This is the fourth of a five-part personal financial planning series sponsored by the Peery Institute of Financial Services. The final installment, on savings and retirement, will appear in the Winter 2006 issue.
People don’t incur debt expecting it to turn into bankruptcy, endanger their financial security, or cause the loss of their home. But many people do find themselves much deeper in the hole than they ever planned—becoming, in a sense, “accidental debtors.”
While debt can be both good and bad, the key is subduing it before it turns ugly. Debt has provided the means for many to gain an education and, in turn, a livelihood. Debt provides the means to own a home. Debt also provides opportunities to create businesses, thereby improving not only one’s quality of life but also the local economy. Determining whether a particular debt is good or bad is largely up to the debtor. Why did you incur the debt? For what purposes did you use the borrowed funds? What are your plans for repayment?
ARE YOU AN ACCIDENTAL DEBTOR?
Many years ago I counseled a telecommunications executive who was a prototypical accidental debtor, someone who realized too late how quickly debt can accumulate. His annual compensation was about $180,000, which, at the time, placed him in the top 5 percent of wage earners in the United States. He owned a nice home in the Northeast, lived a lifestyle commensurate with his earnings, and financed his children’s medical school costs. However, to achieve this standard of living, he and his spouse had incurred $950,000 of debt, more than half of it from credit cards. Annual interest payments on the credit card debt alone were roughly $100,000. This well-intentioned executive quickly learned how debt turns ugly.
Since 1990, the median income for an American household rose 11 percent (after adjusting for inflation), while median household spending jumped 30 percent, according to an analysis by Economy.com. How could the typical family afford to spend so much more than they earned? By borrowing money—median household debt outstanding rose 80 percent.
What are the warning signs of too much debt? How do you know whether you have sunk too deep? The following will help you determine if you already have or are about to incur too much debt:
• Having a low FICO (credit) score. FICO comes from Fair Isaac Company, which came up with the process of condensing a consumer’s credit/debt information into a number. Three-quarters of all lenders use FICO scores when considering requests for loans or credit. Lenders also use this number to determine interest rates, down payments, types of mortgages available, car loan approval, and auto and homeowners insurance premiums. Factors used to calculate the score include payment history, amount owed, length of credit history, the number of credit accounts, and the mix of credit accounts. A FICO score above 660 is acceptable, above 720 is very good, and above 750 is excellent. A score below 660 is uncertain and at times considered risky. A low FICO score can be improved simply by paying current bills on time. Your report changes gradually as new information is added to bank and credit bureau files, with more weight given to recent bill-paying history. A clean record for the last two years can make a significant difference.
• Deciding to incur debt based on the answer to the question, “What is the monthly payment?” Too many large purchases are based on the answer to this seemingly simple question. When you decide to purchase something based on the monthly payment price alone, then you do not fully understand the complexities of incurring debt.
• Having a high debt-to-income ratio. The debt-to-income ratio indicates how much of your income is being used to support debt obligations. Spending more than 35 percent of your monthly income supporting debt payments, including mortgages, is an indication you are on the road to becoming an accidental debtor. Unfortunately, many have started down this path. The median monthly mortgage payment in Utah—not including real estate taxes—equaled 45.3 percent of a worker’s average monthly income in 2002, the fourth-highest level in the nation, according to the Utah Foundation.
• Living by the phrase “Buy now, pay later,” and spending future earnings to meet current needs and wants.
• Making only minimum payments on credit cards. If you cannot afford to pay more than the minimum balance, you cannot afford whatever was charged in the first place.
• Using credit cards to pay for things normally bought with cash.
• Increasing the amount of your total income that goes toward paying off debts.
• Having too many credit cards. For most people, two major credit cards are enough.
• Nearing the credit limit on your credit cards.
• Not knowing the amount owed to creditors.
• Using credit cards to pay off other debts.
• Being denied credit.
• Bouncing checks.
• Lying about spending.
• Hiding statements that indicate debt.
I’m Not an Accidental Debtor
If the previous statements don’t seem to apply, congratulations. You have incurred debt for the right purposes, used the proceeds wisely, and have an effective plan to pay the debt. Keep watch for any of the warning signs listed above.
I Am an Accidental Debtor
If you find yourself in this situation, then you have crossed the biggest hurdle yet—acknowledging that you have gotten in too deep. Ignorance may be bliss, but only until the collector begins calling.
Examine and understand what causes you to overspend. Then, promise to not repeat the mistakes. How did you become an accidental debtor in the first place? Did you consider the available credit to be disposable income? Was it a way to support a lifestyle you could not afford? Were you trying to match a lifestyle you knew as a child? Were you trying to keep up with the Joneses? Whatever the reason, you need to break your habits and, more importantly, manage your way out of debt.
DEBT TRIAGE
With this realization, you can begin to remedy your debt through debt triage. This process involves the following steps:
Spend Less Than You Make
Paying down your debt requires spending less money than you make on a consistent, long-term basis. Nothing else will get the job done.
Make a Repayment Plan
Forgive yourself and focus on repaying the debt. It’s in everyone’s best interest—yours and the people to whom you owe money—to get out of crisis mode and into a repayment plan you can handle.
Know Your Rights
The laws are actually on the debtor’s side, although you will have to get organized to take advantage of them. By law, debt collectors cannot contact you before 8 a.m. or after 9 p.m. and cannot otherwise harass you, family members, or friends. Debtors do not face jail time, and nobody may garnish your wages without a legal proceeding. For more help in dealing with troublesome debt collectors, contact the Federal Trade Commission at 1-877-FTC-HELP or online at www.ftc.gov/bcp/conline/pubs/credit/fdc.htm.
