Credit And Debt Management


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Credit And Debt Management

  1. 1. – the resource for investing and personal finance education. Credit And Debt Management by Cathy Pareto Thank you very much for downloading the printable version of this tutorial. As always, we welcome any feedback or suggestions. Table of Contents 1) Credit And Debt Management: Introduction 2) Credit And Debt Management: Credit Reports And Scores 3) Credit And Debt Management: Building Credit From Scratch 4) Credit And Debt Management: Repairing Credit 5) Credit And Debt Management: Credit Cards 6) Credit And Debt Management: Reducing Debt 7) Credit And Debt Management: Debt Collection And Bankruptcy 8) Credit And Debt Management: Credit Counseling 9) Credit And Debt Management: Credit And Relationships 10) Credit And Debt Management: Conclusion 1) Credit And Debt Management: Introduction America is addicted to debt. Just call us the credit nation, from the highest levels of government all the way down to Main Street USA. America and Americans are obsessed with credit and rely on debt every day. Even as the nation and its consumers struggle under record debt levels, we continue to rack up more. Like it or not, we need credit. As we have established during and since the global financial meltdown of 2008, credit keeps the wheels of the global money machine well greased. Concepts, such as buying a home, starting a business, or buying an investment property often could not become realities without some form of credit. In fact, utility companies, banks, landlords and even employers often require credit checks before extending services or employment. Consider the following statistics: As reported by the Federal Reserve Board (FRB), the size of total U.S. consumer debt grew nearly five times in size from $824 billion in 1990 to nearly $2.2 trillion in 2005. This tutorial can be found at: (Page 1 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  2. 2. – the resource for investing and personal finance education. According to Experian, without factoring in mortgages, in 2008 the average American held over $16,635 in debt. According to ComScore, in 2008 55% of Americans maintained a running balance on their credit card accounts. According to Visa and MasterCard, in 2006 alone there were 984 million bank- issued Visa and MasterCard credit and debit card accounts in the United States. Mail Monitor, a credit card direct mail tracking service, reports that roughly 4.2 billion credit card offers were made to U.S. households in 2008. An online poll conducted by reports that the average rate for bank credit cards reached a whopping 19% in March 2007, whereas the average rate in 2003 was 16.5%. Credit and its associated debts are a part of our reality, and will continue to be for the foreseeable future, and it is up to each individual consumer to not let credit ruin them. Unfortunately for many, it already has. The level of consumer debt has grown exponentially in the U.S., where tens of millions of credit consumers find themselves overwhelmed by their personal debts. If you find yourself in a credit or debt bind, keep reading. This tutorial will provide an overview of credit and debt management concepts that every consumer should know about so they know how to live with credit. Learn how avoiding loans can be possible and enjoyable in Can You Live A Debt-Free Life? 2) Credit And Debt Management: Credit Reports And Scores It's funny how things come to define us as people. Sadly, our credit score is one of those things. A credit score can either be a scarlet letter or one-way pass to easy money; it's probably wise for us to begin our discussion with how the credit-reporting process works. A good credit score can translate to much lower interest rates for mortgages, credit cards and auto loans, resulting in significant savings for you. Credit Bureaus The term "credit bureau" can be used interchangeably with the term "credit reporting agency". These organizations collect credit information about credit consumers by using public records, creditor data, employers and more to compile each person's credit history. The organizations make this information available to current and prospective creditors, employers, landlords and others who are legally allowed to request it. The three credit reporting agencies are: Equifax, Experian and TransUnion. Credit Scoring These agencies use the data they've collected about you to formulate a credit score, a value that will later be used to determine your creditworthiness, or perceived risk, to This tutorial can be found at: (Page 2 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  3. 3. – the resource for investing and personal finance education. creditors. Some of the factors considered in calculating the score include the amount you owe on non-mortgage accounts, such as credit cards, your payment history, number of credit lines open, age of credit file, number of recent credit report inquiries and credit history. (Get a look at the various components of the personal and financial data that go into this dossier in Consumer Credit Report: What's On It.) The FICO® score is the one most widely used by lenders. All three credit reporting agencies have their own names for the FICO® score: Equifax calls it BEACON®, Experian calls it the Experian/Fair Isaac Risk Model, and TransUnion calls it the FICO® Risk Score. Despite the different names, however, the scoring method is consistent across all three. Most people's FICO scores vary slightly by agency because some lenders only report credit data to one or two credit bureaus and not to all three. The FICO score has a scale ranging from 300 to 850 (the higher the score, the better), but most people's scores tend to range between 600 and 850. However, other factors, including income and employment history, are also considered when consumers are evaluated for creditworthiness. Credit Score Components So, what are the main factors of your credit score? The most important determinant is your payment history, which counts for up to 35% of your score. Next is the amounts owed, for 30% of your score, followed by length of credit history, which makes up 15%. Many different things can negatively affect your credit score, so be sure that you know what they are so you can avoid them: Late payments Foreclosure Bankruptcy Judgments Repossessions (the act of a lender taking back a valuable asset, such as a car, if you are unable to repay debt) Too many inquiries (a credit inquiry occurs any time you apply for a new loan or line of credit (LOC)) Charge-offs One of the best methods to avoid any of the aforementioned credit challenges begins with a budget. A budget is merely a guideline of how you spend and how you should allocate your resources. It is intended to track your fixed and variable expenses as well as your savings allocations. A budget is an essential tool for any debt-management plan in that it gives you a better understanding of your financial situation. Knowing how and where you spend your money is an essential building block to fiscal responsibility and offers the best defense against unforeseen or unwanted credit disasters, such as This tutorial can be found at: (Page 3 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  4. 