Financial Basics that will help you avoid being in a similar financial situation in the future.
Understanding the Borrowing Process
When you think about borrowing money, there are several things to consider. Ideally, you should be able to:
- 1. Identify a variety of sources and institutions which lend money
- 2. Evaluate the terms of the loan
- 3. Know how to calculate the cost of credit
- 4. Determine your own debt limit.
- 5. Where Can I Borrow
- 6. Most consumer credit comes from: banks, savings and loan institutions, credit unions, finance companies, and credit card companies.
In addition, many people borrow from relatives or other individuals who may or may not be good credit sources. Individuals who loan money but don’t have a permanent place of business may offer you loans that charge more than the legal interest rate. Wherever you borrow, be sure to get a signed contract, and READ THE FINE PRINT, of the terms and the finance charge calculations.
Terms of the Loan
Borrowing Terms you need to be familiar with include:
- Down Payment - the amount of money required up front. Length of the Time to Repay – the amount of time to repay the loan in full.
- Interest Rate - (APR) is the percentage cost of credit. This is a key to comparing costs. The Truth in Lending Act doesn’t set interest rates or other charges, but it does require that the lender disclose the terms of the credit plan so that you can “comparison shop” for credit. Example: Suppose you borrow $100 for one year and pay a finance charge of $10. If you can keep the entire $100 for a whole year and then pay back $110 at the end of the year, you are paying an APR of 10%. But if you repay the $100 and the finance charge (for a total of $110) in twelve equal monthly installments, you don’t really get to use $100 for the whole year. In fact, you get to use less and less of that $100 each month. In this case, the $10 charge for credit amounts to an APR of 18 percent.
- Finance Charge - the total dollar amount you pay to use credit. In addition to the charges imposed based on a periodic rate, it includes other costs such as interest fees, service charges, annual fees, late charges and some credit-related insurance premiums. Example: Borrowing $100 for a year might cost you $10 in interest. If there were also a service charge of $1, the total finance charge would be $11. (The method used to calculate the balance on which you pay a finance charge makes differences in the cost of credit.)
Costs of Borrowing
Credit costs money! The cost of credit will vary considerably depending on the method used to calculate the balance on which you pay a finance charge. It is
often difficult to figure out the finance charges once you start using a credit card regularly and carrying a balance on it. The bottom line about finance charges on credit cards is this: Try to pay off your credit cards each month. If you can’t afford to pay off your credit cards each month, make the largest payment you can afford, and pay the card off before you make another purchase.
Four methods for calculating finance charge include:
- Adjusted balance method
- Average daily balance
- Two-cycle average daily balance
- Previous balance
The adjusted balance method takes the amount you owed at the beginning of the billing period and subtracts any credits and any payments made by you during the period. New purchases are not counted.
The average daily balance (one of the most common methods) adds your balances for each day in the billing period and divides that total by the number of days in the period. Additionally, payments and credits made during the period are subtracted and new purchases may or may not be included. The two-cycle average daily balance method uses the average daily balances for two billing periods to calculate the finance charge. Payments and credits will be accounted for and new purchases may or may not be included. The previous balance method bases the finance charge on the amount owed at the end of the previous billing period. How do these different methods affect the finance charge? The Bankcard Holders of America (BHA) calculated the finance charges on one account four different ways. The account started with a zero balance the first month. The account holder then charged $1000 and made the minimum payment. The next month, the account holder charged another $1000 and paid off the balance due. The account’s interest rate is 19.8%. The calculations showed varying interest between $16.50 and $49.05. It pays to shop around!
- Average daily balance method, including new purchases: $33
- Average daily balance method, excluding new purchases: $16.50
- Two-cycle average daily balance method, including new purchases: $49.05
- Two-cycle average daily balance method, excluding new purchases: $32.80
Some credit card issuers offer variable interest rate plans that drive the rate to be charged by using a formula. A common formula is: Index + Margin = Variable rate. Some of the common indexes used by credit card issuers are the prime rate, the one-, three-, or six-month Treasury Bill rate, or the federal funds or Federal Reserve discount rate. Most of these indexes can be found in the money or business sections of the paper. The issuer then adds a number of percentage points, the “margin” to the index rate to calculate the rate charged. Another formula to determine the rate to be charged uses a multiplier, or Index x Multiple = Variable rate.