Keep a Debt Journal
Start a record of every conversation with lenders, credit bureaus, and bill collectors, whether by phone or in person. Collect names with dates and key discussion topics, including any agreements or compromises made. This journal becomes increasingly important as you manage your debt.
Opt Out
Stop the flood of credit card offers by calling 1-888-5-OPTOUT or visit optoutprescreen.com. Residents can stop the unsolicited mail for five years or permanently.
Reduce the Interest Rate
Most credit card companies charge interest rates of anywhere from 16 percent to 20 percent. Negotiate with your credit card company for a lower rate, particularly if you have been a faithful customer.
Pay Down the Balance
Pay more than the minimum balance—much more. Most, if not all, of the minimum payment goes toward interest with only the small remaining balance being used to pay down principal. Although compound interest (interest earned on itself) can work wonders for savings, it can be devastating when left unmanaged and working against you.
It’s not possible to pay down credit card debt if only minimum payments are met. For example, presume you have $5,000 of credit card debt with an interest rate of 18 percent and you want to pay down this debt over a certain number of years. How much would you have to pay annually to meet the goal (presuming a flat annual payment is indexed each year based on a 3.2 percent rate of inflation)? As the table below indicates, you would need to pay roughly $900 each year, indexed for inflation, for the debt to be paid down within nine years. By paying only $500 you would never be able to pay down the debt, and the debt remaining after twenty years would be a staggering $75,935 (from the original $5,000).
Keep Track of Credit Card Purchases
Enter credit card purchases into a check register and deduct them from the checking account balance to better keep track of total monthly expenses.
Reduce Your Credit Limit
Ask your credit card company to reduce the limit on your credit card. This self-discipline prevents you from using it for additional purchases once the lower credit limit is attained.
Receive Credit Counseling
When choosing to visit a professional counselor, find out which agencies are members of the National Foundation for Credit Counseling or the Association of Independent Consumer Credit Counseling Agencies. Those are the largest and most respected networks of credit counseling agencies. After narrowing the search, check to see if complaints have been filed against them by contacting the attorney general’s office, Consumer Protection Agency, or Better Business Bureau. Credit agencies are often able to reduce the debt and interest rates being applied to the remaining debt.
Secured vs. Unsecured Debt
Debt may be secured or unsecured. Secured debt allows a lender to recover specific property or assets from the borrower if payments are not made per the loan agreement. For example, mortgage debt is debt that is secured by a house. Examples of unsecured debt include credit cards and personal loans.
This security is a double-edged sword. It benefits the lender by providing the confidence that the debt will be repaid in some manner (either in cash or with proceeds from the sale of the mortgaged home). It also benefits the borrower by permitting the lender to offer loans with a lower interest rate. However, it puts the “securing” asset at risk if you are unable to repay your debt. The lender may sell the home to pay down the debt in the event that payments aren’t made. Secured debt costs less, but be sure to understand the consequences when incurring or repaying debt.
Deductible vs. Nondeductible Interest
Some forms of interest payments are tax-deductible. The interest paid on mortgage and home equity debt, student loans, and debt where the proceeds are used for investment purposes are deductible as itemized deductions (within certain limitations and against certain types of income). Most all other types of interest payments are considered personal interest and are thereby nondeductible.
All things being equal, deductible interest is preferred to nondeductible interest. For example, $100,000 can be borrowed either through a home equity line (deductible interest) or against a credit card (nondeductible interest). If the interest rate on either is 7 percent (although the credit card interest rate would likely be much higher), what is the out-of-pocket cost? Presuming that the marginal income tax rate is 30 percent, the net cost of borrowing against the equity in the home would be roughly 4.9 percent, while the net cost of borrowing against the credit card would be the original 7 percent. That’s a 2.1 percent difference in your favor. This equates to saving $2,100 each year in interest payments. Compare the 4.9 percent net cost to an 18 percent credit card interest rate and the annual savings would be about $13,100 each year in interest payments.
Budget
As stated earlier, paying off debt boils down to spending less money than you make on a consistent, long-term basis. It is the disciplined process of managing income and expenses, commonly referred to as creating a budget. A budget can control a family’s spending, which means having enough money to pay bills and save for retirement, vacations, and children’s education. Here’s one approach to creating a budget:
• Collect six months worth of pay stubs and expenses. Add up the income and divide by six to calculate the monthly income. Do the same with the expenses by adding six month’s worth and dividing by six.
• Evaluate the expenses and look for opportunities to economize by either reducing or forgoing certain expenses.
• Develop a monthly budget and stick to it. This requires discipline and oversight. Be sure to account for cash expenses. Try setting aside time at the end of each day to record these.
• Track your income and expenses monthly and evaluate how the plan is working. Personal financial software can make organizing your expenses easier. Tweak the budget where necessary.
• If you have a spouse and children, involve them in the planning. Come up with something fun that will keep you focused and motivated.
To summarize, let me repeat the following questions: Why do you incur debt? What is your purpose for borrowing funds? What are your plans for repaying the debt? Wise debtors will take great care to ensure that the answers to these questions keep them from becoming accidental debtors and from sinking into a quagmire of debt.
NOTE: This brief summary of planning ideas is for discussion purposes only. It does not contain legal, tax, investment, or insurance advice and cannot be relied upon for implementation and/or protection from penalties. Always consult with your independent attorney, tax advisor, investment manager, and insurance agent for final recommendations before changing or implementing any financial, tax, or estate planning strategy.
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Article written by Timothy A. Clark
Photography by Bradley Slade
About the Author
Timothy A. Clark is a senior vice president and regional director of the Wealth Management Consulting group of the Bank of America Private Bank. He earned his master of taxation degree from Seton Hall University, his MBA from Brigham Young University, and is a CERTIFIED FINANCIAL PLANNER™. He and his wife, Lora, and their three sons reside on Bainbridge Island, Washington.