4. – the resource for investing and personal finance education. foreclosure or bankruptcy. 3) Credit And Debt Management: Building Credit From Scratch Now that we have a fair understanding of how your credit score is determined, let's introduce how credit is established from scratch. You must be of legal age (18) before you can enter into a contract, including a credit card agreement. It is also advisable that any first-time credit consumers request copies of their credit reports from each of the three bureaus even though there may be little information available. Reviewing this information will help you ensure that you have not been a victim of credit bureau reporting errors or identify theft. (To learn more about fixing any errors, see How To Dispute Errors On Your Credit Report.) Next, if you do not already have one, it is highly recommended that you open a checking or savings account (or both) and use it responsibly. Lenders see individuals that have bank accounts as stable and likely more creditworthy, than individuals that do not. Consider Getting a Cosigner If you are young and your parents are willing to consider this, have one of your parents cosign for you when applying for your first credit card. But be aware that adding a joint account holder has its risks because either account holder can be held responsible for repaying the entire account balance if the other applicant is unable to pay. (Parents can read more a in Is Your Teen Ready For A Credit Card? and young adults can learn more in Getting A Loan Without Your Parents.) Cosigning on other types of credit applications creates full liability as well, even though the primary applicant usually intends to fully repay the debt himself. Some examples of this are a parent cosigning a lease for a child's first apartment or a girlfriend cosigning a loan for a boyfriend's car. If the primary borrower stops paying the debt, the bill collectors will track down the cosigner and require her to satisfy the debt. If she doesn't pay, her credit history will deteriorate along with the primary borrower's and legal action may follow against both parties. Start With a Store Credit Card If getting a cosigner is not an option, consider starting your credit history with a department store or retail chain credit card, which is typically issued by a finance company, not a major lender. These creditors tend to offer easier credit to people, but credit limits for new credit consumers are usually set quite low ($1,000 or less) and the cards have much higher interest rates. If approved for a store card, be sure to limit your cards to just one or two. Don't overdo it, because too many inquiries or open lines of credit (LOC) can have a detrimental effect on your score. (Can't get a credit card without a credit history, and can't get a history without a card? Break the catch-22 in How To Establish A Credit History.) This tutorial can be found at: (Page 4 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  5. 5. – the resource for investing and personal finance education. Your Last Resort: A Secured Card If all else fails, you can apply for a secured card, which requires you to deposit and hold money in an account backing the card before you make credit card purchases. While this may sound like a redundant process, it actually helps you establish a payment history, which is critical to lenders. Check out or for a list of secured credit providers. If you opt for this method, screen the card issuer carefully, as the annual or application fees among different providers may vary (this is also true of unsecured credit card providers). Try to find a credit issuer that does not charge an application fee, has a low or no annual fee, allows you to convert your unsecured card to a regular credit card after 12 to 18 months of established payment history, and reports your history to all three credit bureaus. After all, if the issuer doesn't report to the credit bureaus, the card won't help build your credit history. If you've been denied credit because of your credit report, you are entitled to a free copy of your report from the reporting agency the lender used. The lender must supply the credit bureau's name, address and telephone number, usually by a "denial of credit" letter. You then have 60 days after receiving the denial notice to request your free report. 4) Credit And Debt Management: Repairing Credit Repairing your credit when mistakes or unfortunate events in your past have negatively impacted your credit score can be a slow and tedious process. Don't believe the hype of fast-credit-repair companies who claim to make your bad credit disappear - they won't. Accurate negative information on your credit report is there for a reason, and stays on your report for seven years, with the exception of chapter 7 bankruptcy, which lasts on your record for 10. Getting rid of the bad credit in order to improve your credit score requires adding positive information to your credit history. Getting started might seem difficult, but you'll build momentum once you prove that you can handle credit responsibly. Rebuilding your credit means going through the same cycle as a new credit user. But take heed: to build new credit and improve your score, you must retrain yourself and modify your detrimental spending habits. Some examples of poor spending habits include making purchases based on emotion or compulsion. Spending for the sake of spending, or "retail therapy", can be detrimental to your wealth. Before you spend your money, ask yourself if what you are buying is really necessary, or if it will just end up collecting dust in your closet. If you find that the item is more likely to be wasted than used, think twice about buying it. Learning to live more frugally will go a long way toward establishing a fiscally sound life. (Learn how to This tutorial can be found at: (Page 5 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  6. 