care is going through some serious upheaval right now as insurers adjust to the changing world of health care due to the recent legislation passed. A trend today may or may not be a trend tomorrow.

With just those factors, it quickly becomes impossible to offer up an answer. When you add in the uncertainty of life, that just adds another factor.

Your best solution is to simply figure out what you actually need, then seek out the best deal available to you for a health care plan that’s close to it. It might be through your insurer – it might not. Quite honestly, this kind of legwork – really digging into what you need, then trying to find private plans that compare to your one at work – is going to be a long process which may or may not save you anything, but it will certainly give you some peace of mind and a deeper understanding of the health insurance industry.

Q5: Credit card roulette
I have three credit cards – a Chase Amazon card that I use for all of my online purchases, a Sam’s Club card that I use at Sam’s Club and Walmart, and a Barclaycard iTunes card that I got to finance my laptop at 0% last year (paid off before any interest was due). Now, the iTunes card is probably about 1/4 of my total revolving credit limit, but I use it approximately none (once in awhile I’ll throw an oddball iTunes store purchase on it ~$2.00 to remind them that I have a pulse). Does getting rid of the unused card make sense, or would the drop in total revolving credit hurt my credit rating significantly? Currently, my credit rating is pretty stellar – student and car loan in repayment ahead of schedule, credit cards never have carried a balance over month to month (unless it’s 0%).
- Michael

I don’t think it’ll have a significant impact either way since it’s only 1/4 of your overall credit limit and it seems to be your newest card.

The only exception that I can think of is if you keep your other cards charged up to near their credit limit, in which case the iTunes card is helping significantly with your overall debt-to-credit ratio. If you’re actually diligent about keeping your cards paid down (if not paid off completely each month), then there’s no reason not to cancel it.

In fact, if you don’t use it much, i would cancel it, just to minimize your identity theft risk.

Q6: Understanding employer matching
If my company matches 401(k) contributions each pay roll equal to 100% of the first 3% (free money!) and 50% of the next 2%… would my amount looks like this?

Lets says that a 3% contribution for me for each pay roll (bi-weekly) is $30. At $30, I am really investing $60 per check ($120/month) since I have a 100% match for the first 3%.

$40 a pay roll = $75

$50 a pay roll = $85 ($170/month) is this correct?
- Andy

The easiest way to calculate it is to just break it into separate offers. In your case, I would look at it as an offer to completely match 3% of your pay and an additional offer to match half of 2% of your pay. Naturally, you’ll do the full match first.

So, you calculate that 3% of your pay is $30 and thus 2% is $20.

If you contribute $30 and use that full match offer, you get $60 in your retirement plan – $30 times 2.

If you contribute $40, you’ll use $30 of it on the full match offer – $30 times 2 being $60 – and then $10 in the other match offer – $10 times one and a half being $15 – totaling $75.

If you contribute $50, you’ll use $30 of it on the full match offer – $30 times 2 being $60 – and then $20 in the other match offer – $20 times one and a half being $30 – totaling $90.

So, the math is actually a little bit better than what you thought!

Q7: Tax deductible student loan interest
I’ve got around $55,000 in Stafford Student Loans at 6.3% interest, around $10,000 with Wells Fargo Student Loans at about 8%. I also have $1000 from a Federal Pell Grant (which feels like it has no interest!) and I owe my family around $5000.

My question is about how to pay back my student loans. Is the interest on the Stafford and Wells Fargo loans tax deductible? If it IS tax deductible, why would I ever want to make more than the minimum payments?

As I have things planned out now, I will pay back the Wells Fargo loan as quickly as possible, and then set in on the Stafford Loans. I will make minimum payments on the Federal Pell Grant, and the family debt will either be forgiven or paid back after I get onto my feet several years later.

But I’m really curious about the interest for those loans, or any tax breaks I might be eligible for due to paying them back! Any ideas?
- Nick

I don’t know what your exact loan offer is, but most student loans have tax-deductible interest.

