No matter where one stands in the income-earning hierarchy, debt management is vital. Underestimating or ignoring your obligations can delay or even prevent you from accomplishing many financial goals. Here are four myths about managing your debt:
1. My credit report is fine, and so am I. Many people glance at their credit reports once or twice a year, see a decent score and move on. But credit reports often contain inaccuracies that, once taken into account, make your debt picture look much less rosy.
This is why it’s important to review your report regularly and follow up with the issuing credit agency if there’s an inaccuracy. For example, make sure your report doesn’t reflect a lower credit limit than the one you actually have.
2. Shut it down … shut it down now. Closing out credit cards is a tried and untrue approach to debt management. Although you should limit your number of open cards, pay them off or maintain low account balances, and avoid or renegotiate high interest rates, eliminating them isn’t necessarily the way to go.
The major credit-reporting agencies use a combination of metrics to establish your credit score, including credit history and debt utilization (ratio of debt to available credit). Closing out a card reduces your credit history, limiting the data by which you’re evaluated, and increases your debt utilization, which hurts your credit score.
3. I hold the golden ticket. The easiest way to deal with debt may seem a broad, sweeping strike to pay it down. Unfortunately, gathering the funds to make that move may only worsen the overall situation.
For instance, home equity loans typically offer lower interest rates than credit cards and large available balances for wiping out multiple debts. But the greater obligation isn’t really wiped out — only transferred. And the borrower’s very home is put at risk.
Similarly, taking out a 401(k) loan offers easy, low-interest access to funds. But a significantly negative tax impact and marked reduction in one’s retirement savings are downsides that must be considered.
4. Bankruptcy = failure. Well, it certainly isn’t success. And a bankruptcy filing should undoubtedly form the last line of defense in any debt management plan. But, rather than considering it an outright failure, you might want to look at bankruptcy as a last-chance opportunity.
In many cases, a person’s credit score can recover surprisingly quickly — sometimes as soon as three to five years. In addition, some tax liabilities that meet certain requirements can be discharged in bankruptcy. Your financial advisor can tell you more.