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There is a growing feeling of frustration in the country and a large part of it arises from the fact that while people realize that they are in debt, many have no idea how to solve their financial problems or find debt relief. In a classic example of how debt can overwhelm your life, Amy’s story is an all too common one.
Amy, 37, is a single parent of two small children. She does not receive regular child support payments and was barely getting by with her earnings from her job – she has barely been managing to meet her monthly obligations. Things got even worse when she was laid off and found that her finances were stretched too thin to cover anything but her basic household expenses. Amy can’t believe that only a few years ago she was happily married with a new car and house, a variety of credit cards and vacations. Now, Amy claims her life is filled with constant calls from collection agencies and an ever increasing pile of bills that she has no idea how to tackle. The most recent scare was a notice she received from a credit card agency claiming a balance due of five thousand dollars (in combination with late fees, interest and collection agency fees). Amy is struggling to make ends meet and look after her children, but she feels that she is only sinking deeper and deeper into debt.
Amy’s story is an all-too common one. Consumer debt in America is reaching alarming levels. At the rate American consumers are acquiring debt, we will be faced with decades of debt problems in the future.
The key to good debt management is increasing your awareness about what debt is, how it works, and how it affects you. You acquire debt when you purchase any service or goods from a creditor on a non-cash basis. When you incur a debt, your creditor expects that you will repay the debt in full. Typically the debt carries with it an interest rate and penalties or late fees if the terms of repayment are not fulfilled.
It may seem that you spend your life struggling with debt. As the bills pile up each month, it is natural to feel overwhelmed with the amount you spend on debt repayment. But, would it surprise you to know that not all debts are bad? There are some debts that may even help you in the long term. When a lender asks to check your credit report and looks at what kinds of accounts you have accumulated, it is important to realize that some debts will be considered more favorably than others. So, if your goal is to be free from debts, you need to understand which debts carry negative weight and which are looked upon more positively. Smart money management includes being able to differentiate between the two.
Some debts can be considered an investment. They can be “good debts” if they contribute to your overall finances or they increase in value over time. For example, buying a house and taking out a mortgage to do so is considered a good debt. Since the value of most homes appreciate over time, the mortgage loan you take to pay for the house can be counted as an investment. In the same way, a student loan to pay for your college education will help you find a better career and greater future earnings. Hence, a student loan is also a good debt. Therefore, debts such as real estate loans, student loans, home mortgages and business loans that create value may be good investment debts. Many of these debts also have tax benefits and can help produce more wealth over time.
Now let us focus our attention on the other type of debt. If you accumulate debt to purchase things that are consumed and cannot appreciate in value, you are accumulating “bad debt”. It is this kind of debt that causes problems and leads to unstable financial situations. A prime example in this category is credit card debt – largely because of the types of items purchased using them. If you accumulate debt on the purchases of items like clothes or food with your credit card, you should make sure that you pay the balance in full each month. Purchasing disposable or durable items using cards with high interest rates and not paying the balance in full will create bad debt. Not paying the minimum balance often leads to higher rates of interest and late fees that can quickly add up to unmanageable amounts. Ultimately, the item you bought loses value but the amount you paid for it continues to increase.
At the end of the day, whether its good debt or bad debt, you still have to be careful to not take on too much of either kind. If you end up being overloaded with debt, your financial health still suffers.
Apart from good and bad debt, the two main types of debt are secured and unsecured. The easiest way to know whether your debt is secured or unsecured is to ask yourself the question: “Can my creditor take away the object or the property if I am unable to make my monthly payments?” If the answer is yes, then it is considered a secured debt.
Secured debts normally include big budget items such as mortgages for homes and loans for cars. If you do not make your payments to these creditors on a timely basis, the bank or lender concerned is fully within its rights to take back your home or car as their payment. This ability to repossess is the underlying premise in the agreement between your lender and yourself. In such situations, even if you have a poor credit score, it may be possible for you to be approved for a loan more easily if you secure it with the asset involved. Also, since the asset stands as a guarantee, the subsequent rate of interest and monthly installments is often lower than those taken out for unsecured debt items. There might even be tax breaks associated such as tax deductions on mortgage loans. Of course, all these advantages come with the understanding that if you fail to pay as agreed, you may lose your asset.
If money is loaned to you without the backing of any asset as collateral, it is termed as unsecured debt. In these circumstances, even if you do not make your monthly payments, the creditor is not in the position to reclaim the asset or item in lieu of the amount owed. Unsecured debts include medical expenses, unpaid utility bills, credit cards and unsecured loans. The benefit of such loans is that they can provide immediate financial help in times of a cash crunch or in case of an emergency. But as they are not attached to any tangible asset, they garner higher rates of interest and subsequent penalty fees that may lead to more debt in the future.
How do you know when you have too much debt? What parameters should you consider where debt is concerned? When lenders are looking at your financial statements and studying your spending history, most are checking to ensure that your expenses fall within their own guidelines. If the lender feels that there are any excesses or imbalances, your loan application is in danger of attracting higher interest rates or even of not being approved at all. Therefore, as discussed in the previous chapter, a sound budget or spending plan is imperative.
One of the toughest things to do when you are creating a household budget is to actually figure out where your money is being spent. For this, you need to track your expenses over a period of time and then study them to see if you are spending too much in some areas and not enough in others. The table below gives you an approximation of your ideal budget composition.
