How Can You Get Out of Debt with Bad Credit?

As many as 8 out of 10 American adults have some form of debt and the vast majority are stuck in a persistent cycle of interest, penalty fees, and escalating APRs. It’s not always something they accumulated through careless abandon or something they acquired as a means of paying for a lifestyle they otherwise can’t afford. 

In fact, close to a quarter are using debt to pay for necessities like food and utilities. 

Many of these persistent debtors feel trapped. They’re making monthly payments they can barely afford, dealing with creditors that penalize them for every setback, and struggling with credit scores so low they have no hope of acquiring additional loans or credit cards, let alone a mortgage.

So, what should you do if you’re in this position? How can you clear your debt if you have bad credit?

Challenges to Getting out of Debt with Bad Credit

A good credit score makes a massive difference when it comes to escaping debt. You have creditors at your mercy, because they see you as a trustworthy, reliable borrower. You can refinance, consolidate, and generally reduce the size and scale of your debts by using your credit score as leverage.

If your credit score is poor, you can still acquire new credit cards and personal loans, but the interest will be so high and the fees so severe that you’ll become trapped in an endless cycle of escalating repayments and penalty fees. 

The Difference a Good Credit Score Can Make

Let’s forget about consolidation loans for a moment and focus purely on credit cards. If you have an exceptional credit score, there’s no reason why you can’t get a rewards card with an APR as low as 15%. On a balance of $10,000 and with a minimum monthly payment of $300, it will take you 44 months to clear this debt. In that time, you’ll pay $3,017 in interest.

If you have a bad score, your options are a little more limited and you may be stuck with a rate of 26% APR. In this case, it will take you 60 months to clear the debt and cost you close to $8,000 in interest.

The debtor with bad credit clearly needs the money more, but over the course of several years, they’ll have $5,000 less and be forced to deal with the debt for 16 months more.

Statistics like this are why it’s so hard for individuals to escape the cycle of bad credit.

How Much Debt is too Much?

There is no such thing as “too much debt”. The United States has trillions worth of debt and Apple, one of the biggest companies in the world, has billions. You can be rich, have a positive cash flow, and still have a lot of debt. However, everyone has a ceiling point, and this is based on their income.

To estimate yours you can use something known as the debt-to-income ratio. This is calculated by combining your total monthly payments and comparing them to your gross income.

If, for instance, you earn $10,000 a month and have total monthly payments of $3,000 ($1,000 in credit cards; $1,000 in personal loans, and a $1,000 mortgage payment) then your debt-to-income ratio is 30%. 

This ratio doesn’t directly affect your credit score, but it is used by mortgage lenders to determine your creditworthiness. You can also use it yourself to assess your financial situation.

A debt-to-income ratio below 30% is optimal and anything below 20% is ideal. If it climbs above 43%, you’ll start being rejected for mortgages and other major loans and if it climbs above 50%, it’s time to seek help.

A 50% debt to income ratio means, for example, that your monthly payment is $2,500 and your income is $5,000. Once you add utility bills, food, and other essentials to the mix, you won’t have a lot of money to play with and you’ll be one medical disaster away from financial ruin.

What Qualifies as Bad Debt?

All debt can be considered bad as you’ll always pay interest and run the risk of receiving derogatory marks. But some debts are worse than others and these are known as “Bad Debts”.

Generally speaking, bad debt is any form of debt that doesn’t increase your net worth. A mortgage, therefore, is classed as good debt, because it gives you a sizable asset that will likely appreciate in value; a brand-new car is bad debt, because its value will plummet as soon as you drive it away.

Student loans are also considered to be good debts as they help you build towards your future.

Debt is a common part of modern life. If you want a good education, a home, and a clean bill of health in the United States of America, you need to accumulate debt. By focusing only on “good debt” and avoiding “bad debt” (store cards, credit cards, car loans, retail loans) you can increase your chances of turning your life around and greatly improving your financial situation.

Options for Clearing Debt with a Bad Credit Score

Now that we’ve established just how damaging bad credit can be, it’s time to look at your options. There are a few ways you can pay off debt with a Poor or Very Poor credit score, but they may not all be available to you.

Build Your Credit Score

If time is on your side then your first step should be to improve your credit score, thus increasing your chances of making the following options work. This is easier said than done, but in just 3 months you could add up to 200 points to your credit score, which is enough to move from Very Poor to Good or from Fair to Excellent.

