Managing Debts: From Credit Cards to Foreclosures

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Managing Debts From Credit Cards to
Foreclosures

• Debra Sawyer, CPA, CFP
• September 13, 2008

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Debra Sawyer, CPA, CFP

• Keir Educational Resources
• Lead editor and instructor for books and courses
  related to the CFP Certification Examination for
  over 9 years
• Financial planning background
• 10 years experience serving high net worth
  individual clients with a Big 4 public accounting
  firm
• Educational background
• CPA
• CFP certification
• Masters degree in taxation
• Emphasis in estate planning

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Overview

• Interesting statistics
• Debt
• Savings
• 8 steps to managing debt
• Step 1 Create a cash flow statement
• Step 2 Create a budget/spending plan
• Step 3 Manage debt ratios
• Step 4 Evaluate credit card debt
• Step 5 Evaluate mortgage options
• Step 6 Improve credit ratings
• Step 7 Establish emergency fund
• Step 8 Save for retirement
• Question and answer session

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Interesting Debt Statistics

• 16.7 of homes currently for sale are due to
  foreclosure
• NBC Nightly News, August 14, 2008
• 32 of individuals age 65 to 74 had a mortgage on
  their home in 2004 (up from 19 in 1992)
• Federal Reserve
• 40 increase in consumer bankruptcy filings in
  2007
• American Bankruptcy Institute
• 18 of workers borrowed from their 401(k) plan in
  2007 (up from 9 in 2005)
• Boston College Center for Retirement Research
• 90 of parents gave money to their adult children
  to help pay for credit card debts, school loans
  and other large expenses
• Ameriprise Financial

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Interesting Saving Statistics

• 28 of individuals age 55 or older have saved
  less than 10,000
• Employee Benefit Research Institute
• 2 per 1,000 of disposable income saved during
  first quarter of 2008 by American households
• Bureau of Economic Analysis
• 60 of Americans expect to live mainly on Social
  Security benefits in retirement (down from 65 in
  2007)
• Wall Street Journal Online/Harris Interactive
• 18 of American workers believe they will have
  enough to retire comfortably (down from 27 in
  2007)
• Retirement Confidence Survey

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8 Steps to Managing Debt

• Step 1 Create a cash flow statement
• Step 2 Create a budget/spending plan
• Step 3 Manage debt ratios
• Step 4 Evaluate credit card debt
• Step 5 Evaluate mortgage options
• Step 6 Improve credit ratings
• Step 7 Establish emergency fund
• Step 8 Save for retirement

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Step 1 Create a Cash Flow Statement

• Cash inflows
• Salary
• Interest
• Dividends
• Capital gains
• Alimony
• Child support

• Cash outflows
• Mortgage/rent
• Utilities
• Living expenses
• School or daycare
• Car
• Taxes
• Insurance
• Entertainment/vacation
• Savings/ debt service
• Alimony
• Child support

• Total Cash Inflow

• Total Cash Outflow

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Hypothetical Couple Dan and Sue Adams Cash Flow
Statement

• Dans salary - 50,000
• Sues salary - 50,000

• Mortgage - 22,000
• Credit cards - 12,000
• Utilities - 3,000
• Food - 7,000
• Clothing - 4,000
• Payroll taxes and withholding -18,000
• Real estate taxes - 3,000
• Insurance - 2,000
• Car loans - 13,000
• 401(k) plans - 5,000
• Entertainment -5,000
• Unknown - 6,000

• Total Cash Inflow 100,000

• Total Cash Outflow 100,000

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Step 2 Create a Budget/Spending Plan

• Budget/spending plan should accomplish or work
  towards your goals
• Spending only what you earn
• Paying down debt
• Saving regularly for
• Your childs education
• Retirement
• A large purchase or expense
• Look for opportunities to save money to
  accomplish your goals
• Cook your own meals more often
• Drink water with your meal at the restaurant

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Step 2 Create a Budget/Spending Plan

• Key factors to making a successful
  budget/spending plan
• Set realistic goals
• Keep it simple
• Be flexible, if needed
• Track actual results against the budget

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Dan and Sue Adams Spending Plan

• Their goal is to save 10,000 a year in order to
  be able to buy a bigger home in three years
• Approximately 800 per month
• Opportunities with their budget
• They currently pay 12,000 a year on credit card
  debt
• They spent 6,000 a year on unknown items
• Most likely they will need to decrease costs in
  multiple areas to achieve their goal

