Deal with Your Debt
by Liz
Pulliam Weston
(c) 2006
by Pearson Education, Inc.
Prentice
Hall
ISBN
0-13-185675-8
Liz Pulliam also wrote Your Credit Score: How to Fix, Improve and Protect the Three Digit
Number That Shapes Your Financial Future (Prentice Hall 2004)
Introduction
The typical book on debt, meanwhile, focuses almost
entirely on how to pay it off and ignore when debt might actually be beneficial
to your overall financial life.
In reality, debt can be an enormously helpful financial
tool, allowing us to buy homes, get educations and build businesses. Instead of sucking us dry, it can give us the
cash flow we need to grow our long term wealth.
This book is designed to help you identify which debts are
toxic to your financial health and which actually help you get ahead. You'll learn the smart ways to deal with your
debt, including which loans you should pay off and which you should keep.
(My comments will be in parentheses throughout this rather
lengthy report. I found much of interest
in the book. This is written as a quick
reference for me to use in the future to keep on my PDA. Things that interested me are included. Many of the things which might interest you
might not be. Although this may read as
a condensed version, you will miss much by not reading the book for
yourself. The cost of $17.99 is small
for the wealth of information contained.)
Chapter 1 Isn't
Debt-Free the way to be?
Debt isn't the enemy:
In their zeal to pay off debt, some people neglect other
important goals such as saving for retirement, a home or college and ultimately
end up hundreds of thousands of dollars poorer than they might have been.
Worse yet, they might be encouraged to continue fighting a
battle they simply cannot win.
When good debt isn't:
But that leads to another problem with typical debt
advice, since too much "good" (mortgages or education loans) debt can
sink you just as deep as too much "bad" debt.
Which debt should you tackle first?
In some cases, though, it can make more sense to pay a
lower rate debt first, or even a (tax) deductible debt before a non deductible
one.
Why debt management sounds strange:
Even when people manage to make their payments, the price
of debt can really add up over time.
When debt prepayment plans go awry:
You are paying off the wrong debt. (mortgage)
By contrast, money you invest has a chance of beating
inflation over time. (Liz lines up with
Ric Edelman opposite Dave Ramsey on paying off your mortgage. Additional money needs to go into investing
rather than paying off a mortgage.)
You are limiting your financial flexibility:
If Carlos had put the extra payments into savings instead
(of paying off student loans), he would have had an emergency fund of more than
$11,000 by the time he was let go (from his job).
Instead of focusing single-mindedly on paying off all
debt, today's families need to figure out how to put themselves on a strong
financial footing overall.
You are cutting yourself off from credit entirely:
Furthermore, you generally need to use credit to get
credit. The credit scoring systems
employed by most lenders (read FICO) require to have and to use revolving
credit accounts like credit cards to get the best scores.
Closing accounts can actually hurt those credit scores and
make it more difficult to get future credit.
The next time you need to get a mortgage or a car loan, you will be at
the mercy of sub-prime lenders that charge astronomical interest rates to
people with troubled credit histories.
. . . there may be no safe way for a chronic credit abuser
to have plastic.
If that describes you, consider getting help through
therapy (going to a the rapist is not an option in my opinion) or a 12-step
program like Debtors Anonymous or Overspenders Anonymous. Most people, however, can survive a credit
crisis and move on to responsible credit use.
You are neglecting your retirement savings:
You are raiding your retirement funds.
Most people have at least a vague notion that carrying credit
card debt is a bad idea. So when they
leave a job and their employer sends them a check for their 401K balance, they
think that they are being responsible by using the money to pay off credit card
balances.
I wonder how many folks who use 401K loans to pay debts
are really covering up a serious spending problem. Forcing yourself to leave retirement plans
for one purpose -- retirement -- can lead you to find real solutions that will
ultimately create, rather than destroy, future wealth.
Your debt situation is hopeless:
(Liz urges people to consider bankruptcy. The guideline given is if a repayment plan
will not get you out of debt in three to five years, trying to pay off the
debts rather than face up to what ultimately needs to be done wastes time and
money.)
Addressing the Ants as well as the Grasshoppers:
. . . he realized that accelerating the mortgage payments
meant they would have to cut way back on their vacation fund. (Liz sez take the
vacation.)
Chapter 2 Your Debt
Management Plan
There is a three step plan that helps you understand where
you are now, where you want to be and how best to get there.
(1) Get intimate with your debt.
