CESI Personal Finance Guide – Chapter 3: Handling Debt

Chapter 3: Handling Debt

There is a growing feeling of frustration in the country and a large part of it arises from the fact that while people realize that they are in debt, many have no idea how to solve their financial problems or find debt relief. In a classic example of how debt can overwhelm your life, Amy’s story is an all too common one.

Amy, 37, is a single parent of two small children. She does not receive regular child support payments and was barely getting by with her earnings from her job – she has barely been managing to meet her monthly obligations. Things got even worse when she was laid off and found that her finances were stretched too thin to cover anything but her basic household expenses. Amy can’t believe that only a few years ago she was happily married with a new car and house, a variety of credit cards and vacations. Now, Amy claims her life is filled with constant calls from collection agencies and an ever increasing pile of bills that she has no idea how to tackle. The most recent scare was a notice she received from a credit card agency claiming a balance due of five thousand dollars (in combination with late fees, interest and collection agency fees). Amy is struggling to make ends meet and look after her children, but she feels that she is only sinking deeper and deeper into debt.

Amy’s story is an all-too common one. Consumer debt in America is reaching alarming levels. At the rate American consumers are acquiring debt, we will be faced with decades of debt problems in the future.

The key to good debt management is increasing your awareness about what debt is, how it works, and how it affects you. You acquire debt when you purchase any service or goods from a creditor on a non-cash basis. When you incur a debt, your creditor expects that you will repay the debt in full. Typically the debt carries with it an interest rate and penalties or late fees if the terms of repayment are not fulfilled.

Understanding Good vs. Bad Debt

It may seem that you spend your life struggling with debt. As the bills pile up each month, it is natural to feel overwhelmed with the amount you spend on debt repayment. But, would it surprise you to know that not all debts are bad? There are some debts that may even help you in the long term. When a lender asks to check your credit report and looks at what kinds of accounts you have accumulated, it is important to realize that some debts will be considered more favorably than others. So, if your goal is to be free from debts, you need to understand which debts carry negative weight and which are looked upon more positively. Smart money management includes being able to differentiate between the two.

Good Debt

Some debts can be considered an investment. They can be “good debts” if they contribute to your overall finances or they increase in value over time. For example, buying a house and taking out a mortgage to do so is considered a good debt. Since the value of most homes appreciate over time, the mortgage loan you take to pay for the house can be counted as an investment. In the same way, a student loan to pay for your college education will help you find a better career and greater future earnings. Hence, a student loan is also a good debt. Therefore, debts such as real estate loans, student loans, home mortgages and business loans that create value may be good investment debts. Many of these debts also have tax benefits and can help produce more wealth over time.

Bad Debt

Now let us focus our attention on the other type of debt. If you accumulate debt to purchase things that are consumed and cannot appreciate in value, you are accumulating “bad debt”. It is this kind of debt that causes problems and leads to unstable financial situations. A prime example in this category is credit card debt – largely because of the types of items purchased using them. If you accumulate debt on the purchases of items like clothes or food with your credit card, you should make sure that you pay the balance in full each month. Purchasing disposable or durable items using cards with high interest rates and not paying the balance in full will create bad debt. Not paying the minimum balance often leads to higher rates of interest and late fees that can quickly add up to unmanageable amounts. Ultimately, the item you bought loses value but the amount you paid for it continues to increase.

At the end of the day, whether its good debt or bad debt, you still have to be careful to not take on too much of either kind. If you end up being overloaded with debt, your financial health still suffers.

Secured and Unsecured Debt

Apart from good and bad debt, the two main types of debt are secured and unsecured. The easiest way to know whether your debt is secured or unsecured is to ask yourself the question: “Can my creditor take away the object or the property if I am unable to make my monthly payments?” If the answer is yes, then it is considered a secured debt.

