Debt Settlement Arithmetic

In May 15, 2007

I’m writing this post to cover a subject that comes up frequently when people are exploring the debt settlement strategy. I’m referring to the arithmetic of debt settlement. Many consumers get hung up on the math involved, and this topic usually comes up as a concern or an objection to using the settlement strategy. It often gets expressed as a question: “What happens to all that extra interest and the late fees the bank will keep charging me? Will they waive that when I settle with them?”

The short answer is: “No, they won’t. But you shouldn’t care anyway!”

In order to understand why, it’s necessary to dig into the mathematics of credit card debt. Let’s say you have $50,000 of credit card debt, and you have reasonably low rates on all the accounts because you haven’t hit the wall yet and starting missing payments (although you’re about to fall behind or you probably wouldn’t be reading this). A normal level of minimum payments on $50,000 of credit card debt would be around $1,250 per month. That translates to around $15,000 in minimum payments on an annual basis.

At that minimum-payment pace, it will take 10 years or more to pay off the debt, depending on your interest rates. Let’s assume it would take “only” 10 years to pay off the debt this way. That means the total payout would be $150,000 ($15,000 per year for 10 years). Bear in mind that a 10-year payoff scenario via minimum payments is very unrealistic. The reason is because one missed payment during that entire time is enough to trigger sky-high interest rates across the board, resulting in a much longer payoff period, like 20-30 years or more.

The key point to understand in the above figures is this: Basically, you’re paying $15,000 per year for the privilege of STAYING IN DEBT, to the tune of $50,000. Now, if you get off the payment train, you can certainly expect the train to continue rolling down the tracks without you! So, if you temporarily suspend payments, the total debt level will inflate quickly, simply because you’re not sending in enough to cover the finance charges that will continue to accrue.

Let’s say your average interest rate climbs to 28% and you also start getting hit with $39 late fees. Let’s also assume the $50,000 is spread across 6 different credit card accounts. Over the initial period of 6 months, the $50,000 of debt will inflate by around $8,400 based on these figures, and now you’ll owe $58,400, not $50,000. Around $7,000 of that inflation is due to interest ($50,000 at 28% APR for six months) and the rest is late fees ($39 per month on 6 accounts for 6 months).

But hold on a minute! You haven’t been making payments, right? Remember the $1,250 per month you were shelling out, just to stay in debt for the next 10 years (or worse)? Well, save up 6 months’ worth of that minimum payment moolah and now you have $7,500 sitting in the bank. So the TRUE inflation is around $900, and NOT $8,400, because you have to factor in the $7,500 that you have set aside.

OK, so how much debt can you get rid of for $7,500? If you settle one or two of your accounts at 50%, that $7,500 will clear out $15,000 of debt, leaving you $43,400 in debt, not $58,400. And if you do better, with an average settlement of 40% (which is very realistic in many cases), then your $7,500 will retire $18,750 of debt, leaving you with $39,650 of debt remaining to settle. So over the course of six months, you’ve already made a HUGE dent in a total debt load that would have otherwise taken at least 10 years to pay off, if not much longer.

Now, at the end of that initial 6-month period, the accounts you were unable to settle (for lack of funds) will go through the standard charge-off process and get assigned to collection agencies. Normally, the late fees and interest will stop at that point, although in some cases the inflation will continue. It’s mostly the debt purchasers that try to inflate the debt by back-dating interest to the point of charge-off. But the worst of the inflation of debt stops after charge-off, which allows consumers to continue repeating the above process until they have successfully eliminated all their debt in a 1-3 year time-frame. The program duration is dictated by the pace at which you can accumulate funds toward settlements.

Any way you slice it, settlement makes sense mathematically. Once you realize that your $50,000 debt problem is NOT a $50,000 problem, but really a $150,000, $200,000, or $250,000 problem (when paid back via minimums only), then you’ll see that the inflation factor (while you’re waiting to settle) is no big deal. Even if you end up paying out $50,000 over a 3-year program, isn’t that a whole lot better than paying out $150-250k over the next 10-20 years?

The true tragedy of credit card debt is that most people have sufficient cash flow to settle out their accounts. In our example, you were paying $15,000 a year in minimum payments, but not getting anywhere. Three years of that equals $45,000, and is plenty to retire the full debt load even after it inflates significantly due to interest and fees. It’s just that the banks have people caught in the spring-loaded steel trap of relentless credit card mathematics. But it’s only a trap when you play the game the way the banks want you to, that is, to be hostage to minimum payments for the rest of your life. Once you take charge of the situation, suddenly the math starts to turn around and work in your favor again.



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