6. – the resource for investing and personal finance education. talk yourself out of buying things you can't afford in Nine Reasons To Say "No" To Credit.) Repairing Credit After Identity Theft Sometimes your credit report needs fixing when it's not even your fault. The internet has revolutionized how we live, many American consumers conduct business and manage personal financial affairs online. Consequently, identify theft has risen. It is highly recommended that consumers conduct their online transactions on encrypted internet connections and secure networks. But sometimes, even the most guarded of credit consumers can fall victim to identify theft. Identity theft (also known as identity fraud) occurs when someone's personal information such as, Social Security number (SSN), driver's license number, name, address, employer info, account information, etc. is used without the authorization of that individual. Approximately 8.9 million victims a year are claimed by identity theft, according to personal finance guru Suze Orman. Identify theft can be quite destructive, and you'll have to clean up the mess if you want to qualify for new credit. According to the Federal Trade Commission (FTC), some ways to prevent and overcome identity theft include the following: Review your credit on a regular basis, either by ordering reports periodically or by signing up for a credit reporting service. Place fraud alerts on your credit reports. Consider closing any accounts that you think may have been subject to fraud. File a complaint with the FTC. File a report with your local police department. If you do not have the time or discipline to do this yourself, consider hiring a credit repair company to do it for you. These companies typically review your credit report and find errors, discrepancies and any other inconsistencies, then begin the process of trying to remove bad credit from your report. Negative information can stay on your report for up to seven years, but creditors have the option to delete any of it immediately should it be proven inaccurate or incorrect. But frankly, credit repair companies are unable to do anything that you could not do yourself. (Learn more tips and techniques to rebuild a ruined credit rating in Five Keys To Unlocking A Better Credit Score.) Review Your Reports Regularly It is highly recommended that you review your credit report at least twice a year for accuracy, whether you're monitoring for identify theft or simply want to keep an eye out for reporting errors. Consumers are entitled to a free copy of their credit reports from each credit reporting agency at least once a year. Although the free reports do not include your credit score, which may be separately purchased, this is a cost-effective way to track your credit history. But take note that the only official site in which you can take advantage of this benefit is There are many other sites This tutorial can be found at: (Page 6 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  7. 7. – the resource for investing and personal finance education. that lead you to believe you are getting a free report, but then automatically subscribe you to a paid credit reporting service. Furthermore, everyone should get in the habit of shredding their account statements and any other documents containing personal information before throwing them in the trash. You'd be surprised by how easy it can be to steal an identity, and a small investment in a decent shredder can save you considerable grief. Remember, it's much easier to take preventive action than reactive action. You don't want to be faced with unpleasant surprises when applying for credit. Learn how to make sure there are no errors holding you back from obtaining a loan in Check Your Credit Report. 5) Credit And Debt Management: Credit Cards Credit cards offer a convenient way to purchase things without the hassle of carrying cash. Used wisely, they're a great way to defer payment on purchases for roughly a month. Additionally, many lenders offer incentive or rewards programs for every dollar you spend on your card, which many credit consumers find convenient. One could argue that credit cards, provided that the consumer exerts discipline in the way the cards are used, are an excellent tool and provide an effective way to manage cash flows. But credit card usage should encourage healthy spending habits, not irresponsible ones. It's easy to fall into the trap of buying things you cannot afford and allowing your wants to trump your needs. Remember that high outstanding debt on credit cards or other revolving debts can adversely affect your score. (Find out how to make your credit cards work for you - not against you - in Get A Free Ride From Credit Companies and Credit Card Perks You Never Knew You Had.) How to Get Into Trouble With Credit The following is a list of surefire ways to get into credit card trouble: Relying on your credit card to afford necessities (ex. gas, groceries). Playing financial gymnastics (using debt to pay other debt). Spending money you do not have or living a lifestyle you cannot afford. Further, behavioral finance studies have demonstrated that people are willing to spend more for the same good or service bought on credit than with cash. (To learn more about how to manage your plastic responsibly, read Six Major Credit Card Mistakes and Take Control Of Your Credit Cards.) Making Money on Your Bad Decisions and Misfortunes This tutorial can be found at: (Page 7 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  8. 