Even if you're financially responsible, life's unpredictable nature can catch you off guard, making it easy to fall into debt.
Dealing with situations beyond your control, such as a serious illness or an unexpected job loss, is difficult for anyone. Fortunately, there are usually ways to reduce the impact of even serious money problems, as well as strategies for improving your situation if you do find yourself in financial trouble.
Preparing for the Unexpected
It's helpful to start an emergency fund as part of your savings plan if you're able to to do so. You should aim to set aside enough money to cover three to six months of living expenses or perhaps even more. That way, when an unforeseen event puts a drain on your finances, you'll have some back-up funds to help see you through.
Set aside enough money to cover three to six months of living expenses.
Ideally, your emergency fund should be fairly liquid, which means the account value is available as cash or can be converted to cash easily with little or no loss of value. But the money you've put aside for emergencies should also produce some return, or increase in value, to help ensure it doesn't lose purchasing power. Term Share Certificates and Money Market Accounts may fit your needs. So may US Treasury bills, which you can buy online with a TreasuryDirect account linked to your bank account.
For example, you might create a ladder with three 12-month Certificates of equal value that mature on a rolling basis during the year—say in February, July, and October. If you need cash in an emergency, you can liquidate one of the Certificates as it matures rather than rolling it over and extending the ladder with another Certificate. Open a Term Share Certificate account.
Avoid putting funds earmarked as emergency money into a checking account. While the account is liquid, having extra cash so accessible makes it too easy to spend on mini-emergencies or even everyday expenses.
Getting Out of Debt
If you find yourself owing more debt than you're confident you can repay comfortably, you have a number of options.
The simplest thing you can do, if you act quickly, is stop spending on anything that isn't essential; essential items include rent or mortgage, food, and transportation. Since debt doesn't go away by itself, the faster you stop adding to the problem the better. You might also consider how to reduce your expenses in the short-term. For example, do you live near parents or family with room to spare? Consider subletting your apartment or renting your home until you can get your debt under control.
Your emergency fund should be fairly liquid.
Next, you can ask your creditors to rewrite the terms of your credit agreements so that your bills are easier to pay off. This often means making smaller payments over a longer period of time, which does mean that you'll end up paying more interest and therefore increasing the overall cost of resolving debt. But that's usually a better solution in the long run than having to default or declare bankruptcy.
If you need help dealing with your creditors or figuring out the best way to handle your debts, a non-profit credit counseling service, like our partner, Greenpath, may help. As a non-profit that equips people with knowledge and tools to lead financially healthy lives, they can partner with you to ease financial stress, manage debt, save for the future, make informed financial decisions, and achieve your financial goals. As a member, you have free access to GreenPath’s financial experts to guide you through life’s financial challenges.
Be wary, though, of other debt counseling services that require an upfront fee for a solution that doesn't involve changes to your spending habits. Unscrupulous organizations prey on people at their most vulnerable, often by suggesting there is an easy, quick way to get out of debt.
Tapping Other Resources
As a last resort, if you've been contributing to a retirement savings plan at work, you may decide it's better to tap this resource in a financial emergency rather than paying only the minimum due on your credit cards or skipping some payments all together.
Using your retirement funds to solve debt problems is not an ideal solution. After all, you'll still need income from your savings down the road. But if borrowing from your 401(k) or similar plan helps you put a halt to accumulating debt, that may help you get back on your feet faster. And, typically, you can repay the amount you've borrowed on a gradual basis through payroll deductions. The interest you pay goes into your account as well, rather than to a commercial lender.
In some cases, people have used home equity loans to pay off debt. But that type of borrowing puts your home at risk if you default. In addition, it's much harder to find such loans today since this type of cash-out borrowing contributed in part to the current housing crisis.
By resolving your financial problems before they overwhelm you, you can avoid the potential legal consequences of bad debt. These include being sued by your creditors, worrying about a court order to withhold a percentage of your salary to repay your debts, or even facing the possibility of bankruptcy.
Repaying the debts you've built won't happen overnight. But if you get your spending in check and possibly get some professional advice, you can generally resolve your financial problems over time.
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