Debt Management

Debt management addresses the concept of using consumer debt as a financial tool. Individuals should be able to determine appropriate debt levels as compared to their cash flow, recognize the signs of too much debt and know their options for dealing with an excessive debt load. 

Debt is a liability or obligation in the form of a loan, owed by one individual to another and required to be paid by a specific date. Debt is what credit becomes once it is accepted and utilized. An example of this would be when an individual is approved for a credit card once they use the card to make a purchase the subsequent balance would be considered debt.

Individuals need to understand how debt works and how to properly manage it.  Debt can be a powerful financial tool, used to finance education, purchase a home or start a new business. But when debt is not properly managed individuals can quickly find that they are overwhelmed and see their financial obligations spiral out of control.

Warning Signs

Other than using mathematical calculations and cash flow analyses, there are other methods to determine if an individual is having debt problems. When it comes to dealing with debt issues there are certain behaviors that are sometimes exhibited. The following are some of these classic warning signs of a debt issue:

• Missing payments. When an individual is having difficulty making timely payments, this usually is an indication of a problem

• Receiving collection calls and letters. By the time someone is receiving calls and letters they have become more than thirty days delinquent on their bills.

• Shuffling payments. This is sometimes referred to as “Robbing Peter, to pay Paul” and typically signifies a cash flow issue.

• Using the Grace Period. When individuals are paying the bill that is due on the 1st on the 10th this may be more than a bad habit.

• At the Credit Limit. Individuals who have used almost all of their available credit may be demonstrating that they have been subsidizing their income with debt.

• Cash Advances on Credit Cards. Again, this may indicate an individual who has they have been subsidizing their income with debt.

• Creditors Closed Accounts. This will indicate that the creditors are beginning to see a potential problem.

Options for Managing Debt

Individuals may determine they need guidance on how to manage their debt. Excessive debt can seem overwhelming to an individual but there are tools available to help consumers grabble with it. The following will discuss the various strategies and options available as well as some of the potential pitfalls they should be aware employing these options.

Self Help

Self-help is when an individual decides to come up with a plan for dealing with their debt issues on their own. It usually starts with them setting a goal of repaying some or all of their debt in a specific timeframe, creating a budget and contacting their creditors directly. This option will work if the individual has sufficient cash flow and proactively contacts their creditors. Most creditors have now put into place loss prevention departments and will work directly with consumers to work out payment plans to keep accounts from going into collections. A highly motivated individual can be successful with this type of debt management option.

For individuals who are still having trouble managing their debt, suggesting they prioritize their debt payments. It’s seldom that experts agree with each other, but the one thing they do seem to agree upon is that the best way to approach debt repayment is to prioritize outstanding debts.

Secured debt should be the first item on the list to be repaid. This is simply because a creditor can take the collateral to satisfy the outstanding debt. These are merely suggestions as to how bills should be prioritized:

1. Mortgage: Failure to do so can result in the loss of the home. You may suggest they call their lenders immediately to discuss available options.

2. Car payments: If a car is an essential means of transportation.

3. Child support (if applicable): Non-payment may result in imprisonment.

4. Income tax debt: Taxes, unfortunately, need to be paid. Suggest they contact the IRS directly to see about working out a payment plan.

5. Court judgment: If a court judgment has been ordered failure to pay can have serious consequences.

6. Student loans: Although these are considered unsecured debts, failure to pay can result in seizure of tax refunds, or other special collection remedies.

7. Uncollateralized loans should take lesser priority: This would include credit card debt, debts owed to professionals, and any open merchant accounts. It is always possible that the past due accounts will be turned over to a debt collector.

Individuals should understand that failure to repay any contractual obligation can have serious consequences. Again, you do not want to give legal advice but speaking in general terms you can review what some of these possible outcomes can be for failure to repay a debt:

• Bank setoff is a provision in a bank loan that allows the bank to seize an individual’s bank account(s) to satisfy the amount of money owed, without any legal proceedings.

• Collections refers to debt that has been turned over to a collection agency by a creditor. It is for the collection agency to “collect” what they can from the debtor.

• Eviction refers to the process of removing a tenant from a rental property by a law enforcement officer. In some jurisdictions the landlord must win an eviction lawsuit or prevail in another step in the legal process before a tenant can be evicted.

• Foreclosure is a legal proceeding initiated by a creditor to take possession of property on which the mortgage has been defaulted.

• Lawsuits are criminal or civil actions brought before a court in which the party commencing the action (the plaintiff) seeks a legal remedy.

• Liens are an official claim or charge against collateral for funds owed. A lien may be placed on either personal property or real property, turning that property into collateral for the money or services owed.

• Repossession is a term which generally refers to an act carried out by a financial institution when it takes back an object that was used as either collateral, or rented, or leased in a transaction.

• Wage garnishments are the most common type of garnishment. This process is the result of a court order which mandates that funds be deducted from an employee’s wages. The most common examples of reasons for garnishments are unpaid child support, unpaid taxes, unpaid court fees and any other type of money judgments.

If an individual believes that self-help will not work for them there are other options available to them.

Debt Management Plans

Under a debt management plan (DMP), a third-party organization, typically a non-profit credit counseling agency, negotiates with the individual’s creditors on their behalf to set up a plan for repaying their debt. The individual then makes monthly payments directly to the agency which in turn remits these funds to creditors. The agency will provide financial counseling and education to the individual over the course of the debt management plan, which will take on average 36 to 60 months. The agency is paid by both the creditor and the creditor. Individuals should work with only a properly licensed DMP provider in the state where they reside.