8. – the resource for investing and personal finance education. Credit card companies hate it when their customers pay their bills in full every month because it gives them little opportunity to make money. This type of customer is known (ironically) as a "deadbeat", because creditors make the least amount of money from them. Meanwhile, creditors use the term "revolvers" for the more than 50 million Americans that carry balances from month to month, racking up handsome fees for the credit card companies. Credit card companies bank on consumers' inability or unwillingness to pay off their purchases every month. There are two ways credit card companies compute the interest they charge you. One is more costly to you than the other, so it's worth being informed. The first method used is the average daily balance method. This is the best method for many consumers because payments on the card lower the interest payable immediately. With this calculation method, if you had a balance of $1,300 for the first 16 days of the cycle, then a balance of $1,000 for the next 15 days of the cycle, your average daily balance would be calculated like this: ($1300 x 16) + ($1000 x 15) / 31 days = $1,154.84 average daily balance The second method is called the two-cycle average daily balance method. This method takes into account the average daily balance from both your previous statement and your current billing cycle, which may potentially lead to higher finance charges. Using the previous example, if your average daily balance was $1,154 in the previous cycle and $600 in the current cycle, even though you have paid down a good chunk of your balance, you would pay interest on $877, not $600. Here's how your credit card company would calculate it: ($1,154 + $600) / 2 months = $877 Other Credit Traps to Avoid While a good portion of creditors' revenue comes from the interest they charge consumers on outstanding balances, they also make money from annual fees, late charges, over-the-limit charges and merchant fees. Consumers nationwide have been burned by excessive fees, grossly high interest rates and credit terms that seem to be charged at the whim of the credit card companies. Consumers should also beware of convenience checks and cash advances from credit card companies. There can be huge differences in the interest rates and transaction fees associated with these types of credit events, and the card companies make a bundle on the use of these options. If you're being charged $5 to take out $20 on your credit card as a cash advance, plus paying interest on this $25, you can see where you are the big loser in the payment scenario. Another area where credit cards trap consumers is the shrinking grace period. It used to be that people had 30 days to pay their credit card bills, but the average grace period has shrunk to 23 days. This tutorial can be found at: (Page 8 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  9. 9. – the resource for investing and personal finance education. College Students and Credit Another way credit card companies make money is by luring young and financially unstable prospective customers with arguably deceptive and targeted offers like teaser rates or gift items. University students are particularly vulnerable to this trap, since credit card representatives often man tables in university student centers, offering giveaways for students who apply for cards on the spot. Teaser rates especially seem to shock these new consumers. Many card companies incentivize the consumer to open an account because of a low interest rate, and then later the consumer finds that the rate has skyrocketed. Before you open any card, be sure to read the fine print so you can avoid any unhappy surprises like this. (For more on reading the fine print, see Watch Out For Changes In Credit Card Agreements.) Credit cards offer obvious advantages to cash-strapped college students who may lack the money to pay for day-to-day expenses. After all, it's easier for them to spend on plastic if current cash flow is a challenge. If used responsibly, credit cards can allow students to build up positive credit histories that will increase their access to credit in the future. However, if college students have failed to learn sound financial management skills from their parents or from formal training in high school, the disadvantages of credit cards can outweigh the advantages. Here are some interesting facts about students and credit cards: Nearly 67% of students report owning at least one credit card. Of the students with cards, about 65% pay their bills in full every month, which is higher than the general adult population. The average undergrad has $2,200 in credit card debt. The average young adult who carries credit card debt spends nearly 24% of their income on debt payments. According to a U.S. Public Research Interest Group study, 76% of students in the study claim that they stopped at credit card marketing tables on campus to apply for their cards, and nearly one-third were offered gifts as an incentive to sign up. If you're one of the many who carry a balance from month to month, the next section, will discuss strategies for reducing your debt. 6) Credit And Debt Management: Reducing Debt The portion of disposable income that American families devote to debt is higher than ever, according to the Federal Reserve. Unfortunately, the pace at which Americans borrow their way through life is simply unsustainable, and a good testament to this fact is the global credit crisis of 2008. Of course, there is not much that we can do as individuals to bail a country out of debt, but there is much that we can do to bail ourselves out of it. This tutorial can be found at: (Page 9 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  10. 10. – the resource for investing and personal finance education. Debt Reduction The first step in your debt-liberation plan begins with banning any further charging on your cards. While we do not suggest that you close your accounts (as this may impact your credit score negatively, we do recommend that you either cut up your cards or lock them away in a safe place so you are not tempted to use them. (Find out the consequences before deciding to end your credit agreements in Should You Close Your Credit Card?) Conquering the debt beast requires organization and discipline. Therefore, the next step in your debt-liberation strategy should be a budget. A budget is not intended to deprive you; it's intended to guide you and help you monitor your spending. People from all walks of life and of all socioeconomic levels need and use budgets. Keeping a budget is one of the most effective methods to build wealth and control debt. (For more on creating your budget, see our Budgeting Basics tutorial.) In preparation for creating this budget, make a list of all the credit card amounts