Secured Debt

Secured debts normally include big budget items such as mortgages for homes and loans for cars. If you do not make your payments to these creditors on a timely basis, the bank or lender concerned is fully within its rights to take back your home or car as their payment. This ability to repossess is the underlying premise in the agreement between your lender and yourself. In such situations, even if you have a poor credit score, it may be possible for you to be approved for a loan more easily if you secure it with the asset involved. Also, since the asset stands as a guarantee, the subsequent rate of interest and monthly installments is often lower than those taken out for unsecured debt items. There might even be tax breaks associated such as tax deductions on mortgage loans. Of course, all these advantages come with the understanding that if you fail to pay as agreed, you may lose your asset.

Advantages of Secured Debt

• Secured debts may be useful for those individuals with poor credit histories or low credit scores. It becomes slightly easier for them to obtain a loan when they pledge their asset as collateral, though the rate of interest will definitely be higher than for someone with a good credit history.
• This guarantee of an asset can work towards lowering the interest rate as a result. This also can lead to more manageable and lower monthly installments.
• There can be tax deductions involved with some cases of secured debt such as mortgages that lead to further savings.

Disadvantages of Secured Debt

• If you fail to make your monthly repayments, the lender is allowed to reclaim your asset, which has been held as collateral.
• If the asset is then put on sale to recover the loan, and the sale amount is less than the original price paid, the debtor can be held responsible for paying the difference in the amount.
• When property that is held as collateral is foreclosed, it can be very detrimental to your credit rating.

Unsecured Debt

If money is loaned to you without the backing of any asset as collateral, it is termed as unsecured debt. In these circumstances, even if you do not make your monthly payments, the creditor is not in the position to reclaim the asset or item in lieu of the amount owed. Unsecured debts include medical expenses, unpaid utility bills, credit cards and unsecured loans. The benefit of such loans is that they can provide immediate financial help in times of a cash crunch or in case of an emergency. But as they are not attached to any tangible asset, they garner higher rates of interest and subsequent penalty fees that may lead to more debt in the future.

Advantages of Unsecured Debt

• Useful for those who need money immediately.
• Easier to apply for than secured debts since they lack any type of collateral requirements. This cuts down on the time taken for documentation and processing.
• When emergency situations occur, an unsecured loan could help tide you over the lean times until you are back on your feet again.

Disadvantages of Unsecured Debt

• Even though repossession cannot occur in this type of debt, failure to make your payments could lead to higher rates of interest and crippling late charges and penalty fees.
• When you exhibit a pattern of late or default payments in this type of loan, it could reflect badly on your credit score and harm your ability to obtain other types of credit such as a home or auto loan.
• Since unsecured debt is often more accessible, it can be easier to over-extend your debt load and take on more debt than you can comfortably manage.

Recommended Debt Percentages

How do you know when you have too much debt? What parameters should you consider where debt is concerned? When lenders are looking at your financial statements and studying your spending history, most are checking to ensure that your expenses fall within their own guidelines. If the lender feels that there are any excesses or imbalances, your loan application is in danger of attracting higher interest rates or even of not being approved at all. Therefore, as discussed in the previous chapter, a sound budget or spending plan is imperative.

One of the toughest things to do when you are creating a household budget is to actually figure out where your money is being spent. For this, you need to track your expenses over a period of time and then study them to see if you are spending too much in some areas and not enough in others. The table below gives you an approximation of your ideal budget composition.

Remember, these are only broad guidelines and different percentages may apply depending on the individual or circumstances. Once you have kept track of your spending over a few months, you need to study the averages and see if they fall within the parameters listed above. You may notice that in some categories you are spending too much, while in others (like savings) you need to put in more money. At the end of the day, you do not need to be a financial genius to manage your money wisely. All that you need is some basic knowledge of what works and what doesn’t and some cold hard calculations to reinforce your plan.

Calculating Debt-to-Income Ratio

Are you thinking of finally buying that new car, expensive piece of furniture or even your dream house? You may think you are in a good position to do so. You have paid all your bills on time and you have calculated that you can manage your monthly payments in the future.