Make sure you include every debt you owe, including:
Mortgages, Home equity loans and lines of credit, Credit cards, Student loans,
Auto loans, Other bank or credit union loans, Money owed to check cashing
outfits or payday lenders, 401K or other retirement plan loans, Debts owed to
friends and family (Not included on Liz's list, perhaps by over site, are over
due monthlies such as utility bills).
For each debt write down the following:
Current balance owed. At this point is doesn't matter what
the original loan amount was, what matters is how far you have to go.
Whether the loan is an installment debt or revolving
credit. Installment debt include
mortgages, auto loans and other debts where you have a set schedule of payments
to make and a specific payoff date when the loan is expected to be retired. Revolving debt includes credit cards and
lines of credit, where you have a credit limit that you can draw on -- and pay
off -- repeatedly. Paying off revolving
debt increases your financial flexibility because you can always draw on that
freed up credit line in and emergency.
That may not be possible with an installment loan. (This only works if they have not lowered
your credit limit)
Current interest rate. You should find this on your most
recent statements, typically listed as your "annual percentage rate."
Whether the rate is fixed or variable, and when it might
change next. Credit card rates are
typically variable and can change month to month. Installment loans usually carry fixed rates.
Whether the interest is tax deductible. This is actually more complicated that it
might seem. (Most mortgages would be
included. Some would not. Credit card interest is not unless it can be
shown as a business expense.)
Minimum payment owed.
Again, this is something you will probably find on your
latest statement.
Typical payment made.
Whether there's a penalty for paying off the loan faster
than scheduled. (Most loans figure interest on unpaid balances. Loans that had interest prefigured use the
rule of 78s which has a prepayment penalty built in because interest is not
rebated until the complete balance is paid.)
Prepayment penalties aren't that common.
(They are common on many mortgages for the first two or three years.)
(2) Assess Your Financial Situation.
Every financial plan needs to start with goals: What you really want and what you are trying
to achieve. The real work of financial
planning comes when you try to figure out which goals are the most important
and how to prioritize them and how to save for them while paying for the expenses
of your day to day life.
Retirement Savings:
This needs to be a high priority for almost
everybody. Is should take precedence
over just about every other goal, including your child's education.
This is really tough for many parents to hear since they
are so focused on providing a better life for their kids. One of my personal finance professors put it
this way: "If worse comes to worst, your child can always borrow money for
school. No one will lend you money for
your retirement."
The value of starting early -- and not stopping:
(The illustration used dramatically shows why stopping
contributions to a 401K to pay off debt is a net loss situation.)
Financial flexibility:
Unfortunately, traditional debt repayment plans ignore how
close to the edge most people live. They
typically advise paying off the highest rate debt first, even if doing so could
make you more vulnerable to financial setbacks.
Save or Pay Off Debt First:
Again, most people are not in the enviable position of
having financial flexibility to spare.
And what many want to know is: should I pay off on my debt repayment
plans until I get my emergency fund together -- or should I pay off my debts
first?
I'm of the school that urges people to pay off their
credit card debts before they do anything else.
Credit cards usually carry pretty high interest rates, and every dollar
of credit card debt you pay off frees up a dollar of unused credit space on
your cards that can be used if you face a real emergency. Unused credit on cards or on a home equity
line of credit can serve as a de facto emergency fund until you get around to a
real one.
(This flies in the face of what DA teaches since it makes
your credit card your emergency fund. I
go along with what John Fuhrman teaches in the "The Credit Diet" and
what Clason teaches in "The Richest Man in Babylon." The first thing
we need to do is establish new habits.
Saving instead of spending is an important habit to start even before
the debts are paid. This one thing can
take you out of the house refinance cycle and the debt cycle of paying off most
of your debt to only get deeply in debt again.
Debtors Anonymous emphasis is about breaking the debt cycle which is
more important than getting out of debt.)
Paying down your revolving debt like credit cards and
lines of credit can have another beneficial effect. It can quickly boost your credit score. Paying down debt is a great way of
strengthening your credit score and putting you in a good position to get low
rates the next time you need a loan.
(3) Create your Game Plan:
(Liz gives three ways to increase your cash.
(1) What could you sell?
Perhaps you could hold a yard sale to simultaneously reduce your clutter
and boost your bank balance.
(2) Where can you cut?
Remember, the deeper you slice, the quicker you will be out of debt.
(3) Can you pick up more income? Debtors are typically under earners.
Later chapters also deal with ways to save you money and
increase your cash flow by lowering interest rates.)