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Step 3 Manage Debt Ratios

• Some rules of thumb which can be used as
  guidelines
• Consumer debt payments should be no more than 20
  of take-home pay
• Monthly mortgage payments should be no more than
  28 of gross income
• Monthly payments on all debt should be no more
  than 36 of monthly gross income

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Step 3 Dan and Sue Adams Debt Ratios

• They spend 32 on consumer debt payments
• (12,000 credit card debt 13,000 car loans) /
  (100,000 salary - 18,000 taxes - 5,000 401(k)
  plan) 32
• Should be no more than 20 of take-home pay
• They spend 22 on mortgage payments
• 22,000 mortgage / 100,000 income 22
• Well within the target of no more than 28 of
  gross income
• They spend 47 on total debt payments
• (22,000 mortgage 12,000 credit card debt
  13,000 car loan ) / 100,000 income 47
• Should be no more than 36 of monthly gross
  income

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Step 4 Evaluate Credit Card Debt

• Review all credit cards to determine
• Outstanding balance
• Current interest rate
• When promotional rate period ends, if applicable
• Monthly payments
• Minimum monthly payments
• Amount you are actually paying each month
• Due dates

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Step 4 Evaluate Credit Card Debt

• Create a payment schedule
• Pay the minimum balance on credit cards with the
  lowest interest rates
• Pay the maximum about you can afford on the
  credit card with the highest interest rate
• Pay at least 20 more than the minimum amount
  each month
• Focus on paying off one credit card at a time
• Make all payments by the due dates
• Avoid late fees
• Minimize the risk of increased interest rates on
  that card and other credit cards

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Step 4 Evaluate Credit Card Debt

• Do not use credit cards with balances for
  purchases that you will pay off each month
• The monthly finance charges are calculated on the
  outstanding balance plus the current purchases
• Pay for these purchases with another credit card
  or by cash or check
• Make sure you pay the other credit card balance
  in full by the due date to avoid finance charges

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Step 4 Dan and Sue Adams Credit Card Debt

• They have the following credit card debts
• Dans Visa
• Outstanding balance 13,000
• Interest rate 12.99
• Minimum payment 450 per month
• Sues MasterCard
• Outstanding balance 17,000
• Interest rate 10.75
• Minimum payment 550 per month
• They should pay down Dans Visa card first due to
  the higher interest rate
• An extra 100 payment per month will pay off the
  credit card 7 months earlier (28 months vs. 35
  months)

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Step 4 Dan and Sue Adams Credit Card Debt

• Dan has a Discover card that he does not
  currently use with a zero balance
• He should use the Discover card to pay for any
  purchases he can pay for in full that month
• Sue has an American Express Card that she uses
  periodically but has a zero balance
• She should use the American Express card to pay
  for any purchases she can pay for in full that
  month
• Alternatively, they could both pay for these
  items in cash or with checks

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Step 5 Evaluate Mortgage Options

• Review mortgage
• Outstanding balance
• Current interest rate
• When promotional rate period ends, if applicable
• Monthly payments
• Minimum monthly payments
• Amount you are actually paying each month
• Due dates
• Type of mortgage
• Fixed
• Adjustable rate mortgage (ARM)
• Interest only
• Home equity lines of credit or home equity loan

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Step 5 Evaluate Mortgage Options

• Determine if refinancing makes sense
• Advantages
• Could decrease monthly payments by extending the
  term back out to 30 years
• Interest rates maybe lower
• Could go to a bimonthly payment plan to payoff
  loan earlier
• Pay 50 of normal monthly payment twice a month
• If currently have an adjustable rate mortgage
  (ARM), could lock in rate with a fixed rate
  mortgage
• If currently have an interest only mortgage,
  could start paying down principle if change to
  fixed rate or ARM mortgage

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Step 5 Evaluate Mortgage Options

• Determine if refinancing makes sense
• Disadvantages
• Points, fees and other closing costs could reduce
  the cost savings
• Typically need to stay in the home for a couple
  years to recoup the costs
• If changing to an ARM, typically want to have the
  term of the arm be equal to or slightly longer
  than how long you expect to live in the home
• Banks have tightened their loan processes given
  the current housing market

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Step 5 Evaluate Mortgage Options