But before you sign on the dotted line, there is one more thing you need to check. When it comes to lenders determining your interest rate and loan eligibility, the big factor at stake is something called Debt-to-Income Ratio.

The percentage of your income that goes towards paying off your debt is what is termed as a Debt-to-Income (DTI) Ratio. A number of lenders use this ratio to figure out how much of a loan you are eligible for and what interest rates are applicable. It is recommended that you assess your current financial situation and calculate your Debt-To-Income Ratio regularly.

Some DTI calculators include mortgage or rent payments while others don’t. Generally, it is better to follow the method used by mortgage lenders where your mortgage payments are also included, thus offering a more comprehensive picture.

How To Calculate Your DTI:

1. Add up your total net monthly income (the amount you keep after taxes). This is comprised of monthly wages and overtime, any commissions or bonuses that are specified, rent from income property as well as alimony or child support, if applicable. If your income varies from month to month you will need to work out a monthly average over the past two years.

2. Add all your monthly debt payments. This would include all credit card bills, loans and mortgages or rent payments, if applicable.

3. Divide your total monthly debts by your total monthly income. The result is your Debt-to-Income Ratio.

What Is a Healthy Debt Load?

If this Debt-to-Income Ratio is too high, you could be charged higher interest rates or even denied a loan. With a lower Debt-To-Income Ratio, you will have a much higher chance of qualifying for a loan and receiving favorable rates. Is your debt load healthy? Well, it ultimately depends on your lender, but in general the following guidelines are followed:

While most guidelines inform you that a 36% or lower DTI is recommended, it is actually difficult to apply a universal average for everyone. Your ideal ratio would depend upon personal circumstances, number of dependents in your family, any unusual expenses such as medical requirements, etc., and individual spending habits. But as a rule, anything over 36% would get tougher and tougher to manage so it pays to err on the side of caution.

Repaying and Managing Your Debt

The average American household carries a number of debt obligations. These could include home mortgages, a second mortgage or home equity loan, car loan(s), student loans(s), multiple credit cards, and others. Trying to juggle all of them and meet your monthly payments is never an easy task. There are, however, some guidelines you can follow to streamline the process and help you avoid falling into a trap of debt generating more debt.

How To Manage Your Debt

• Pay on time: This is the most important of all the rules and one that, if followed, will help you avoid a host of financial problems. You should aim to pay your debt obligations on time, every time. Try to send your payments at least one week before the final due date to avoid late fees. If you know your payment is going to be late, call your creditor immediately and explain the situation. Often, they will then make a notation in your account and you may avoid late fees or penalty charges.
• Talk to your creditors:  There may be times when you just cannot make your monthly payment. Illness, divorce or unemployment may lead to unforeseen problems in meeting your deadlines. This is the time when you need to talk to your bank or lender and work out a mutually acceptable agreement. Maybe you could pay half the payment due immediately and the rest the next month? There may also be deferment plans available that might help you tide over the money crunch. The main thing here is to work with your creditor and always keep in contact. Creditors often are glad to work with you if they feel you are making an honest attempt to remedy the situation.
• Maintain all records: When speaking or communicating with your lender, keep and maintain a meticulous record of your conversation. Always make a note of the date and time, the name of the person you are speaking with, the issue that you have discussed, and the solutions your creditor offered. You can also ask for a confirmation or an ID code to prove that you contacted your creditor. All these records will stand as important proof in case you receive a non-payment notification or are slapped with penalty fees and other notices.
• Handling collection calls:  If you do receive a collection notice, contact your creditor immediately. If a repayment agreement had already been agreed upon, find out the reason your account was sent to collections. Request that they renegotiate your plan and remove your account from collections immediately as this can seriously hamper your credit history. In case this is not possible, never ignore any collection or payment due notices. Inform yourself about your rights under the Fair Debt Collection Practices Act. Finally, seek credit counseling services from a professional advisor. With their help, you can work your way back to a stronger financial footing.

