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Managing Debt

To be “In Debt” means to owe money to someone else, usually making fixed payments to pay back the amount over time, plus interest.

Debt means different things to different people – having some debt is perfectly healthy for your personal finances, but too much can leave you buried. There is also a major difference between debt held by people and businesses.

Personal Debt

Your “Personal Debt” is how much money you owe to other people, businesses, banks, credit card companies, and other creditors. Your total debt also includes any outstanding mortgages and student loans.

Having personal debt is not inherently a bad thing, but getting too much that you are unable to pay back in a timely fashion is a huge problem. If you reach the point where you are unable to pay back your personal debt, it is known as being insolvent.

Sources of Personal Debt

There are many sources of personal debt, some are considered healthier than others.

Credit Card Debt

creditcardCredit Card Debt is outstanding balances on your credit card. Each month you will be required to make minimum payments, but interest will continue to accrue on the outstanding balance you can’t pay back (and so you need to pay back even more later).

Using a credit card is the most basic way you can build credit, which is essential to building a good Credit Score and an important milestone in getting additional loans for mortgages and other big purchases later in life, but credit card debt that grows too quickly, and remains outstanding for too long, is one of the key sources of financial trouble for young people.

Credit card debt is fairly easy for young people, especially students and people just starting their first jobs, to lose track of and build up. This is because when using a credit card can sometimes be used as “bridge funds” between paychecks or student loan payouts, it leaves you vulnerable to any other unexpected shock making you unable to pay back the full amount on time. Every time you leave a balance on your card, interest builds up, making it more expensive to pay off later.

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This can lead to relatively small starting balances to become bigger financial headaches later, especially the longer you need to put off paying it.

Credit card debt does have its place in most people’s financial lives, though. When used appropriately, credit cards can be a great way to build up a credit history, and most credit card companies offer reward programs that can make it more attractive to use than cash for everyday purchases.

Student Loan Debt

Graduate with Hire Me SignMost university students need to take out student loans to finance their education. Student loans are a lump-sum form of debt that usually pay out every semester or year, but do not need to be repaid until after you graduate university and find a job.

Student loans are popular because they make it easier for more people to obtain higher education, and by living off borrowed money, students can focus entirely on their studies (although even students who work often need to take out small loans to help pay for tuition). The major downside to this is that it means students begin their professional lives with a large cloud of student loan debt looming.

Even though you may not need to start paying back your loans until after graduation, interest usually starts accumulating as soon as the loan is dispersed. This means that the longer you wait to start paying it back, the bigger the debt becomes.

Student loan debt is also treated differently form other types of debt – even if you file bankruptcy, you probably won’t be able to discharge your student loans. This loophole in the law exists to prevent fresh graduates from declaring bankruptcy right out of school and discharging their full debt immediately, but it means that regardless of how insolvent you become, you will still have to keep paying back your student loans.

Mortgages and Car Loans

houseMortgages and car loans are loans taken out to pay for a house or car. These loans usually have the house or car you’re buying posted as “collateral”, meaning if you fail to pay back the loan, the house or car could be repossessed to pay back the debt.

Mortgages and car loans are usually looked at in a more favorable light than credit card debt – so long as you made a good purchase with a decent interest rate, taking out these loans is seen as a necessary part of your credit life. Their major downside is that these loans are typically much larger than what you would see with normal credit card debt, which means you will be paying them back for much longer.

The longer you are paying back a debt, the more careful you have to be that you always have at least the minimum payments on-hand to prevent the loan from going in default. This is because that if you take out a 20 year mortgage on your house, you need to be sure that you have a plan to keep making the mortgage payments even if you lose your job somewhere along the line, or other financial disaster strikes.

Generally speaking, if you find yourself in the position where you think you might not be able to continue to make mortgage or car payments, you will be in a better position if you sell off the house or car yourself than if you wait until your creditors seek repossession.

Impact of Debt on your Net Worth

Your Net Worth is based on your balance of assets (like your house, cash, jewelry, and anything else of value) against your liabilities (or your total debt). As your debt increases, your net worth goes down.

The flip side is that if you use debt to make valuable purchases, like using a mortgage to buy a house, your home value might increase at a higher rate than the interest you pay on it. When calculating your net worth, you will need to balance your lifetime growth in assets against how fast your debt grows. 

Defaulting On Personal Debt – Creditor’s Options

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The most effective way to avoid defaulting on your debt when you run into trouble is to just talk with your creditor! They are people too, and just explaining your situation can get lower payments and better terms until you get your footing!
If you “default” on your debt, it means you are unable to repay, and your creditors start attempting to recover their loss. This can lead both to debt collection and bankruptcy protection.

There are a few different legal methods that creditors can take to collect their debt, but there are also consumer protections against illegal practices.

