Pay Back Time

Remedies for your holiday debt hangover
 

If you’re like many Americans, you turned your holiday spirit into credit card charges for the perfect gifts for friends and family. It probably felt good at the time. But now, as bills demanding payment arrive, you can feel your exuberance from a few months ago turning into buyer’s remorse. Welcome to a whole new kind of holiday hangover.

According to the Gallup Organization, American shoppers planned to spend an average of $730 on gifts this year. January is payback time, and unfortunately, most experts don’t classify those short-term holiday charges as “good debt”.

“Good debt?” you ask. Is there really such a thing? You bet. Here’s a guide for how you can convert bad debt into good or –even better- avoid bad debt altogether.

Defining debt

According to Dr. Robert Manning, author of Credit Card Nation and professor of business at the Rochester Institute of Technology, Americans have differentiated between good and bad debt for years. However, two factors have profoundly changed the way we think about debt and affordability: the deregulation of the financial services industry, which increased access to consumer credit beginning in the 1970s; and a billion dollar barrage of advertising.

“Consumer credit has been transformed from a privilege to an entitlement”, say Manning. “We’ve come to believe that if we can get a loan for something, we can afford it. And that’s simply not the case.”

So how can you tell if you debt’s good or bad? See the chart on page 4 for some general guidelines.

All generations: big spenders

Consumer debt (not including mortgages) hit a record high of $1.98 trillion in 2003, which translates to about $187,000 per U.S. household. The savings rate, however, is at an all-time low: An average household today saves less than 2 percent of disposable income, compared with about 11 percent in 1984.

One factor contributing to the growing debt problem, says Manning, is that young adults are getting credit before they’ve ever had an income. “People get credit cards before they even finish high school,” he says. “As a result, their financial decision-making is influenced more by lenders and retailers than by their parents and real-life experiences.”

However, no segment of the population is immune, according to Demos, a think tank and advocacy group. Take a look:

Among 18-24 year olds

• Credit card debt spiked 104 percent from 1992 to 2001
• The average household with credit card debt in this age group spends nearly 30 percent of its income on payments
• Nearly three out of four carry credit card balances. Nearly one out of five reported being late on a loan payment in the last year.

 
Among 25-34 year olds

• Average credit card debt for this age group rose by 55 percent from 1992 to 2001.
• This group has the second-highest rate of personal bankruptcy fillings.

Among 35-44 year olds

• From 1991-2001, bankruptcy for this age group jumped 51 percent.
• Today, 35-44 year olds lead all age segments for bankruptcy filings.

Among 45+:

• Average credit card debt for transitioners, that age 55-64, jumped 47 percent—to $4,088—during the past decade.
• Nearly one-third of U.S. retirees carry credit card balances, with an average debt of $4,041—an increase over the past decade.

Where do you stand?

Your financial picture depends on circumstances such as your life stage and family situation, and may be influenced by outside economic variables like the financial and real estate markets. While it may not be practical to be entirely debt-free or keep within the leanest debt guidelines, here are a few to strive for:

Housing Ratio: Total housing costs (mortgage, taxes and insurance)/ gross monthly income. It generally should not be above 28 percent.

Total Debt-to-Income Ratio: Total debt payments (including housing)/gross monthly income. It generally should not exceed 36 percent.

Grade your current debt-to-income ratio with this scale:

 Less than 20 percent—you’re in good shape. Look for opportunities to scale back, especially if you’re planning a big purchase.

21 percent- 35 percent—you could be spending too much on debt repayment and not saving enough.

36 percent- 50 percent—evaluate your financial situation, spending habits, and goals. Develop a plan to get out of debt and lower your payments.

51 percent or more—get help to get your debt in check.

Take-control tips

According to June Walbert, a USAA Certified Financial Planner practitioner, awareness is the first step to managing debt. “Individuals should know how much they’re spending and what they’re spending their money on,” advises Walbert. “Creating and sticking to a budget that includes a disciplined savings plan- saving a set amount every month and living on the remainder-is the best way to accomplish that.”