you owe, the annual fees you pay, your current minimum monthly payments, and the interest rate and credit limit associated with each card. List your highest-interest card at the top, as this will be a priority in your debt-payoff strategy. Your list should look like the following: Annual Interest Monthly Total Card Fee Rate Minimum Balance HFC Visa $35 21.90% $300 $3000 Home $0 16.80% $150 $3000 Depot Discover $0 9.90% $150 $3000 Total $35 -- $600 $9000 Then, determine an amount that you can commit toward paying off your credit cards each month. This number obviously should be higher than your total monthly minimum required payments. You can most effectively determine this amount once you have created a list of all your other monthly expenses. The Waterfall Method Once you've determined how much you will allocate to consumer debt payments, use the waterfall payment method to pay off your debt. Attack the highest-rate cards first (making the required minimum payments on the rest of the debts). Some consumers may be tempted to pay off the cards having the smaller balances first because it seems easier, but attacking the highest-rate card first makes the most financial sense since that card is costing you the most in interest payments. Once the first card is paid in full, then use what you were paying toward that card and "roll it down" to the next-highest- This tutorial can be found at: (Page 10 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  11. 11. – the resource for investing and personal finance education. rate card. For example, if you have three credit cards each with a $3,000 balance but with rates of 21.9%, 16.8% and 9.9% and payments of $300, $150 and $150 respectively, once the 21.9% card is paid off, you would reallocate those $300 payments to the card with 16.8% interest for a new total of $450 to that card and the same $150 to the card with 9.9%. This is also called the "roll-down method". This process may take months or years to complete, depending on the amounts owed. But with sufficient patience and discipline, it is an effective method to free you from the shackles of debt. (Learn how managing your debt could mean the difference between spending $45,000 or saving $184,000 in Expert Tips For Cutting Credit Card Debt and The Indiana Jones Guide To Getting Ahead.) Finally, it is worth considering any annual fees you are paying for your credit cards. You may find that some of the cards that charge an annual membership fee offer you the best rates and/or perks. For those who are attracted to certain credit card perks, such as premium travel benefits or advance concert ticket sales, the annual fee might be worthwhile. Some cards, however, charge an annual fee with no corresponding benefits, and it's up to you to decide if you're willing to pay that much for access to credit. 7) Credit And Debt Management: Debt Collection And Bankruptcy It's never a good day when a debt collector is knocking on your door. Not only is being on the receiving end of debt collection costly, it can be downright stressful and humiliating. Unfortunately for the debtor, creditors can be quite relentless in their pursuit, often peppering debtors with phone calls to their homes and jobs in an attempt to motivate the debtor to pay up in a timely fashion. Debt collectors even have the legal authority to contact a debtor on his cell phone if the debtor included the cell phone number on his application. Negotiating With Debt Collectors In cases where the original credit issuer is unable to collect payment on outstanding debts, the process is often outsourced to a professional debt collector or collection agency that operates as an agent of the creditor in exchange for a fee or percentage of debts owed). These collectors are often given some flexibility in offering payment arrangements to debtors. For example, to satisfy debts quickly (and therefore get them written off the books of the credit issuer), debt settlement options like term settlements or final cash settlements are often considered. When a debtor has reached a point of considerable payment delinquency, the debt collectors may deem the account to be uncollectable and be willing to negotiate a settlement with the consumer. In negotiation with debt collectors, arranging for a full and This tutorial can be found at: (Page 11 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  12. 12. – the resource for investing and personal finance education. final settlement of one's debt is often an ideal way to proceed. With this type of arrangement, your debts are fully satisfied without further deterioration of your credit. In a final settlement, you make one lump-sum payment of much less than you actually owe to your creditors in return for the remainder of your debt being written off. A term settlement is similar to a final settlement, but is often staggered over a specific time frame (e.g., six months) and does not provide as much of a reduced debt repayment. (Find out how you can take charge if you're being harassed by a debt-collection agency in Negotiating A Debt Settlement.) It's worth noting that consumers do have a moral and ethical obligation to repay their debts. The ability to possibly negotiate settlements with your creditors should not be deemed an invitation to irresponsibly run up your debt and then negotiate it away. Every financial decision you make has a consequence, and credit management is no exception. The Fair Debt Collection Practices Act Not all debt collection processes are quite so friendly. Despite federal and state legislation prohibiting abusive collection practices, debt collectors continue to abuse consumers in order to unfairly pressure them into paying debts. Abusive or intimidating debt collection tactics are not acceptable and do not have to be tolerated. Consumers do have rights in this matter. The Fair Debt Collection Practices Act (FDCPA)protects consumers from professional debt collectors who collect on loans they did not originate by using unfair, deceptive or abusive practices. The act technically does not apply to banks, department stores and other lenders who collect their own debts, but no lender is allowed to use such practices. The following are some highlights of the rules: Debt collectors can contact people other than the debtor only to locate the debtor. Within five days after making contact, debt collectors are required to send written notice informing the debtor of the amount of the debt, the name of the creditor and the fact that the debt will be considered valid unless disputed within 30 days (but only if the debt collector did not provide this information in the initial contact). Debt collectors may not harass, oppress or abuse debtors with threats or obscene language or annoying or anonymous telephone calls, and they may not publicize the debt. Debt collectors cannot make false, deceptive, or misleading claims for the purpose of collecting a debt. This includes the debt collector misrepresenting his identity or lying about the status of the debt or the consequences of not paying the debt. This tutorial can be found at: (Page 12 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  13. 