Repossession

If you posted anything as collateral for your loan (like your car), your creditor can take possession of it if you stop making your loan payments, usually without notice. Your creditor can then sell off what is repossessed, and use the sale to satisfy the amount that was owed.

If they can’t get back the amount that you owe them when it is sold, you will still be liable to pay back the difference.

Wage Garnishment

Your creditor can sue you to pay back the loan amount, and the court will give them some different ways to get their money back. One of the most common of these is “Wage Garnishment”, where a certain amount is taken out of your paycheck directly and sent to the creditor before you even see it. There is generally a 25% cap on how much can be taken, but your cap can be lower depending on where you live.

Property Lien

A “Property Lien” is another type of court order which gives your creditor the right to put a claim against the title of any property you own. This is basically a public statement saying that your creditor gets a piece of this property’s value because of the money you owe. Having a property lien does not automatically do anything, but it opens up the door to foreclosure, or when your creditors force the sale of your property to satisfy the debt you owe.

Most creditors prefer to avoid foreclosure, since it is a lot of work to arrange the sale, so it is typically left as a “last resort”. Instead, if you have a property lien, you will typically have to pay it off using the proceeds you make when you sell the property before you have a “clear title” that you can transfer to the new owners. If your creditor does decide to foreclose on your property, they only have a right to the amount that they’re owed in the sale – if the property is sold for more than you owe, you get to keep the rest.

Defaulting On Personal Debt – Debtor’s Rights

Even if you default on your debt, you still have certain rights and options available.

The Fair Debt Collection Practices Act

This act is a consumer protections measure that helps protect people from unfair harassment by their creditors. It makes it illegal for creditors to:

  • Call you outside 8 am – 9 pm
  • Call you at work if you tell them your boss does not allow it
  • Publicly post your name and address as a “bad debtor”
  • Pretend to be a lawyer or police officer to force you to pay your debt
  • Pretend they have a court order when they don’t
  • Contact you at all if they know you are represented by a debt attorney
  • Contact your friends/family/co-workers and tell them about your debts
  • Contact you (other than with official court papers) after you explicit request in writing that they stop

The Act also requires anyone who contacts you about your debt to tell you who they are calling on behalf of, and the total amount you owe. If a debt collector breaks any of these rules, they can be penalized by the Consumer Financial Protection Bureau.

Bankruptcy

Monopoly-Banker-with-Empty-PocketsIf you really find yourself insolvent, you may need to consider bankruptcy. A simple bankruptcy, or “Chapter 7“, is a basic sell-off of all your assets above a minimum threshold (usually $5000 – $6000). A trustee takes possession of all your property and assets, and sells them all off. It then takes the total proceeds and distributes it between your creditors. This accounts for over 90% of all bankruptcies.

After going bankrupt, all debts (apart from student loan debt, child support, and a few other special cases) is “discharged”, or disappears. However, the person who filed bankruptcy generally will be unable to obtain any new credit for 3 to 5 years (including simple credit cards, or even renting an apartment). A bankruptcy will appear on your credit report for 7 years, and works strongly against you for

Business Debt

Business debt works a bit differently from personal debt – businesses (especially big businesses) are usually in debt, and a lot of it, nearly all the time. Making payments on this debt is generally considered part of their normal operating expenses.

Why is it different for businesses?

For personal debt, you will hold your debt for a period of time, but eventually you need to retire and live off of your savings, so it is in your best interest to minimize how much debt you have by that time. You will also probably have a certain cap on how much more money you earn each year – most people don’t expect to make 20% raises every year for their entire life.

These constraints do not apply for businesses – they expect to exist and continue to do business forever, so they do not have a point on their horizon where they need to be “debt free”.

The biggest difference, though, is that businesses use debt as leverage – they borrow money in order to make more money (opening new factories, hiring new workers, doing more research ect). Each time a business takes out a loan, they are saying that they expect to be able to use that money to make more money than it costs them. For example, if they can borrow $10,000 with a 10% interest rate to bring a new product to market this year and earn $30,000 in extra revenue, it is a good deal to take the loan.

As businesses pay off their debts, they will often continue to re-finance, or borrow against the new value they have created since their last loan. This means that their actual dollar amount of debt grows over time. With individuals, we are mostly concerned with how big our debt is, but a business only needs to worry about how much they are paying back relative to how much they are earning. If their earnings keep going up, there isn’t much of a problem if their debt is growing too (just so long as their debt is not growing faster than their revenues).

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1 of 5) Which form of debt is the easiest to lose track of and build up?

2 of 5) What makes student loan debt different from most other debt?

3 of 5) If you default on a loan, you might get…
4 of 5) Which of the following is prohibited by the Fair Debt Collection Practices Act?
5 of 5) What does it mean to use debt as leverage?

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