Should you pay off your debt with more debt?
(Liz outlines how dangerous it is to replace unsecured
debt with secured debt. Refinancing a
home to a payment you cannot afford puts your home at risk. A credit card company cannot foreclose on your
home. Borrowing money from your
retirement account not only carries tax disadvantages but puts your future
security at risk.)
Debt "solutions" to avoid:
Unsecured debt consolidation loans usually just stretch
out your payments.
If You Are Already Drowning in Debt:
Don't let bill collectors tell you what debts are most
important. You are the one that needs to
decide.
(Task 1) Prioritize your bills into three categories:
essential, important and non-essential.
Non-essential bills include debts that aren't secured by
property. Skipping these payments won't
put you out on the street.
(Task 2) Match your resources to your bills.
(Task 3) Figure out a repayment plan.
Choose Your Path and Take Action:
If you have easy access to your cards, you'll keep using
them. Credit cards need to be off limits
until you are debt free. You don't need
to actually close your credit card accounts, which could potentially hurt your
score. AS IT STANDS, HOWEVER, BEING
UNABLE TO PAY A DEBT IS NOT A CRIME.
Chapter 2 Summary:
You need to know all relevant details about your debt
before you can properly manage it.
The rates you pay on your borrowing depend heavily on your
credit score.
Retirement savings and financial flexibility need to be
key parts of most people's financial plans even when -- especially when -- they
are paying off debt.
Some common "solutions" for debt, such as
borrowing against home equity and tapping into retirement accounts, often make
matters worse.
If you can't pay off unsecured debts like credit cards and
medical bills within three to five years, you may need to consider bankruptcy.
Chapter 3 Credit Cards
A large group of credit card borrowers -- about 40% by
most estimates -- use cards solely for convenience, charging balances that they
pay off in full each month.
Credit cards provide protections that simply aren't
available if you pay by cash or check (or debit card).
If someone steals your card or uses your account number
without your permission, you are not typically liable for a dime since most
issuers waive the $50 fee they could legally charge.
Credit cards can provide an important safety valve in a
nation that has pretty much forgotten how to put aside a little money for a
rainy day. (And Liz, you might be part
of the problem. Let people start saving
before they pay off their credit cards.)
At 2%, the typical minimum payment on $5,000 of credit
card debt is only $100 a month. At 13%
interest you would need 27 years to pay off the balance and you will end up
paying for everything you bought twice over when you count the interest you
have paid.
At 19%, that same debt would take 54 years to retire and
you will pay for everything more than four times.
Now imagine that instead of sending that $100 a month to a
credit card company, you invested it instead.
Over a working lifetime, you could rack up a nest egg of nearly $350,000
assuming your investments earned an average of 8% APR.
That's a pretty steep price to pay for the
"convenience" of not paying off your balance.
Carrying a balance also leaves you vulnerable to many
different ways credit card companies have devised to ding their customers, from
rates that soar overnight to sneaky balance transfer fees. (Liz mentions late fees and over limit fees
just a little bit later.)
Credit card debt is simply corrosive.
One quarter of US households don't have any cards at all,
and another thirty percent or so regularly pay off their balances in full.
Of the households that did carry a balance, the median
(half owed less and half owed more) amount owed was $1900.
So where do we get the idea that the average American
household is $9,000 in hock? The idea is
actually a misquote of a real but easily misunderstood statistic. Averages can be incredibly deceiving. A few folks have a lot and that skews the
average. (Liz was trying to make two
points here: The debt situation is not that bad for most households. But it is really bad for the few that are
skewing the average.)
Pay off your credit card balances in full every month.
Running out of cash before the end of the month is not an
emergency. That's just over sending.
Even though most Americans appear to be handling their
debt just fine, a significant -- and growing -- number of people are in serious
trouble.
Carrying a credit card balance makes you more vulnerable
to whatever setbacks life throws in your way.
Floors but no ceilings:
Credit cards have created interest rate "floors"
to protect their profits. While card
issuers have limited their "downside," there is really no limit on
their "upside."
Overnight rate changes.
No matter how iron-clad you think your rate guarantee is, the credit
card company can wiggle out of it thanks to the fine print in the application
you signed or in those little brochures the credit card companies sent you
after you got your card.
Typically, the credit card company can give you just 15
days notice to change any of the rates or terms or conditions on your account.
Credit card companies cruise the credit reports
regularly. You are "punished"
with "universal default" penalties.