13. – the resource for investing and personal finance education. Violations of the FDCPA can lead to lawsuits and punitive damages on the consumer's behalf. (Learn more about your rights when dealing with debt collectors in Outfox The Debt Collector's Hounds.) The Bankruptcy Option Despite the efforts of debt collectors, debtors sometimes cannot or will not satisfy their debt obligations. To get a fresh start, individuals are able to declare one of two forms of bankruptcy: chapter 7 or chapter 13. According to U.S. Courts bankruptcy statistics, 822,590 U.S. families filed for bankruptcy in 2007. Under chapter 7, the debtor is obligated to surrender certain assets in order to satisfy the claims of creditors as well as costs associated with the bankruptcy. However, specific assets are exempt from the reach of creditors. In some states, your home is protected from creditors under homestead exemption rules. Other major exempted assets include qualified retirement accounts, such as pensions, 401(k) plans, 403(b) plans, individual retirement accounts (IRAs), profit-sharing plans, stock bonus plans, employee annuities and 457 plans. Under chapter 7 rules, most debts are completely discharged in bankruptcy, and the debtor is no longer responsible for repayment. Child support, alimony, education loans and most unpaid taxes cannot be discharged, and the debtor cannot file again for eight years. Conversely, under chapter 13 bankruptcy, while the debtor is typically not forced to relinquish any assets, the courts will structure a repayment plan to be satisfied within a specified time frame. During chapter 13 proceedings, the bankruptcy judge often will reduce payments and/or debt values in order to make repayment more manageable for the debtor. While both types of bankruptcy have a negative impact on one's credit report, each has different connotations. Chapter 7 stays on your credit report for 10 years because you are discharging all debts. Chapter 13 involves a repayment plan, so it stays on your credit for seven years. That said, bankruptcy is really a forever decision because as a consumer (or even as an employee applying for a new job) you are often asked if you have ever filed for bankruptcy, and of course you must disclose that you have because otherwise you are committing fraud. However, it's worth noting that it is illegal for an employer to discriminate against you just because you filed for bankruptcy. (Find out how to determine whether this option will help or hurt your financial situation in Should You File For Bankruptcy?, What You Need To Know About Bankruptcy and Life After Bankruptcy.) Bankruptcy Testing The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 changed the way consumers can qualify for bankruptcy protection. It used to be that you filed for either chapter 7 or 13 and that was it. This is no longer the case. The credit industry This tutorial can be found at: (Page 13 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  14. 14. – the resource for investing and personal finance education. lobbied hard and successfully to have Congress tighten the bankruptcy laws so it would be more difficult for individuals to discharge their debts under court protection. The 2005 act introduced the concept of "means testing," which directly influences whether bankruptcy filers qualify for chapter 7 or chapter 13. The following are two phases of the test: median income test means test The median income test used in bankruptcy evaluations is based on the median state incomes published by the U.S. Census Bureau. As long as your aggregate household income is below or equal to the state's median income threshold, then chapter 7 is an option for the debtor. However, if your household income is greater, then you have to apply the means test to determine your eligibility to file chapter 7. For example, a Florida man supporting his family of four faces a state median income of only $68,494 (in 2008). If the man's income exceeds this amount, he would not automatically qualify for chapter 7 and would have to apply the means test. The means test checks to see if the debtor's current monthly income (reduced by allowed expenses) exceeds an amount allowed under the act for a family of the same size. The means test is basically an "excess income" test used to determine what money is left over each month, to repay unsecured creditors. Included within the calculation of a debtor's allowed monthly expenses are the following: Standard living expenses. Housing expenses. Transportation expenses. Other necessary expenses, such as child care, taxes, alimony, insurance payments, food and more. Not sure of what types of living expenses might be considered under the means test? Additional information is available online at the U.S. Department of Justice website, where they publish charts for the National Standards for Allowable Living Expenses. So, after reviewing the standards for living expenses during the means test process, if the debtor determines that his income either meets or exceeds the threshold income levels, then a chapter 7 bankruptcy will not be possible. Instead, a chapter 13 bankruptcy will be the only available option. It should be noted that any chapter 13 plan must have a minimum duration of at least five years unless the plan provides that all allowed, unsecured claims are to be paid within a shorter time frame. The Bankruptcy Act's Effectiveness This tutorial can be found at: (Page 14 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  15. 