How To Repay Your Debt

There are a number of ways you can repay your debt such as:

• Check:  This is the most common mode of payment. However, you should make a note of your bill schedule so that all payments can be sent ahead of their due dates to avoid late fees.
• Automatic draft:  With an automatic draft, your lender can withdraw your payment electronically and apply it to your account on the due date each month. This is often used for home loans and other fixed loan payments. Some creditors may even reduce your interest rate if you use this feature. It is the simplest and most error free way of paying your bills. But, you will need to ensure that you always have enough money in your account to cover the automatic draft as you need to avoid overdraft fees for non-sufficient funds.
• Online payments:  Another easy way to make your installment payments. Many banks offer free online bill pay features with your bank account.
• Bill payment providers:  There are service providers that will handle the process of paying your bills on your behalf. You merely need to send all your bills to them and they work out a plan where all payments are made on time. You’ll need to be sure that sufficient funds are in your account to cover all payments. They will also be responsible for any billing disputes and charges that occur. This service will come at a cost though it does ensure peace of mind.
• By cash:  This would require an actual physical visit to the payment office. The fees for cash transactions are also sometimes higher. This option is normally chosen by default by people who do not have bank accounts.

How To Handle Your Debt

• Begin immediately. If you have debts and bills due, it is imperative to prioritize them. Don’t wait for a financial crisis to occur to start getting your act together. It might be too late by then. Dealing with your debts effectively and keeping to a budget will help you from reaching a point of no return.
• In order to prioritize your debts, you need to list out the interest rates, other fees, any balances, and minimum monthly payments for each and every debt you have. This is also the time to take note of the applicable terms and conditions on your loans and credit cards.
• Determine your strategy for money and debt management. If you have reached a point where you are living comfortably, your goal should be to pay off your debts as quickly as possible. If you are working hard to make ends meet, the main priority is to cover the basic necessities and minimize the potential of any future financial problems.
• To pay off your debts, always begin with the one with the highest interest rate and work yourself down to the one with the lowest. Pay the monthly minimum on all other debts and pay off as much as you possibly can each month on the first debt with the highest interest rate. Proceed in this way to pay off your debts, moving on to debt with the next highest interest rate and so on till you are debt free.
• Safe guard your home. The highest priority debt is your mortgage payment if you own a home. Though it may vary from state to state, lenders may begin foreclosure proceedings after just three missed payments. If you are renting, you could be evicted even after just one missed payment. This will only lead to further stress and a negative mark on your credit report.
• Do not ignore your utility bills. Power, water, and other utility companies are often more lenient regarding late or default payments and are often accommodating enough to negotiate a new plan. But consistently missed payments will sooner or later result in shutting down of the service and more hardship.
• Save money on transportation costs. Carpool or use public transportation if possible. If not, keep your car loan payments up to date as lenders will repossess your car easily, often without notice. Pay your insurance premiums as well.
• Pay child support and alimony on time. Failure to do so could result in severe consequences!
• Pay all your taxes, such as property taxes and income taxes. Avoiding these could result in criminal proceedings.
• Pay your student loans especially in regards to government backed student loans. The penalties for default on student loans can be steep. In addition, laws have been passed that make it virtually impossible to discharge student loan debt through avenues such as a bankruptcy.
• Pay your medical bills. Though looked at more leniently than other loans, they still remain a priority for repayment and can be reported as delinquent if sent to collection.

Consumer Rights and Protection Laws

Consumer protection law is the area of public law that governs the relationship between consumers and the businesses that sell goods and services. Consumer protection can cover a large scale of applications such as product liability, unfair business practices, misrepresentation, privacy rights and other consumer and business relations. These laws can deal with issues like credit and debt repair, product safety, contracts, pricing, personal loans and collection agency regulations.

It is every consumer’s right to know more about the product or service that is being purchased. These rights protect not only the consumer but also aim to guarantee fair trade practices.