Credit scores are calculated based on 5 criteria, each weighted differently. Improving your score is a simple case of understanding what these criteria are and knowing how to manipulate them in your favor:

  • 10% – New Credit Accounts: Avoid opening any new accounts or applying for anything unless it is absolutely necessary. If you do apply for new loans, make sure those applications occur within a 14- to 30-day period (depending on the credit scoring system) so that all inquiries merge into one.
  • 10% – Mixture of Credit: This can only be improved by adding a variety of credit accounts to your credit report. However, in the short-term, this will do more harm than good and is therefore not something you should do simply for the sake of improving your score. It’s worth keeping in mind for the future, though.
  • 15% – Age of Accounts: Age is key. The older the accounts are, the better. Don’t open anything new and keep all cleared accounts active where possible.
  • 30% – Credit Utilization: This aspect of your credit score compares your available credit (such as the combined limits of all credit cards) to the used credit (such as the balance on those cards). You can improve it by increasing the number of payments you make every month but also by requesting an increased credit limit. This won’t reduce your score and will simply add some much-needed percentage points to your utilization ratio. You can also add yourself as an authorized user to a friend’s or family member’s credit card and keep all cleared credit cards active.
  • 35% – Payment History: Dispute all errors on your report and do everything you can to remove them. Keep meeting your minimum monthly payment obligations and every month your payment history will improve and your credit score will improve with it.

If you’re in such dire straits that you can’t increase your limits, acquire any new credit or do anything else discussed below, then seek to build your credit score with the following:

  • A Secured Credit Card: Offered by many credit card companies, these cards are secured against a cash deposit. You get all the benefits (including the convenience of a secure credit card) without the risks that large, unsecured debts can bring.
  • Online Lending Circles: These services bring many debtors together. They essentially just move money around, but everything is reported to the credit bureaus and if you meet the terms of service you can slowly build your score.
  • Credit Counselor: An expert in finance, budgeting, and debt relief who can help you find a solution that is tailor made for your specific needs. They can’t improve your credit score directly, but they can show you how.

Get a Cosigner

A cosigner with good credit can help you acquire a personal loan, consolidation learn, or low-interest credit card. If your parents are homeowners, you can also consider home equity loans or reverse mortgages, swapping home equity for a cash sum that you can use to clear your debts.

It’s not an option for everyone, however, and you’ll need to find someone who trusts you and has a strong credit score or a home to use as collateral.

A Debt Management Plan

You can get a debt management plan through a credit counseling agency or credit union. They work with debtors suffering hardship and essentially consolidate and then manage debts on their behalf.

You can reduce all debts to a single monthly payment, eliminating the risk of penalty rates, extra fees, and escalating payments.

They often require that you cancel all your credit cards except for one, which should only be used in emergencies. This is really the only downside to debt management, as canceling cards and other credit accounts will reduce your credit utilization score. 

If you fail to make your monthly payment during any given month the agreement may be canceled, at which point your creditors will defer to the original terms of the loan/credit.

A Debt Consolidation Loan

Consolidation loans are somewhat misunderstood. The idea behind these loans is that you consolidate multiple high-interest debts into one low-interest personal loan. The problem is, you can’t acquire this personal loan yourself, because if you have bad credit then low-interest loans are not exactly easy to come by.

You have to go through a debt consolidation company. These companies work with all kinds of credit scores and provide a debt consolidation loan that is large enough to cover your debts and has an interest rate low enough to reduce your monthly payment.

But, of course, creditors are not there to do you any favors. While the interest rates and monthly repayments are lower, the loan term is extended, which means you’ll have the debts for longer and will repay more interest over the term.

This is something that few debtors take into consideration as they get too caught up in the APR and monthly payment. As an example, let’s imagine that you have three credit cards totaling $20,000 and charging an average of 25% interest. With a minimum payment of $800 a month, it will take you 3 years to clear the debt and cost you over $8,500 in total interest.

If you consolidate that debt with a 10% interest rate, you can reduce the monthly payment to $264.30, but in doing so you’ll have the debt for 10 years and will repay over $11,700 in total interest.

A Balance Transfer Credit Card

A balance transfer credit card is basically a debt consolidation loan, only you’re moving multiple credit card balances onto a single card. Balance transfer cards offer introductory 0% interest rates that last for up to 18 months. 

You’ll need to pay a transfer fee of between 3% and 5%, which means a $20,000 balance will grow to $21,000, but if you continue making that $800 monthly payment then you’ll reduce your balance to just $6,600 by the time that introductory period ends.

Your credit score will drop temporarily when you sign up for a new credit card, but the drop will be small and will diminish over time. 

Your credit score will also drop if you close all credit cards that you clear, so keep these open if you can.