15. – the resource for investing and personal finance education. One other component of the Bankruptcy Act is the mandatory requirement that debtors go through credit counseling and financial management courses in order to qualify for bankruptcy and debt discharge. Counseling must start at least 180 days before filing for federal bankruptcy protection and must be completed with an agency approved by the United States Trustee's office, which can be found at the U.S. Trustee Program website. This particular portion of the act is quite controversial, given that the credit counseling industry is not only unregulated, but is beset with unimaginable fraud and abuse. We'll discuss this further in our next chapter. (Learn more about the 2005 law in Changing The Face Of Bankruptcy.) While the intention of a stricter bankruptcy code was to dissuade consumers from seeking bankruptcy protection so easily, thus forcing them to be more accountable for their credit decisions, the average amount discharged under chapter 7 bankruptcies actually tripled to $61,000 between 2005 and 2008. The number of personal bankruptcies has also increased since the Bankruptcy Act took effect. According to the Administrative Office of the U.S. Courts, personal bankruptcies were up 25% in the period from June 2007 to June 2008 when compared to the previous year. These statistics offer a true testament to the dire financial position many Americans find themselves in. Find out how to avoid this financial move in Prevent Bankruptcy With These Tips. 8) Credit And Debt Management: Credit Counseling Credit counseling can be an appropriate solution for consumers who find themselves overwhelmed by their credit obligations and need help restructuring what they owe. While not all credit counseling agencies are created equal, the reputable agency's goal is to help consumers gain better control of their financial situations by providing education and debt-counseling services to consumers in need. Also, as mentioned in the previous section on debt collectors, credit counseling is required for debtors seeking chapter 13 bankruptcy protections. Finding a Reputable Credit Counseling Firm Unfortunately, the credit-counseling industry is unregulated. This lack of regulation has introduced the possibility that some so-called counseling or debt-settlement agencies are nothing more than profit-seekers preying on vulnerable, unsuspecting consumers. Many counseling agencies pose as nonprofits and get away with grossly overcharging clients for services, implementing monthly fees, conducting questionable or illegal business practices and doing little to negotiate with credit card companies to reduce their clients' rates and/or debt. In the last six years, the FTC has filed more than a dozen civil actions against such companies. Anyone seeking credit counseling should do so with a reputable nonprofit organization. An excellent consumer resource for finding such an organization is the National This tutorial can be found at: (Page 15 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  16. 16. – the resource for investing and personal finance education. Foundation for Credit Counseling (NFCC). NFCC is the national voice for its member agencies, which are nonprofit, mission-driven, community-based consumer counseling agencies that provide budget counseling and education, debt-management plans, counseling referral services, financial literacy courses and housing information. Once you have narrowed down your list of potential agencies to work with, conduct some due diligence on them by confirming their statuses with the Better Business Bureau (BBB), your state's attorney general or a local consumer protection agency. Additionally, the FTC's website offers some excellent tips for choosing the right credit counseling organization. Trustworthy agencies will typically send you free information, including details of the services they provide. They need not ask you for any details about your financial situation. If you are required to provide specific financial details about yourself, pay any upfront consulting fees or retainers, or sign any paperwork before acquiring information about the firm, consider this a red flag and run away. (Learn more about how to find the help you need in How To Find A Credit Counselor, or how to do it yourself in Seven Tips For The Do-It-Yourself Debt Manager.) What to Expect From Credit Counseling A credit counseling agency helps the client identify his or her creditors and assess the debts due and the monthly payments they are committed to. It structures a plan for the debtor and then negotiates with creditors on behalf of its clients to reduce the consumer's interest rates, payments, debt amounts or some combination thereof. The goal of the credit counseling agency is to help you find a payment plan that you can afford (assuming the creditor approves of the arrangements) and target a specific payoff date to make you debt-free. These programs primarily service consumer-related debts, such as personal loans or credit cards; however, mortgages are not typically included. The idea behind a debt-management plan is that while you can afford to make some type of monthly payment, you need help negotiating with your creditors on things like interest rates (they often reduce or eliminate interest altogether) or monthly payment amounts. This type of plan is voluntary. It is not a legal agreement between you and your creditors. It typically lasts for no more than five years, and it is expected that you will not apply for or use credit during the length of the program. With this plan, you typically deposit a fixed payment each month with the credit counseling agency, and they in turn use this money to pay the creditors outlined in your program. This helps the agency centralize your cash flows and ensures your timely deposits and payments to your creditors. They pay the debts each month on your behalf, subject to whatever arrangements (ex. rate reduction, payment reduction, revised billing cycle) they have negotiated for you. For this service and for the negotiations made on your behalf with your creditors, the agency collects a nominal fee. So, how will this affect your credit? If you are enrolled in a credit counseling program, it's likely that you already have a history of late payments and overutilization of credit that have already negatively impacted your credit score. While creditors will appreciate This tutorial can be found at: (Page 16 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  17. 