The key is to act before you find yourself in serious financial trouble.

Losing your job, coping with serious illness, and going through a divorce can threaten your economic security and undermine your ability to keep up with your credit obligations. So can spending more than you can comfortably afford to repay. While you may be able to juggle creditors for a time, sooner or later, you could find yourself in serious trouble.

One preventive measure is to build an emergency fund, accumulating at least six months of living expenses in readily accessible accounts. Some combination of relatively short-term certificates of deposit (CDs) and US Treasury bills will generally work. The goal is not to touch the money except in a real emergency. Ideally it will last long enough to get you back on your financial feet.

Red flags

The most effective way to handle evolving credit problems is to recognize the danger signals, not ignore them:

• Your debts, including your mortgage if you have one, are more than 40% of your monthly income.
• You’re making only the minimum payment on your credit cards.
• You’re skipping some payments entirely every month.
• You’ve borrowed up to your credit limit on one or more of your revolving credit accounts.
• You’re using savings or investment accounts to pay your monthly bills.
• You’re putting off essential medical or dental treatment.

Unless you can increase your income or cut your expenses, you could find yourself in a situation from which it’s difficult to extract yourself.

If you default, your income tax refund can be withheld to pay your debts and your wages can be garnished, which means a percentage of your paycheck is withheld to pay your creditors. It’s not only embarrassing and leaves you even shorter of cash, but it could affect your job security or chances of promotion. You could also be responsible for paying court or collection costs.

The doctor is out

People who call themselves credit doctors claim they can restore your credit reputation. Don’t believe it, especially if they promise you won’t be required to make any changes in your spending habits. Their approach is never better than misrepresentation, and it’s often fraud.

Being proactive

If you owe more than you can repay, ask your creditors to change the terms of your credit agreements. They may agree to add the amount you are behind to the end of a loan, reduce your monthly payment, or both. This approach will extend the repayment period and cost you more in finance charges, but it may keep you from drowning in debt.

And don’t wait too long to act. In many cases, including most mortgage loans and student loans, it’s possible to work out repayment only if you have not defaulted. Information about possible remedies for repaying federal student loans is available at www.studentaid.ed.gov. For mortgage issues, begin by checking with your lender or loan servicer. The servicer is the bank or other organization to which you make payments.

You may want to seek professional help from an accredited credit counselor who can help create a payment plan. You need to be careful in selecting someone to work with, as qualifications vary. Before you choose, be sure you know the kinds of advice the counselor will provide and what the service will cost. You may want to search online to see if any complaints or other problems emerge when you type in a prospective counselor’s name or agency affiliation.

You can also check with the National Foundation for Credit Counseling (www.nfcc.org) or the Financial Counseling Association of America (www.fcaa.org) for a referral in your area.

One loan from many

In some cases, you may want to investigate loan consolidation. In that case, you take a new loan large enough to pay off your existing debt, so that you owe just one lender rather than many. But unless you can confirm that the cost of the new loan will be less than the combined costs of your existing loans, you may be facing greater hardship.

The interest rates and fees on consolidated loans tend to be high, especially since you already have damaged credit. And some loan consolidators impose a large pre-payment penalty if you want to pay off the debt early.

The one place consolidation may make the most sense, and is apt to be reasonable, is with federal student loans that you take directly from—and consolidate with—the government.

What about bankruptcy?

Bankruptcy is the last resort for resolving credit problems, a harsh but legal remedy for preventing financial disaster. In general, bankruptcy is a three-step process:

1. You file a petition in federal or state court saying that you are insolvent, which means you have no assets to pay your debts.
2. You work out a repayment plan with your creditors and the court.
3. You discharge your debts, or settle them, typically for less than the full value of what you owe.

Bankruptcy does provide legal protection from your creditors, resolves most though not all debts, and may prevent the loss of your home, depending on the jurisdiction in which it is handled. And bankruptcy does offer you the chance to start again.

On the other hand, your financial affairs are public knowledge, hashed out in court and part of the public record. Your credit standing is seriously damaged, you forfeit assets, and some debts still remain outstanding.

It’s essential—and in some cases mandatory—to consult an experienced attorney before filing for bankruptcy.

This information is provided with the understanding that the authors and publishers are not engaged in rendering financial, accounting or legal advice, and they assume no legal responsibility for the completeness or accuracy of the contents. Some charts and graphs have been edited for illustrative purposes. The text is based on information available at time of publication. Readers should consult a financial professional about their own situation before acting on any information.