Beyond creating a budget, you should:

• Avoid charging more than you can pay off each month. You’ll spend less and save on interest payments.
• Cut up all credit cards except one low rate card, and notify the card companies to close those accounts.
• If you don’t pay off your balance each month, transfer your high-interest rate credit card debt to the low-rate card. Look for low balance transfer rates (and be sure to read the fine print for terms and conditions).
• Consider consolidating bad debt with a home equity loan or a home equity line of credit. However, make sue to change your spending habits so you’re simply not incurring more debt, and remember that your home secures the repayment of that debt.
• Shop for the lowest-interest rate products. Insure your home, car, and income so that unexpected events don’t add to your debt.
• Fund an emergency account with three to six months of living expenses, and stop using credit for emergencies.

And don’t forget that you can get help from a professional financial adviser when you’re in the middle of a tough financial situation. Walbert explains, “People wonder, “Should I stop contributing to my retirement plan to pay off my credit card debt? Or should I pay down my mortgage or car loan? I help members develop prioritized plan to pay off their debt.” Walbert also acts an accountability partner who expects progress repots. “That causes many of them to think twice about making purchase that will make their financial situation worse,” she says.

Whether you go it alone or enlist professional help, controlling your debt is essential to beating a financial hangover that could last for years to come.
 

Good Debt 

Characteristics
 

§         Tax deductible Low interest rate

• Fixed interest rate is preferable
• Set payoff date
• Shortest possible duration with

       manageable payments

Example

§         Home mortgage- A completive, fixed rate home mortgage loan for the shortest manageable term. Interest is tax deductible (up to certain limits), and you can leverage the equity you build up for future financial goals.

§         Student loan- Interest is tax deductible within certain income parameters, and you can consider it an investment in someone’s future.

§         Home equity loan- Interest is usually tax deductible. A good option to consolidate bad debt or cover a major one-time expense, assuming you can lock in a competitive fixed rate (and be disciplined about how you use your available credit).

§         Home equity line of credit—for ongoing expenses such as tuition, this is a flexible, tax advantaged solution (again, as long as you’re disciplined with the available credit). Interest is usually tax deductible.

§         Installment loan- Three variables determine if it’s beneficial or not: the annual percentage rate, the term of the loan, and any additional costs such as origination fees.

       Benefits

• Could offer a return on investment that exceeds the total cost of the debt.
• Frees up cash flow or allows you to save for other investments or education costs.
• Allows you to obtain future credit at a lower price. By obtaining only good debt, you increase your chances of paying your debt down faster and on time, which improves your credit rating.
• Lets you build equity in existing assets that you can leverage to meet future financial goals.

Bad Debt

 Characteristics

• No set payoff date (revolving credit)
• High interest rate
• Variable interest rate over the life of the debt
• Easy to accumulate and access

Example

• High-interest-rate or variable-rate credit card-

If you’re using one or more cards with high and /or variable interest rates and you don’t pay your balance, you’re spending too much on finance charges.

• Borrowing against a 401(k) plan- typically you can borrow up to 50 percent of your vested balance up to $50,000. If you don’t repay the loan, you’ll owe income tax plus a 10 percent early withdrawal penalty.
• Borrowing against a life insurance policy- if you borrow against the cash value of your life insurance policy and then die, the line is deducted from money your beneficiaries receive if you die before repaying the loan.

Pitfalls

§         Can stand in the way of long-term financial goals.

§         Can lead to poor credit history, which means you could pay more for future credit. People with bad credit pay up to 80 percent more in interest rates than those with good credit.

§         Could prevent you from getting preferred insurance rates or even a job.

According to a 2004 report by the Public Interest Research Group, as many as 79 percent of all credit reports contain errors—25 percent of which are serious enough to cause the denial of credit