Do’s and Don’ts of Credit Cards
You’ll want to shop around for any credit. Picking the right credit card can save you money. Look at the various sources. Be sure to read the contract carefully. As with any loan, or service, it’s better when you don’t rush it. Know the penalties for missed payments. Figure out the total price when paying with credit. Make the largest payments you can afford. Use your credit cards when you’ve evaluated the situation and taken into consideration all payment options. Don’t be misled into thinking that small payments are easy.
When looking for a credit card, compare Annual Percentage Rate (APR), grace period, annual fees, transaction fees (such as cash advance, late payment and over-the-limit fees), and balance computation method for the finance charge. Also, know what features are offered, such as credit limit, special services, and how widely the card is accepted.
High Cost Financial Services
Beware of high cost financial services such as pawnshops, rent-to-own programs, check-cashing outlets, rapid-refund tax services and check-deferral or payday loan services.
Pawnshops charge a very high interest for loans based on the value of tangible assets (such as jewelry or other valuable items). Rent-to-own programs offer an opportunity to obtain home entertainment systems or appliances with a small weekly fee. However, the amount paid for the item usually far exceeds the cost if the item was bought on credit. Check-cashing outlets charge high fees (sometimes 2 or 3 percent) just to have a paycheck or government check cashed.
Rapid-refund tax services provide “instant refunds” when you pay to have your federal tax return prepared. However, this “instant refund” is a loan with interest rates as high as 120 percent.
Check-deferral services (payday loans) allow consumers to get a cash advance on their next paycheck. However, these short-term loans are very expensive. A $200, two week advance may cost over $30 (with annual costs exceeding $900). One honeymooner found out the hard way how expensive payday loans could be. He wrote a check (that was never supposed to be cashed) for $500 to a payday lender. He was to pay off the loan in two weeks and pay a service fee of $3 for each $100 borrowed. When he was unable to repay the loan with interest, the whole procedure was replayed two weeks later, and again, and again. A year later, he owed the lender $3,600 and he was still unable to pay. (That’s when he finally told his new bride…yikes!)
Your Financial Debt Load
What is Debt Load? Debt load is a term that is used to describe the amount of debt a consumer has. It is often used to understand if you are carrying a “safe” amount of credit. Creditors look at a debt/income ratio, comparing your income with your outgo to analyze whether you have too much debt. The debt/income ratio is figured monthly, and reveals either how good, or bad, your financial picture is on a day-to-day basis.
You can figure this ratio for yourself! Add all of your non-housing monthly payments except for your utilities or taxes, and then compare that total with your total gross annual wages divided by 12. If you don’t have fixed monthly payments on revolving debts such as credit cards, you can estimate your monthly payments at 4% of the total amount you owe. When you divide your monthly debt payments by your total monthly income, you will get your monthly non-housing debt/income ratio. It is usually expressed as a percentage so move the decimal point two places to the right.
Here’s an example:
Gross monthly income is $2,000
Monthly debt is $500 (credit card payments, gasoline bills, and car payments)
$500/$2000 = 25%
Your debt/income ratio is 25%
Here’s a comfortable rule of thumb to follow:
If your non-housing debt is 10% or less you’re in great financial fitness If your non-housing debt is between 10% – 20%, then you’ll probably be able to get credit, but as you approach 20%, you’re getting too high!
The 20-10 Rule for Consumer Credit
Another conservative rule of thumb for other consumer credit, not counting a house payment, is called the 20-10 rule. This means that total household debt (not including house payments) shouldn’t exceed 20% of your net household income. (Your net income is how much you actually “bring home” after taxes in your paycheck.) Ideally, monthly payments shouldn’t exceed 10% of the NET amount you bring home. For example, if you bring home $60,000 per year, your total consumer debt shouldn’t exceed $12,000 and total monthly payments shouldn’t exceed $500 per month.
Real Estate Debt
There have been many attempts to devise formulas for setting limits on the amount of real estate debt one should carry. One rule of thumb is 2 (or 2 ½ to 3) times your annual income. If the annual household income is $70,000, a mortgage company might loan up to $210,000 provided the house is worth the money and the other credit factors are satisfactory. However, be careful. Just because a lender may be willing to extend credit doesn’t mean that you should necessarily borrow that amount. You should also factor in your own specific fixed and variable expenses to determine your own ability to pay. How much you spend on real estate may depend on what area of the country you live in. Remember, if you’re high on the real estate debt, you may want to be lower on the debt/income ratio to compensate.