Many people who run into serious financial trouble find
their card companies begin to lower their credit limits, increasing the chances
they will go over their new, lower credit limit.
Over limit and late fees have become a huge profit center
for credit card issuers.
Most people can create and execute their own debt
repayment plans without any outside help:
(Liz gives several approaches to paying off your
debt. The method I prefer is choosing
the largest payment with the fewest number of payments left.)
Whichever account you choose to tackle first, your plan of
attack is to pay as little as possible on your other debts and throw every
available dollar at the debt you are targeting.
Once that debt is retired, you then again decide on the
next debt you wish to eliminate and direct your money there, again paying the
minimums on your other bills.
As you pay off your debt, don't ask your credit card
issuer to close your account or to lower your credit limit unless you really
can't control your spending. Closing accounts of lowering credit limits can
hurt your credit score.
Using more than thirty percent of the available limit on
any card can hurt your credit score.
Chapter 4 Mortgages
Myth #1 Real Estate
Prices Always Rise.
Once house prices fall, they can take years to bounce
back. A spike in foreclosures can start
a cycle which feeds on itself. Lenders
slash prices of foreclosed real estate to sell quickly, which brings down the
value of neighboring houses. That wipes
out the equity of other over extended borrowers and now they too may be more
likely to walk away from their loans -- leading to more fire sales and further
depressing values. People who can afford
to buy homes put off the purchase, waiting for prices to stabilize. That reduces demand which pushes prices
lower.
Myth #2 A House is
a Great Investment
Generally, a mortgage is the very last debt you'll want to
pay off. (If you are paying down your
mortgage), you will need to make sure your additional payment is applied to the
principal (and not to the escrow or credited to future payments).
(Liz makes the point that it is better to put money in a
retirement savings rather than pay down your mortgage. If one loses an income for a period of time,
saved money can be used to make a mortgage payment. Paid down principal will not eliminate future
house payments coming due. A house might
need to be sold to take out the equity.)
Chapter 5 Home
Equity Borrowing
You don't want to squander your home equity -- a long term
asset -- on short term spending.
The voices encouraging you to spend your home equity
freely are, unfortunately, loud and numerous.
In general, you should never use your home equity to buy
anything that declines in value.
Chapter 6 Student
Loans
Chapter 7 Auto
Loans
If you are "upside down" on a car loan, try to
"drive out" the loan. (This
might be difficult since the long term, high interest loan lasts a lot longer
than the automobile.)
Chapter 8
Retirement Plan Loans
The real cost of retirement plan loans:
The tax penalties and lost future income should be enough
to dissuade anyone from tapping his or her retirement funds early. But you should also realize that creditors
cannot touch the money in most
retirement plans. If worse comes to
worst and you need to file for bankruptcy, the money in your retirement plan
can usually be preserved so that you don't end up impoverished in your old age.
Chapter 9 Loans You
Don't Want to Get or Give
Today, high rate loans are big business. Four out of the ten largest banks, for
example, have payday lending arms. The
largest provider of refund anticipation loans is H&R Block. Title (car title) lenders and rent to own
outfits can be found in most communities.
All are capitalizing on people's desire for quick cash,
regardless of the cost. Most target low
income, working people who may feel they have limited options and who often
don't fully understand what they are paying for these loans. Instead of a short term solution, these loans
often spiral into a long term problem.
Payday Loans:
What you may not realize is that the fee you are paying
for the short term loan represents an annualized interest rate of 400% to 600%.
Rent To Own Deals:
A television that retails for $400, for example, might
cost 78 weekly payments of $20, or a total cost of $1,560.
Title Loans:
You may have borrowed only $250 to $500, but the lender
will get a car worth thousands of dollars.
Refund Anticipation Loans:
Those fees can eat up as much as a third of your
refund. So for the "privilege' of
not waiting those two weeks, you pay an average of 222% on a $1,980 refund
loan.
Pawn Shop Loans;
Pawnshop loans have a high rate of defaults. About one in five items used as collateral is
never reclaimed. If you will be parting
with the article anyway, consider selling it on eBay or to a dealer.
Three more loans to beware:
125 or high LTV mortgages.
Debt consolidation loans.
You may wind up paying a higher interest rate on your debt plus numerous
fees that increase your costs.
Margin Loans. The
big risk is your loan may be "called" with little warning if the
value of your security drops.