To ensure that consumers are protected from deception or fraudulent trade practices, the Federal Trade Commission (FTC) was set up. The directives of the FTC are executed by the Bureau of Consumer Protection, assisted by the General Counsel. The Bureau of Consumer Protection (the Bureau) enforces FTC laws that make it compulsory for sellers of goods and services to inform consumers about key product or service attributes, and applicable risk factors. This ensures that consumers can make free and well informed choices about what they buy. Apart from advertising and alerting consumers about their rights, the Bureau initiates action against those who defraud customers, and allows consumers to file complaints regarding fraud or identity theft.

Since we live in times when the virtual world rules our daily life and, more importantly, our monetary transactions, FTC laws are especially vital as they encompass financial services such as loans, mortgages, investments, and other online financial transactions. Check out the agency’s web site (link to http://www.ftc.gov) for more comprehensive information on how to adopt safe business practices as well as how to reduce the occurrence of fraud for consumers. These guidelines include information on:

• How to read the fine print in claims of discounts, and understanding the language and jargon involved in contracts.
• Creditors’ rights in case of non-payment of loans.
• Ways to ensure safe online transactions, maintain privacy, and guard against scams and identity theft through the Internet.
• How to finalize a loan and check the accuracy of your credit report and credit card bills.

Debt Collection and Consumer Rights

If collectors have started calling you or knocking at your door, it is important to understand the limits of what can and cannot be done by third-party collection agencies. The Fair Debt Collection Practices Act (FDCPA) provides protection for consumers and informs you about the rules that a debt collector must abide by. In cases of personal debt (car loans, credit cards), family debt (medical loans), and household debt (mortgages), the FDCPA prohibits harassment in cases of collections. If a collector indulges in any type of unscrupulous behavior, the FDCPA clearly delineates what is and is not acceptable under law.

However, the Federal Trade Commission’s FDCPA rules do not apply to in-house collection agents or original creditors. If you owe money to a retail store for example, the owner is not bound by the rules. But, as soon as the debt is handed over to third-party bill collection agency, these rules are applicable:

• Collectors have to contact you only by mail, telegram, email, or fax and not by postcard.
• You can be called on the phone only between 8:00am and 9:00pm.
• Without prior permission, you cannot be contacted at work. If you tell the caller that your boss objects to such calls in office, they may not call you at work.
• At the outset, the agent has to reveal his/her true identity.
• No collector can threaten you with jail or imply that you have broken the law. (If a check bounces however, it is considered a crime in certain states.)
• If any information about you is sought out, the collector has to first tell the informant for what the information is required. This information can then not be revealed to anyone else but your attorney.
• There should be no verbal abuse, threatening or profane language or threats of violence.
• The caller cannot threaten to take legal action against you unless they fully intend to do so in keeping with the governing laws in your jurisdiction.

There are, however, a few things you should do if contacted by a collection agency:

• Inform the caller that you are recording the phone conversation.
• Ask for their particulars such as name, address and phone number for the record.
• If you get a letter at your mailing address from the agency, you are within your rights to send a return receipt letter telling them to contact you through your lawyer in the future. Or even ask them not to contact you further. In this case, they can now only contact you to inform you if any further legal action has been taken against you.

Each state has different rules that govern the relationship between debtors and creditors. It would pay to go online and research the relevant laws that apply in your state or even hire an attorney to protect your rights. For more information, or to file a complaint, call the Federal Trade Commission at 877-382-4357 or visit the agency’s Web site: http://www.ftc.gov.

In This Chapter You Learned:

• The difference between good and bad debt and how good debt can help you.
• The advantages and disadvantages of secured and unsecured debt.
• That the percentage of your income that goes towards paying off your debt is what is termed as a Debt-to-Income (DTI) ratio.
• How to prioritize your debts immediately and deal with them effectively through a number of tried-and-tested strategies.
• The importance of understanding your rights as a consumer and how debt collection laws work