Remember, these are only broad guidelines and different percentages may apply depending on the individual or circumstances. Once you have kept track of your spending over a few months, you need to study the averages and see if they fall within the parameters listed above. You may notice that in some categories you are spending too much, while in others (like savings) you need to put in more money. At the end of the day, you do not need to be a financial genius to manage your money wisely. All that you need is some basic knowledge of what works and what doesn’t and some cold hard calculations to reinforce your plan.
Are you thinking of finally buying that new car, expensive piece of furniture or even your dream house? You may think you are in a good position to do so. You have paid all your bills on time and you have calculated that you can manage your monthly payments in the future.
But before you sign on the dotted line, there is one more thing you need to check. When it comes to lenders determining your interest rate and loan eligibility, the big factor at stake is something called Debt-to-Income Ratio.
The percentage of your income that goes towards paying off your debt is what is termed as a Debt-to-Income (DTI) Ratio. A number of lenders use this ratio to figure out how much of a loan you are eligible for and what interest rates are applicable. It is recommended that you assess your current financial situation and calculate your Debt-To-Income Ratio regularly.
Some DTI calculators include mortgage or rent payments while others don’t. Generally, it is better to follow the method used by mortgage lenders where your mortgage payments are also included, thus offering a more comprehensive picture.
1. Add up your total net monthly income (the amount you keep after taxes). This is comprised of monthly wages and overtime, any commissions or bonuses that are specified, rent from income property as well as alimony or child support, if applicable. If your income varies from month to month you will need to work out a monthly average over the past two years.
2. Add all your monthly debt payments. This would include all credit card bills, loans and mortgages or rent payments, if applicable.
3. Divide your total monthly debts by your total monthly income. The result is your Debt-to-Income Ratio.
If this Debt-to-Income Ratio is too high, you could be charged higher interest rates or even denied a loan. With a lower Debt-To-Income Ratio, you will have a much higher chance of qualifying for a loan and receiving favorable rates. Is your debt load healthy? Well, it ultimately depends on your lender, but in general the following guidelines are followed:
While most guidelines inform you that a 36% or lower DTI is recommended, it is actually difficult to apply a universal average for everyone. Your ideal ratio would depend upon personal circumstances, number of dependents in your family, any unusual expenses such as medical requirements, etc., and individual spending habits. But as a rule, anything over 36% would get tougher and tougher to manage so it pays to err on the side of caution.
The average American household carries a number of debt obligations. These could include home mortgages, a second mortgage or home equity loan, car loan(s), student loans(s), multiple credit cards, and others. Trying to juggle all of them and meet your monthly payments is never an easy task. There are, however, some guidelines you can follow to streamline the process and help you avoid falling into a trap of debt generating more debt.
There are a number of ways you can repay your debt such as:
Consumer protection law is the area of public law that governs the relationship between consumers and the businesses that sell goods and services. Consumer protection can cover a large scale of applications such as product liability, unfair business practices, misrepresentation, privacy rights and other consumer and business relations. These laws can deal with issues like credit and debt repair, product safety, contracts, pricing, personal loans and collection agency regulations.
It is every consumer’s right to know more about the product or service that is being purchased. These rights protect not only the consumer but also aim to guarantee fair trade practices.
To ensure that consumers are protected from deception or fraudulent trade practices, the Federal Trade Commission (FTC) was set up. The directives of the FTC are executed by the Bureau of Consumer Protection, assisted by the General Counsel. The Bureau of Consumer Protection (the Bureau) enforces FTC laws that make it compulsory for sellers of goods and services to inform consumers about key product or service attributes, and applicable risk factors. This ensures that consumers can make free and well informed choices about what they buy. Apart from advertising and alerting consumers about their rights, the Bureau initiates action against those who defraud customers, and allows consumers to file complaints regarding fraud or identity theft.
Since we live in times when the virtual world rules our daily life and, more importantly, our monetary transactions, FTC laws are especially vital as they encompass financial services such as loans, mortgages, investments, and other online financial transactions. Check out the agency’s web site (link to http://www.ftc.gov) for more comprehensive information on how to adopt safe business practices as well as how to reduce the occurrence of fraud for consumers. These guidelines include information on:
If collectors have started calling you or knocking at your door, it is important to understand the limits of what can and cannot be done by third-party collection agencies. The Fair Debt Collection Practices Act (FDCPA) provides protection for consumers and informs you about the rules that a debt collector must abide by. In cases of personal debt (car loans, credit cards), family debt (medical loans), and household debt (mortgages), the FDCPA prohibits harassment in cases of collections. If a collector indulges in any type of unscrupulous behavior, the FDCPA clearly delineates what is and is not acceptable under law.
However, the Federal Trade Commission’s FDCPA rules do not apply to in-house collection agents or original creditors. If you owe money to a retail store for example, the owner is not bound by the rules. But, as soon as the debt is handed over to third-party bill collection agency, these rules are applicable:
There are, however, a few things you should do if contacted by a collection agency:
Each state has different rules that govern the relationship between debtors and creditors. It would pay to go online and research the relevant laws that apply in your state or even hire an attorney to protect your rights. For more information, or to file a complaint, call the Federal Trade Commission at 877-382-4357 or visit the agency’s Web site: http://www.ftc.gov.
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Consumer Education Services, Inc. empowers people to overcome their financial challenges and lead financially-healthy lives.
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