• Determine if home equity loan or line of credit
  makes sense
• Advantages
• Interest on first 100,000 of debt is tax
  deductible
• Loan proceeds can be used to pay down other
  nondeductible debt like credit cards or car
  payments
• Disadvantages
• Must have equity in your home
• Typically lenders will loan up to 80 of FMV of
  home outstanding first mortgage
• For example, Sam could only get a 10,000 loan if
  his home is worth 200,000 and he already had a
  150,000 first mortgage (200,000 x 80 -
  150,000)

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Step 5 Evaluate Mortgage Options

• Determine if selling the home makes sense
• Advantages
• Downsize the home to a more manageable monthly
  payment
• Rent a home or apartment until you can payoff
  other debts
• Avoid foreclosure
• Disadvantages
• You have to move
• You might lose money on your home due to recent
  decline in housing prices
• Offer on home might be less than outstanding
  mortgage
• Use a short sale to reach a settlement with
  lender on difference

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Step 5 Evaluate Mortgage Options

• Determine if letting the bank foreclose on your
  home makes sense
• Advantages
• You are no longer responsible for the mortgage
• Possible option when you owe more than what your
  home is worth
• Disadvantages
• You have to move
• You lose any equity you have in your home
• Negatively impacts your credit ratings

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Step 5 Evaluate Mortgage Options

• Determine if a reverse mortgage makes sense
• Advantages
• An owner (age 62 or older) of a home that is
  fully paid for receives periodic income from a
  mortgage lender for a period of years or for life
• At the homeowners death, the lender can sell the
  home to generate the cash to repay the loan
• Any proceeds remaining after paying off the loan
  go to the homeowners estate
• Disadvantages
• The reverse mortgage has to be repaid if the
  owner sells the home before passing away

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Step 5 Dan and Sue Adams Mortgage

• They bought the home 10 years ago with a 300,000
  mortgage
• They currently owe 220,000
• The loan was a 3 year ARM at 5
• The annual payments were originally 19,000
• The current rate on the loan is 8
• The annual payments are now 22,000
• If they refinance today at 8 on a new 30 year
  loan, their payments will be 19,000
• The 3,000 savings can be used to pay down the
  credit cards
• They eliminate the risk of future interest rate
  increases
• Of course, they did incur some closing costs on
  the refinance

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Step 6 Improve Credit Ratings

• Pay your bills on time
• Cancel credit cards
• Cards that you do not use at all
• Cards that you would not need if you used another
  card
• Cards with the highest interest rate
• Keep the card you have had the longest
• Decrease your credit limits on existing cards if
  above amount needed
• Keep one card with a high credit limit
• Review credit report for any inaccurate
  information

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Dan and Sue Adams Improve Their Credit Ratings

• Dan should cancel his American Gas Company credit
  card that he does not use
• Sue should cancel her Large Department Store
  credit card that she does not use
• They should both review their credit reports and
  correct any inaccurate information

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Step 7 Establish Emergency Fund

• Individuals should have an adequate fund that can
  be drawn upon quickly if needed to cover major
  unexpected adverse events
• Major medical expenses
• Laid off from work
• Disability following a car accident
• Typically 3 to 6 months of expenses
• 3 months if stable income stream
• 6 months (or more) if self employed

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Dan and Sue AdamsEmergency Fund

• Their goal should be to have an emergency fund of
  25,000 to 50,000
• 3 months of expenses 25,000
• 6 months of expenses 50,000

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Step 8 Save for Retirement

• Saving for retirement should be planned as part
  of the budget
• Do not consider savings as whatever amount is
  left as you will never save a dime
• Establish a realistic goal
• For example, 5 to 10 of annual income

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Step 8 Save for Retirement

• Possible ways to save money
• Take advantage of employer matching contributions
  on retirement accounts
• Direct deposit money from each paycheck into a
  savings account
• Deposit bonuses into a savings account
• Utilize programs at your bank where they round up
  your debit purchases to the next dollar and
  deposit the difference in a savings account

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Dan and Sue AdamsRetirement Savings Plan

• Dans employer matches 100 of the first 4 of
  his salary contributed to a 401(k) plan
• He currently only contributes 2.5 of his salary
• If he increases his contribution to 4, his
  employer contribution will increase by 1.5 which
  is 750 more per year
• Sue will have 100 per paycheck directly
  deposited into a savings account at her bank

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What Other Questions Do You Have About Debt
Management?