Why You Don't Want to Cosign a Loan:
Don't sign if you can't afford to pay off the loan
yourself. Don't sign if you don't have
control over the payments. The lender
isn't required to inform you if your co-borrower falls behind. So, by the time you know there is trouble,
your credit is probably already trashed.
Make sure the loan statements and payment coupons are sent to you so
that you can monitor the loan.
The Right Way to Make a Personal Loan:
Are lending money you can't afford to lose? "You should always be prepared for your
loan to be a gift. If you get it back,
that's just gravy." Whatever your
relationship to the borrower, his need for cash isn't more important than financial
survival. If you can't afford to say goodbye to this money, don't lend it. Are you enabling or helping? Enabling just allows the other party to
continue the destructive behavior that got him into trouble in the first
place. Any money lent to an addict, or
alcoholic or compulsive gambler is almost certainly enabling. So too is a loan to someone who spends
compulsively, repeatedly runs up credit card debt or "underearns." "Underearner" is a term used to
describe people who settle for low paying jobs when their skills and experience
qualify them for much better-paying jobs.
Credit Limits:
Don't start the short term loan cycle.
Consider your alternatives. Cutting your spending, raising extra cash and
negotiating with your creditors are better solutions than most high-rate loans.
Chapter 10 Dealing
With a Debt Crisis
It is human to want to hope for the best -- that your
unemployed spouse will land a job, that your boss will give you a raise, that
nest month's expenses will be a bit lower so you can get ahead. But wishing and dreaming won’t make it
so. Debt problems don't get better on
their own, and usually they get much worse.
The more your situation deteriorates the fewer options you'll have
left. So whether the crisis is here or
just on its way, it is important to take action now.
Dealing with Creditors;
Mortgage: Be
realistic. If your financial situation is unlikely to get better any time soon,
even the most generous workout might not help you keep your home and could
leave you worse off. It's typically much
better to sell an unaffordable house while you still have some equity and
hopefully and intact credit rating than to lose it to foreclosure. If you no longer have any equity left in your
house, consider trying to arrange a "short sale" that will get you
out from under the mortgage. Another
alternative is 'deed in lieu of foreclosure."
Auto: Many people
are shocked by how quickly a lender can repossess a car. If you owe more than the car is worth, the
lender may not only repossess the car but sue you for the unpaid balance.
Student Loans: (You
cannot hide. Bankruptcy does not make
them go away.)
IRS: The IRS has
vast and efficient powers to collect.
Medical Providers:
medical providers often "resolve" insurance disputes by
turning to collection agencies to get the patient to pay. Remember that medical bills are among the
unsecured debt that can be wiped out in bankruptcy. If your finances are headed down that rocky
road, you may well decide to conserve whatever cash you have rather than making
pointless payments.
Credit Cards:
Lenders may look on credit counseling as similar to a chapter 13
bankruptcy.
Child support and Alimony:
you typically can’t' get rid of the amounts you already owe, but a court
may be able to grant a repayment schedule.
Dealing With Collection Agencies:
Some creditors do their collections in-house using a
special department. Others give the
accounts to an outside collection agency on a "contingency" basis,
which means the collector keeps a portion of what's collected. Finally, a creditor may sell its overdue
accounts to a collection agency outright for pennies on the dollar.
If you can repay even a part of your debt, you should
negotiate with a collector as to how the debt will be reported to credit
bureaus. Most have more flexibility than
they are willing to admit to erase or minimize negative marks. (Get it in writing before you pay the money.)
Don't talk until you have a plan. Collectors really aren't interested in your
tales of woe. Many just assume you are
lying no matter what you say. You don't
want to make a bunch of promises that you can not keep.
Write the collector and tell them to not contact you by
phone. Assume that the collector will
respond to this by filing a law suit.
Owing money, typically, is not a crime and local law enforcement doesn't
issue warrants for credit card debt.
Find out your rights.
The federal Fair Debt Collection Practices Act is available on several
web sites.
Negotiate hard.
You'll be in the best negotiating position if you can offer a lump sum
to settle a debt. But even if you can
offer only payments, try to offer less than you can actually pay. You might be surprised at how quickly your
creditors agree to settle.
A collector might report the unpaid portion as
"forgiven debt" to the IRS.
(You may need to pay income tax on this amount.)
Chapter 11 Putting
Your Debt Management Plan into Action
Track your spending
Trim your expenses.
Look for cash.
Review your priorities.
Stay on track.
Watch for signs of "frugality burn out." Don't put off all of your rewards for the
future; enjoy a few today as well.