The 28/36 Rule
Here’s another rule that is used by mortgage lenders – the “28/36 rule”. Your monthly household debt service should not exceed 28% of your gross monthly income. Your total debt service, including your house payments plus all other payments, should not exceed 36% of your gross monthly income. Other Considerations In determining your own debt load limits, you can start with the rules of thumb described above, but you also need to consider:
- The stability of your income
- Your other regular expenses
- Your need for cash from month to month
- The changes in your cash needs as you and your household grows older
- All you personal needs and wants and goals
- Any extraordinary expenses you might have which would affect the standard rules, such as caring for sick family members, or special medical needs.
Remember that your debt SPENDS your future income. And you have less money now to do things you want to do because you must pay for items you’ve already bought, and in many cases, already discarded. Begin the habit of regular savings. It’s much cheaper to save for an item first than to buy it on credit. Keep your future debt load reasonable.
It’s hard to admit when you’re having a problem with debt. It is natural. Debt can be painful. Here are some things that might indicate you’re headed for trouble.
- Next month’s bills are here before you’ve paid last months.
- You get frustrated when you start to write checks.
- There are more bills than you thought.
- You know what past-due notices look like.
- You get an overdue balance on a credit card statement.
- You avoid opening letters.
- You rarely keep a running balance in your checkbook.
Finding yourself in a difficult situation isn’t the end of the road.
Reducing Your Debt Load – First Steps
There are two great ways to change your debt load and debt/income ratio.
- Cut spending
- Bring in more money.
Cutting spending can be the fastest way to reduce the debt load, unless additional work and income is readily available. Take either action, or both, now to help prepare you for the future. Some have equated cutting spending, with surgery for your money management. But, as you heal with better financial health, you’ll probably also notice that your attitude, relations with others, emotions and sense of humor start getting better too!
Recognize that you don’t have to continue to add to your debt load with additional purchases. Say no to a higher debt load right now if you found yourself outside the comfort zone on any of the rules we described in this chapter. Remember, you may have found a terrific bargain on a stereo, but if you don’t pay it off for 3 years, the money you “saved” won’t matter.
Avoid “impulse purchases”. You’ll be surprised at what a difference this tip can make.
Learn to cook, or take your lunch to work. The difference between buying lunch out for a week, and your grocery bill for bringing lunch to work should quickly show you how fast you can reduce your debt load by taking steps now. Even the baby steps help. Don’t think that if you can’t save more than $100 it’s not worth it. A little bit every day is a great start on your financial fitness program. Think about ways to bring in additional money, either a part-time job, or maybe a better job. There is more than one way to change your debt load!
Remember that financial fitness is your goal. Cutting your debt load is a great start for your financial fitness program.
Your Financial Situation – What Happened
Here’s some statistics regarding why consumers don’t pay their bills:
I Need More Money
Out of control bills are the result of a lot of things – most of them very good reasons to spend money. The car that died suddenly and had to be repaired. The home you “stretched” to buy and its’ mortgage. The Christmas gifts. The clothes, for the new job and school for the kids. Debt is the result of many decisions – some we’re aware of making, and some we’re not. Just keeping up with life – kids, work and taking care of parents – it’s easy to loose track of how these decisions get made. To get the most value from this lesson, you need to take a hard look at yourself and your habits and decision making. The exercises included in this lesson will set the stage for real and long lasting changes in behavior that will lead the way to financial freedom.
It is important to take stock of your situation. Understanding where you are now, how you got into the predicament, and where you can go from here is probably not going to be the most fun you’ve ever had. It is not much fun, but once it’s done, you may be surprised at how you spend your money. And, how the ideas presented can help you in the future.
Earning and Spending
The spending decisions we make are often just part of “getting by”, and done in haste as we go through life, with kids, work, parents, the house and mortgage. In fact, sometimes we don’t feel we have time to plan, since we’re so busy. In fact, our spending patterns are often the result of emotional and psychological reasons that have no bearing on actual need or desire, or even well thought out decision making. Families and upbringing have a big impact on your “money style.” Some of us learn to spend for comfort, or to avoid doing something else. Some grow up believing we are only as good as the things we own. Getting a handle on the emotional urges can help you control spending.
