Figure Out Which Debt to Pay Off First
If you have debt – on credit cards, student loans or anything else – that you were paying down while you were working at your old job, you need to figure out how to manage your debt payments in light of your reduced income.
“Although you will pay more interest the longer a debt is outstanding, the short-term game plan must be to maintain a reserve to meet your core living expenses,” says certified public accountant Deborah Smith Pegues, bestselling author of “Financial Survival in Uncertain Times” and “30 Days to Taming Your Finances” (Harvest House Publishers). “This will reduce the stress of worrying about the immediate future and allow you to think more clearly and creatively about your next steps.”
In other words, it’s probably time to temporarily back down and make only the minimum monthly payments on your debts.
“Unless your severance pay is significant – six to 12 months of living expenses – and the demand for your skills in the marketplace fairly strong, then keeping a secure reserve is the best option,” Smith Pegues says. Consistent payments on debts will keep your credit score from suffering, but don’t worry about making extra payments, as you may have been doing before you got laid off. “There will be plenty of time to double up on debt payments once you are gainfully employed,” she says.
If you can afford it, making the minimum monthly payments on all your debts will help you in the long run. In the short run, it might be necessary to stop making them to keep the lights on and get dinner on the table. Before you consider defaulting or making late payments on your debts – or treating severance pay as a windfall to knock out debt – make sure you know all your options and the consequences of each choice.
Tackling Credit Card Debt
You might be tempted to use part of your severance pay to knock out high-interest debt, such as a credit card balance. Depending on how much severance you get, the money might seem like a windfall, and the interest savings could be significant. Suppose you have a $1,000 balance with a 30% annual percentage rate (APR). You’re paying $300 a year to carry that balance. It could really be helpful to save $300 a year when money is tight.
“If you have a decent cash reserve, by all means, pay off some of the credit card debt to save yourself the interest,” says certified financial planner Damon Gonzalez of Domestique Capital in Plano, Texas. “If it takes longer than expected to find a job, you can always charge your credit cards back up.”
But it could also be helpful to keep the $1,000 in the bank that you could use to pay off the balance, so you can use it if you need it for your essential expenses. You can’t usually put a mortgage payment or utility bill on a credit card; when the option is available, it usually comes with a service charge, such as a 3% fee.
Unless you have another source of income like a spouse who works, paying off debt while unemployed becomes a low priority, says Jason J. Hamilton, president of Keep It Simple Financial Planning, a registered investment advisory firm in Santa Ana, Calif. If you have $100,000 in cash and $10,000 in debt, paying off the debt might make sense, but if you only have one month’s worth of expenses in the bank, paying off debt shouldn’t be your focus.
If you do pay off any credit card balances, don’t close the cards: You might need to rely on them later if you remain unemployed for a long time, and without a job, it will be hard to qualify for a new card. Also, because the length of your credit history is an important factor in your credit score, it’s good to keep old accounts open, as long as you aren’t paying an annual fee. What's more, having available, unused credit improves your credit utilization ratio and your credit score.
Hamilton says he recommends being proactive with your creditors after a job loss. “From my experience, most creditors are actually pretty responsive if you communicate with them and tell them what's going on and ask for deferment, for example, for a month or two,” he says.
Creditors may lower or temporarily suspend your required minimum payments if you request a hardship program, but they may also lower your credit limits, according to Bankrate. A better option may be to pretend you have a lower interest rate offer from another card and ask if your creditor will reduce its rate to compete.
Another option is to have an employed spouse apply for a credit card with a 0% introductory APR balance transfer offer. If he or she is approved, you can transfer your household’s highest-interest balances to this card and give yourself some breathing room. Your payments will be lower since you don’t have to pay interest during the 0% introductory period, which usually lasts about 12 months. You’ll still need to make minimum monthly payments to keep the 0% offer; if you slip up, you’ll owe lots of interest. You also don’t want to make any new purchases on this card. There typically won’t be a grace period, meaning you’ll pay interest on new purchases from the day you make them. (For more, read 0% Balance Transfers: Who Really Benefits and Understanding Credit Card Balance Transfers.)
Managing Student Loan Debt
Some older people who are out of work might also be struggling to pay student loans – either their own or ones they took out to help their kids. To make these payments more manageable while you’re unemployed, see if your lender offers deferment or forbearance. Deferment means you temporarily don’t have to repay the principal or interest on your loan: If you have a federal direct loan, Federal Family Education loan or Perkins loan, you can request deferment for up to three years due to unemployment. The federal government may pay interest on your loan during deferment, depending on your circumstances. For private loans, policies vary by lender. If you don’t qualify for deferment, forbearance can allow you to suspend payments for up to 12 months, though interest will continue to accrue. Contact your lender to discuss your options.
Focus on just paying the interest on any private or unsubsidized loans during a period of deferment or forbearance, says Andrew Josuweit, CEO of Student Loan Hero, a site that educates borrowers about ways to pay off student loans smarter and faster. Otherwise, letting it accrue will result in an even bigger financial headache and loan balance down the road. “With careful budgeting, you may still be able to afford a monthly small interest payment and stay on top of your debt balance, even if you don’t have a steady income,” he said.
Other Debts: Medical, Auto and Home Equity
You have a few options if you have medical debt to deal with while you’re unemployed. One is to work with a medical bill advocate, who can review all your bills for errors. If they find mistakes that save you money, you both win: Your bill goes down and you use part of that savings to pay the advocate. Another is to explain your situation to the company you owe the debt to and see if it will let you work out a payment plan or restructure an existing one. Defaulting on medical debt will cost you in terms of increased interest owed and damage to your credit score, and if you want to keep getting treatment from the provider you owe money to, you’ll need to keep making payments.
If you have car payments, consider whether you can sell one or both of your vehicles and purchase less expensive models that will come with lower monthly payments. You may not qualify for a new auto loan while you’re unemployed, but maybe you can get enough cash from selling a car to buy a new one without a loan, or perhaps you can get by with one household vehicle. If you have an employed spouse or partner, he or she may qualify for a new auto loan, or may be able to help you refinance an existing loan to lower your monthly payment by getting a lower interest rate and/or extending your loan term. In the long run, refinancing into a longer term may cost you money, but in the short term, it may help you avoid defaulting on your bills.
Finally, if you have a home equity loan or line of credit (HELOC), treat those payments like you treat your mortgage payment: They’re essential. Your house secures these loans, so if you stop paying them, you could eventually find yourself in foreclosure. If you have a variable-rate HELOC, see if you can convert it to a fixed-rate home equity loan so your monthly payments will be stable and predictable and won’t fluctuate when interest rates change. (See How HELOCs Can Hurt You and How a HELOC Fixed-Rate Option Works.)
Now that you have a handle on how to deal with debt while you’re unemployed, let’s take a look at whether it makes sense to draw on your retirement accounts to make ends meet until you find a new job.Will You Need a Retirement Drawdown Strategy?