Debt Settlement

Debt settlement companies work best when you have bad credit resulting from multiple missed payments, collections, and charge-offs. At this point, your creditors/collectors are desperate to cut their losses and get a return, even if it’s just a fraction of the original balance. They’re open for negotiations and a debt settlement specialist will use this to their advantage and try to settle for between 40% and 90% of the balance.

The problem is, they will also request that you stop making payments as soon as the debt settlement process begins. This deprives your creditors of interest payments and makes them more inclined to settle. It also gives you more money to use towards the settlements. 

At the same time, it destroys your credit score, or what’s left of it, and there’s a risk you’ll be sued. This process can also last for up to 4 or 5 years and it may take several more years to rebuild your credit score after this.

Staying out of Debt and Building Your Credit Score

Clearing your debts is just half the battle. If you think your credit score is low now, wait until you go through debt settlement, bankruptcy, and even debt management. These debt relief methods will clear your debts, but they’ll do so in a way that damages your credit score and leaves derogatory marks that may remain for years.

The good news is that you have a clean slate and can slowly rebuild your credit score and get back on your feet. Just keep the following tips in mind:

Spend What you Can Afford

Don’t deprive yourself of credit cards just because you spent years battling credit card debt. A credit card gives you a secure and convenient way to spend money. It can help you during an emergency and cover you several days before payday when money is tight and your options are limited. A credit card with a large and relatively untouched credit limit is also hugely beneficial for your credit score.

So, by all means, keep your credit cards active, but be careful how you use them in the future. Only spend the money that you’re 100% confident you can repay. In most cases, you should limit yourself to spending money that you already have in your bank and then transferring that money across every couple of weeks. 

Not only will this prevent your balance from growing, in which case you’re one financial disaster away from that balance rolling over, but it will also improve your credit score.

Credit cards are reported to the credit bureaus once every 30 days and your balance will show as credit card debt even if you have every intention of paying the balance in full and have done so for every previous month. By clearing that balance early or repaying large quantities of it, your debt will be much lower at the end of the month.

Give Yourself a Strict Budget

Set a strict spending budget every month based on incomings and outgoings. Don’t just calculate your debt-to-income ratio—include all outgoings, such as food, bills, and other essentials, and calculate your incomings after tax. The figure you arrive at is your disposable income, at which point you can reduce it by 70%. This is the amount of money that you can comfortably spend every month, with the rest going towards your savings.

As an example, let’s imagine that you earn $4,000 per month after tax and have all the following obligations:

  • Credit Card Debt: $500
  • Personal Loan Debt: $500
  • Other Creditors: $100
  • Utility Bills: $300
  • Food: $600
  • Subscriptions: $200
  • Other Payments: $300
  • Remaining Balance = $1,500 – 70% = $450

Every month you have $450 to spend on eating out, day trips, clothes, electronics, and other luxuries. This ensures that your debts are paid, and you don’t spend money you don’t have. It will also prioritize your savings, which can help you during a future emergency.

Reduce Housing Expenses

A growing number of Americans are spending up to 50% of their income on housing expenses, including rent and insurance. If you have a mortgage, 50% is still a huge amount to spend, but it’s excusable because every month you move one step close to owning your home.

But if you’re spending all that income on rent, then you’re not moving any closer to acquiring an asset and are just flushing money down the drain. Try to reduce your housing expenses by moving to cheaper accommodation. If you move out of the city you get better accommodation for less, albeit with the added expense of an extended commute.

Reduce Your Subscriptions

The average American household spends several thousand dollars on nonessential subscription services every year. These packages cost just $5 to $30 each and seem insignificant at first, but if you have 5 of them that’s between $25 and $150 a month or $300 and $1,800 a month.

Amazon Prime, Netflix, Hulu, Xbox Live, PlayStation Plus, Beauty Boxes, Music Streaming Services, Meal Delivery Services, Diet Clubs, Gift Boxes—it’s easy to accumulate thousands of dollars’ worth of annual debt without even realizing it. Get rid of the services that you don’t use and focus on the bare essentials.

Summary: Which Option is Right for you?

Your options are pretty limited if you have bad credit, but there are still a few things that you can do. If you have trusting parents who own their own home, begin by asking them to cosign or help you in other ways. If you have money for settlements, lots of derogatory marks and heaps of unsecured debt, then debt settlement might be the way to go.

If you’re struggling to make a decision, contact a credit counseling service in the first instance. They will ask you a few basic questions, asses your situation, and then recommend the best course of action. This service is provided for free by settlement companies, but you may not get the best advice as they’re more inclined to direct you towards their own services. However, even the best counseling services will charge you less than $40 for a short 30- to 60-minute appointment and this is all you need.