17. – the resource for investing and personal finance education. your efforts to enter a debt-management plan that demonstrates your desire to repay your debts, your credit score may nevertheless be affected. In fact, your participation in a credit counseling program may show up on your credit history. Creditors will likely hesitate to extend further credit to you, even after your counseling is completed, until they can see a couple of years of solid repayment history on your credit report. 9) Credit And Debt Management: Credit And Relationships Credit obligations are a serious matter, and we have already established the important role your credit score plays in your life. As we've discussed, you may want to think twice before entering into any joint credit obligations with a friend or relative. And, combining marriage and credit can be equally challenging. Just because you get married does not mean that you suddenly share your spouse's credit history. You have to actually apply jointly for credit in order to be listed as joint debtors. With the exception of any joint debts, spouses will continue to have separate credit histories. So if your husband has poor credit but you have exemplary credit, his credit will not negatively impact your history. The two histories are completely independent despite the fact that you are married. Joint debts, however, are reported on both individuals' credit reports no matter who is actually making the payments or using the accounts. Some couples opt to keep their credit separate by maintaining individual credit accounts. That is a little harder to accomplish when buying a home together, however, because the asset is usually acquired using the income and credit history of both spouses. If one spouse has good credit and the other has lousy credit, it's worth considering how best to apply for a mortgage (or any other type of loan or credit), since the spouse with the poor history may drag down the applicant with good history. This can mean higher borrowing rates and therefore greater debt costs for the couple. While some couples choose to commingle their debts and assets, others find it more efficient and less adversarial to keep their finances separate. However, some states' laws can make it difficult for married couples to keep their finances separate. Community property states like Arizona, Texas and California (among others) dictate that any debts (or assets) acquired during the marriage are split between husband and wife. If both spouses own title to an asset, then each owns a half interest. None of this may matter if you stay married, but these issues can become critical in the event of a separation or divorce. (Learn more in State Laws Dictate Division Of Joint Property.) It is well understood how much stress money matters can place on a marriage and it is no secret that the number one issue that couples fight over is money. Couples would be well advised to consider having open and honest discussions about money throughout their relationship, especially before they get married. All of the financial cards, good and bad, should be laid on the table before tying the knot. The worst time to be surprised This tutorial can be found at: (Page 17 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  18. 18. – the resource for investing and personal finance education. about your partner's financial missteps is after the fact (for example, in the midst of buying a new home together). (Read more about managing the financial challenges faced by couples in Relationship Money Matters, Combining Credit For A Happy Financial-Ever-After and Say "I Do" To Financial Compatibility.) Credit and Divorce If you find yourself on the path to divorce, be aware of the credit issues prevalent in divorce situations. Sometimes one spouse decides to stop paying jointly owned debts during the separation or divorce process. This decision can considerably damage both spouses' credit and continue to haunt them for several years. Many legal or financial professionals specializing in divorce suggest that each spouse obtain a credit report before the divorce begins. Not only will this help the couple assess what debts the couple has jointly and separately, but it can also give the couple the ability to compare its scores and any erroneous reporting before and after the divorce. Because divorce can be a lengthy and often messy process, both spouses should consider closing any joint credit and bank accounts. While you will still be responsible for paying off the debt of any closed credit accounts, no further charges or withdrawals will be possible. For more, read Get Through Divorce With Your Finances Intact. 10) Credit And Debt Management: Conclusion Americans can no longer afford what has become a charge-it-all culture. Credit is an unavoidable part of our reality these days; nobody can deny that it is a critical component of our global financial markets. However, any extreme is usually bad, and that truth extends to credit and debt. People who over-consume, overspend and charge their way through life will inevitably pay the piper, and not just in terms of their financial stability. Americans' struggle to dig out of debt has also given rise to health problems. According to research psychologist Paul Lavrakas, as many as 10 to 16 million Americans suffer from anxiety, depression and cardiac problems directly resulting from money worries. A 2008 AP-AOL health poll reveals the following information about the health problems faced by debtors: Insomnia or sleeping problems are pervasive in 39% of people with high debt stress versus 17% for people with low levels of debt stress. Severe anxiety is pervasive in 29% of people with debt stress versus 4% for people with low levels of debt stress. Muscle tension and lower back pain is pervasive in 51% of people with debt stress versus 31% for people with low levels of debt stress. This tutorial can be found at: (Page 18 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.
  19. 19. – the resource for investing and personal finance education. If used sensibly, credit cards and other consumer debts can make our lives easier and more productive. Using the tips from this tutorial to become more disciplined, organized and financially responsible will help you pave your road to wealth. This tutorial can be found at: (Page 19 of 19) Copyright © 2009, Investopedia ULC - All rights reserved.