We get our ideas about how we should live based on cultural influences. Sometimes it is assumed that a new job “requires” new clothes and a new car. For others, a trip out of town presents “new” shopping opportunities and those presents that much is bought for those at home. Or, you live in a neighborhood where everyone has…
Another way to think of money is as the tool of life. We trade our lives for money. We work or commute instead of taking care of children or playing in a rock and roll band, or maybe painting. Sometimes, we can be so caught up in earning a living and making payments that we don’t even realize that every day we are making decisions about how we are spending our lives.
How Do I Get Out of This Mess?
Getting out of this mess begins with understanding your own predicament, patterns, spending and decision making habits. Sometimes we make decisions about what we need based on emotions or cultural influences. Sometimes people who receive promotions feel the need to dress in similar expensive clothes as their new “peers”. Learning to examine your real needs and emotions is a start. Getting control of spending requires working toward a balance between what we want, and what we need that corresponds to our values. It sounds so easy … and can be so difficult. Balancing the demands of a job, or looking for work, family, church, school, and let’s not forget – recreation.
Sometimes the ability to mentally categorize money into different areas can be used in a positive way toward set goals. Putting money into the “new clothes fund” or “new house savings” makes it easier not to touch that money. Specific goals are more satisfying and easier to work for than a general goal, like “getting out of debt.”
You aren’t alone, and there are people willing to help you get out of this mess. The lesson on credit counseling, 4D will provide some ideas of where you can go for assistance. You can locate a credit counseling office near you, and contact them in person, by phone or through the internet.
The Absolute Last Resort
Bankruptcy is not the absolute cure most are led to believe. First, it costs to hire an attorney and file the necessary documents in the bankruptcy court. If you attempt to do it yourself or hire a typing service your rights could be in jeopardy. Second, not all of your debts will be discharged. If you owe taxes, alimony or child support, or student loans you will still have most of those debts after the bankruptcy proceeding. Third, all of the debt that you discharge becomes a loss to your creditors who are not likely to want to deal with you again in the future. Lastly, the bankruptcy will be on your credit report for 10 years or more depending on which type you file. Although you may be able to obtain credit after a bankruptcy you will pay much higher interest rates and fees.
There are various types of bankruptcy, which are identified by the chapter number where they appear in the bankruptcy code. The most common types for consumers are Chapter 7 and Chapter 13. A Chapter 7 is often referred to as “straight ” bankruptcy or a “liquidation”. In a Chapter 7 bankruptcy you would agree to turn over all of your non-exempt assets to a Chapter 7 trustee. The trustee will then sell your assets and distribute the money to your creditors. The overwhelming majority of consumer Chapter 7 cases are considered to be “no asset” cases and the creditors without security, like a house or a car, get nothing.
The Chapter 13 bankruptcy is considered a reorganization of the debtor’s obligations. This type of bankruptcy is available if your secured and unsecured debts fall within a certain range; currently you can have no more than $807,750 in secured debt and $269,250 in unsecured debt to qualify. You would propose a plan based on your available disposable income to pay your creditors over a thirty- six (36) to sixty (60) month period. The secured creditors usually get most of their debt repaid while the unsecured can get anywhere from 0% to 100% of their debt. Once the plan is approved you would make a single monthly payment to the Chapter 13 trustee who in turn distributes the funds to your creditors. This works much the same way as a credit counseling debt repayment plan.
Although there are instances where bankruptcy is the only solution it should always be the last resort in resolving financial problems. The foregoing is a very brief description of a very complicated subject and is not intended to give legal advice. All legal questions should be directed to an attorney. Debt Settlement using the services of a Certified Debt Specialist is recognized as the number one alternative to filing for bankruptcy.
Why Does Debt Settlement Work?
What lenders and other creditors want is to at least recover their investment. Thus they would most certainly prefer to settle for a lower amount than to risk the borrower filing for bankruptcy and maybe get nothing at all. However, creditors will want to get as much money as possible and will present a hard negotiating position so as to achieve this goal.
That’s why a debt settlement program should be carried out by professional debt negotiators. Certified Debt Specialists know exactly how to deal with creditors and obtain higher waives on the claimed debts. Certified Debt Specialists know exactly how long they can push so as to make creditors give up a larger portion of the outstanding debt and thus enhance your financial situation.