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Why People With Multiple Debts Should Consider Walking Away From All the Debts At Once

The Great Recession is unlike any other recession or depression in living American memory because of the combination of joblessness, plummeting home values, and unparalleled levels of individual debt.

However the current frenzy over underwater homes and walkaways has obscured the big picture: it’s not just homes, or even homes + credit cards. The true debtor picture in the Great Recession is the convergence of plummeting equity, mortgage balloon payments, usurious credit card interest rates on high balances, tight money preventing loan consolidation, and runaway medical insurance costs.

In the face of that reality, the Pollyanna school of financial advice continues to churn out last-century inspirational articles like "How I paid off my debts in 3 years!" (Some articles admit to a six-figure income or help from relatives; other articles are clearly planted by banks or published on bank-subsidized websites.)

For most people nearing financial collapse, the Pollyanna method won’t work this time around. People on the edge of the precipice should consider the total walkaway – mortgage, credit cards, medical bills, department store accounts, the works. Here’s why:

Credit report checks may breed lawsuits against you. Stopping payment on one account while continuing to pay the others can generate a lawsuit, particularly if you are walking away from an underwater home with $50,000 or more in deficiency.

Mortgage-holders in particular rarely bothered with a lawsuit in earlier recessions, because they figured that you were flat broke. In the old days of the 1990s people would let the lights go out before they stopped paying the mortgage. No longer. So now creditors are pulling credit reports to see if you’re current on other debts – and if so, they figure you have money to go after.

Why would a creditor pull a credit report? Because they’ve seen this headline on the front page of every newspaper in the U.S.: "Owners Walk Away From Their Mortgages Even Though They Can Afford To Pay." Even a banker can figure this out; these people have cash.

Bad credit reports only affect you for a few years – usually seven years at most. Legal judgments can last decades if the creditor keeps renewing them, and a judgment allows the creditor to directly go after your assets or income – not just harass you by phone or mail.

Credit report checks cripple your ability to negotiate short payoffs. If a lawsuit is imminent – or has already been filed – you want a strong negotiating position, and the strongest position is the appearance of being broke. What collector is going to agree to a "paid in full" deal at 20 cents on the dollar when a credit report shows that you’re current on all your other bills?

Not many. Therefore in this recession the correct tactic for most financially hammered people is to stop paying all accounts – and from that position of strength, negotiate any short payoffs with the creditors closest to filing a winning lawsuit.

Doesn’t settling with one creditor weaken your position with the others? Not necessarily. Instead of Delinquent/Delinquent/Delinquent, after settling one debt your credit report shows Settled/Delinquent/Delinquent. If Creditors B and C are debating whether or not to sue, you tell them that the settlement with Creditor A left you flat broke. This is believable because it’s every collector’s nightmare – that the other collectors will clean you out first.

Credit rebuilding is likely to be easier than it was (and it was always easier than most people think). You buy a used car and pay 18% interest instead of 3%, take out one of those ripoff $150-in-upfront-fees credit cards (preferably from a real bank, not a supermarket machine) and then demand an upgrade to real credit after a year, get your name added to a couple of utility bills, and in 2-3 years you’re back to an average credit score. This beats struggling along for years trying to pay down the debt through repayment plans, with a continuing FICO score of 450 as the reward for "doing the right thing."

Paradoxically, people who do a total walkaway usually regain a good credit rating sooner than those who struggle along for years making payments as best they can. Why? Because people on repayment plans live for years at the edge of eviction, which is reflected in their credit reports, through repeated late payments due to unexpected expenses like medical bills and auto repairs.

In contrast, how will the total walkaway look later on? Well, the banks will be mad at you for awhile, but the 2010 year-end bonuses will calm the executives down. Meanwhile you’ll be paying steadily on the car payments, and regaining your financial health, and they’ll be looking for people to lend money to. By that time you’ll look good to them – unlike the people they roped into repayment plans. The banks will still be kicking those people in the teeth, but you’ll be looking like a financial success again.

As a total walkaway bonus, your credit report won’t look like "strategic default," it will look like a "situational default," something that happened despite your best efforts – which (potentially) means less of a black mark against you with Fannie Mae or Freddie Mac if you apply for a mortgage in the next few years.

In short: if you don’t have a specific plan in mind – where you’ve figured out the angles on how to budget for emergencies, work the lenders, and keep your current credit rating – you’re probably better off with a total walkaway. You’ll have that much more cash in pocket … and that much more time to reorganize your life.

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