The part of your question that deals with “why would I ever make more than a minimum payment” is troubling, though. This is a tax deduction, not a tax credit.

Let’s say you have $2,000 in student loan interest this year and you made $40,000. A tax deduction means that you just pay taxes on $38,000 this year – $40,000 minus your $2,000 in interest. That will only actually save you a couple hundred bucks on your tax return – you’ll still be losing about $1,800 in interest.

A tax deduction really isn’t an enormous savings and it certainly isn’t a reason to hang onto a 6% debt.

Q8: Selling old trading cards
When cleaning out my closet, I discovered a box of old Magic: the Gathering cards from my high school days. I don’t have even the vaguest idea of what any of them are worth. How would I go about figuring out if they’re worth dealing with? What would you do with them?
- Emory

Depending on how old they are, this can be a bit of a challenge.

The first thing I’d do is start identifying what you have. You can use this page to figure out which sets your cards belong to, which you’ll need to know before you use a card-pricing site. I suggest using a retailer like Star City Games and using them as a guide.

If you find individual cards of worth – specific ones worth more than $20 – I would sell them on eBay. I’d take the rest of them and sell them as a bulk lot on eBay, listing the ones worth more than $2 in the auction listing.

It will take some time and you might find you don’t have much of value, but if you do have old cards, you very well might have some significant value there.

Q9: What next?
I wanted to run some numbers by you to see what you thought.

2 40 year old adults no kids(by choice)

Two incomes=$130K/year combined

Two new cars(2008 and 2009) both paid off.

240K house with about a 200K balance 4% fixed rate 20 years left. No PMI

50K in emergency funds-This has been in TIPS for the last year

230K in 401k. Probably about 20K of that is in Roth 401K

No other debt

About 20K in company stock. 15% discount on company stock. I usually use this money to buy cars and go on vacations.

My wife puts about $5,500/yr in her 401K and gets a match of about $3,600/yr

I put $2,400/year in a roth 401k, $3,200/year in my 401K, and I get a match of about $3,600/yr

Any recommendations on if we should be apply more towards the Roth 401K and move away from the normal 401K? I know we don’t know what the rate will be when we retire so it’s kind of a gamble. Any opinions on this mix?
- Curtis

If a person is eligible for a Roth, I usually tell them to put their money into the Roth option.

The reasoning is simple. The United States is racking up nearly a trillion dollars in debt per year. Current income tax rates are staggeringly low compared to the 1950s and 1960s. In other words, the current taxation path isn’t a sustainable one. The fight to keep tax rates low is merely fighting the inevitable growth in rates – it will happen, sooner or later. The numbers don’t add up if we don’t do it.

If you believe that the tax rates will be higher in retirement than they are now – and I certainly do – then you’re better off paying the taxes on retirement savings now. That points straight toward a Roth.

Q10: Rebounding from a bankruptcy
I recently filed bankruptcy and am in the process of rebuilding my finances since i depleted everything in the process. I want to build my emergency fund quickly and somewhat effortlessly and thought about selling the contents of my closet (I have way too many clothes/shoes). What the best financial savvy way to accomplish this? I thought of ebay but am wondering if it would be too costly with their fees, and shipping costs and all.
- Joni

In my experience, the most effective way to re-sell quality articles of clothing that aren’t deeply worn is through a local consignment shop. Used clothes buyers on eBay are usually looking for bulk items and don’t want to be paying a high rate for them.

If I were you, I’d ask trusted friends in the area if they have any experience with clothing consignment shops and follow their lead. If you can’t find any information that way, use the yellow pages, then research the shops that you find and see what others have said online about them.

If your clothes are mostly low-end, I wouldn’t expect to get a whole lot for them, no matter what their condition.

Got any questions? Email them to me or leave them in the comments and I’ll attempt to answer them in a future mailbag. However, I do receive hundreds of questions per week, so I may not necessarily be able to answer yours.

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