Debt Consolidation

Debt consolidation is the process of taking out a loan for the purposes of paying off and consolidating many debts into one debt. This is often done to the lower interest rates being paid or to secure a fixed interest rate on the outstanding debt. Debt consolidation may be used for several unsecured debts into another unsecured debt, but more often it involves a secured debt against an asset that serves as collateral.

For this option to be successful an individual’s needs to be disciplined and after the consolidation has occurred, they need to not accumulate new unsecured debt, thus increasing their outstanding liabilities. Also, if the consolidation loan will be secured with their home, they need to understand that this will place this asset at risk if they should default on the loan.

Certain federal student loans are eligible for consolidation and can simplify an individual’s payments, but it may result in the loss of certain benefits. The Direct Consolidation Loan program is a federal loan made by the U.S. Department of Education that allows individuals to combine one or more federal student loans into one new loan. As a result of consolidation, they will only have to make one monthly payment on their federal loans and the amount of time to repay the loan will be extended.

Debt Settlement

Under a debt settlement program, a third-party organization, typically a for-profit debt settlement company or law firm negotiates with the individual’s in the hopes that the creditors will accept reduced payment in lieu of the full balance due. Individuals are often advised by the debt settlement firm to stop paying their debts and to begin saving money; the savings are then used to make the offers to the creditors.

The potential risks for individuals using this method, include that many of the companies operating in this field are not properly licensed and there have been numerous consumer complaints. Also, many creditors will not work with debt settlement firms and once they learn individuals have contracted with one, they may send the account into collection or legal, which will only increase the outstanding balance owed.

There is also a possible income tax consequence that individuals should be aware of. Not paying the full balance to a creditor may also be considered a taxable event. So, every creditor that an individual “settles” with will send a form 1099-C at the end of the year for the amount of the forgiven debt. Potentially the taxes due can wipe out the savings provided from the settlement process.

Lastly, individuals should be aware the Federal Trade Commission’s Telemarketing Sales Rule prohibits for-profit companies that offer debt settlement from charging or collecting a fee unless they first settle, reduce, or alter a debt.

Offer in Compromise

The Offer in Compromise (OIC) program allows an individual to work with the Internal Revenue Service (IRS) to resolve outstanding tax debts. An OIC is where a taxpayer can settle a tax debt for less than the full amount owed. The IRS will consider these offers if the taxpayer cannot pay their full tax liability or doing so would create a financial hardship. The IRS takes into consideration an individual’s income, expenses and current assets.

A tax professional can be hired to assist with filing an OIC but the IRS cautions that taxpayers should thoroughly check his or her qualifications. Companies that advertise incredible savings may not be able to produce such results for every taxpayer.  The IRS provides an OIC Pre-qualifier which may be a helpful tool.

Mortgage Modification

Under a mortgage modification process, the original terms of a mortgage are changed by the creditor. Individuals can work with Department of Housing and Urban Development (HUD) approved housing counseling agencies and receive free foreclosure prevention, rate reduction, and/or mortgage modification assistance. The government has created several programs to assist homeowners who are struggling with their mortgage payments.

Individuals do need to be cautious of foreclosure rescue and mortgage modification scams as they have been a growing problem. These firms charge thousands of dollars at a time when individuals can least afford to pay. The rescue firms will promise or guarantee to “save” a home or to lower mortgage payments all for a fee. A homeowner should never have to pay a fee for assistance. Also, they should never sign over the deed to their house on the promise of being able to “buy it back” once the mortgage is brought current.

Bankruptcy

Bankruptcy is a legal process whereby an individual’s outstanding debt is either reduced or eliminated under protection and supervision of the court. When applicable, a schedule of payments to be made to creditors will be drawn up under court supervision.

Under the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 Pre-filing bankruptcy credit counseling and post-filing debtor education are mandatory requirements for all individuals in the bankruptcy process. Both programs must be administered by a government-approved agency or provider who will provide a certificate which will be filed with the bankruptcy court.

There are several types of bankruptcy known as chapters. Below is a review of the two most common chapters that individuals file. Because bankruptcy is a complex and legal process you should not advise an individual on which chapter of bankruptcy they should consider utilizing unless you are a licensed attorney.

Chapter 7

A Chapter 7 bankruptcy is also known as a straight liquidation. This is when the individual, known as the debtor, petitions the court to take their non-exempt assets and liquidate them to pay off their debts. If their debts exceed their assets, those debts are forgiven, giving the debtor a clean slate. 

Certain debts cannot be discharged, including federal student loans, child support payments, alimony and back taxes.

A Chapter 7 filing will stay on an individual’s credit report for ten years from the filing date.

Chapter 13

A Chapter 13 bankruptcy is also known as the wage earners plan. Under this plan, debts will be restructured by the court. The repayment schedule will be determined by the debtor’s income and expenses. Repayment plans are typically between three to five years and are restructured so that between 10 percent and 99 percent of the outstanding debt is repaid. Under a Chapter 13 plan, debtors often keep certain assets, such as their homes.  A Chapter 13 bankruptcy stays on an individual’s credit report for seven years from filing.