Credit Card and Debt Management Notes

Credit Card Interest Calculation Methods

• Adjusted Balance Method: This method gives credit for payments made during the billing cycle before calculating interest. The payment is deducted from the previous balance, and interest is then calculated on the reduced amount.
  • Example: Previous balance of $400$. A payment of $300$ is made. The interest is calculated on $400 - 300 = 100$. If the monthly interest rate is $1.5\%$ (representing an $18\%$ annual rate divided by $12$ months), the interest would be $100 \times 0.015 = \$1.50$.
• Previous Balance Method: Interest is calculated on the entire previous balance, irrespective of any payments made during the current billing cycle. Payments are not deducted before interest calculation.
  • Example: Previous balance of $400$. A payment of $300$ is made. Interest is still calculated on the original $400$. With a $1.5\%$ monthly interest rate, the interest would be $400 \times 0.015 = \$6.00$.
• Comparison: The adjusted balance method is more favorable to the consumer as it results in lower interest charges ($\$1.50$ vs. $\$6.00$ in the examples). Companies that use the previous balance method often do so to maximize their interest earnings.
• Disclosure: Lenders are required to disclose the method they use for calculating interest. Consumers should inquire about this method when choosing a credit card.
• Average Daily Balance Method: This is probably the most commonly used method. It involves adding the daily balances for each day in the billing cycle and then dividing by the number of days in the cycle (e.g., $30$ days for September) to get the average daily balance. Interest is then calculated on this average.

Understanding Credit Card Payments and Debt

• Float and Grace Period: Already discussed in previous lectures, the grace period is the number of days you have to make a payment without being charged any interest.
• Minimum Monthly Payment: Credit card companies prefer consumers to make only the minimum monthly payment because it primarily covers the interest due, leaving the principal balance high. This ensures they continue to earn significant interest over a longer period.
  • Payment Allocation: When a payment is made, the amount is first applied to the interest due, and any remaining amount is then applied to the principal.
    • Example: If you pay $\$100$ and owe $\$98$ in interest, $\$98$ goes to interest, and only $\$2$ goes to principal. This significantly slows down principal reduction.
• Consequences of Minimum Payments: Making only minimum payments can take a very long time (e.g., $13$ or $26$ years) to pay off a balance and results in paying much more in total interest.
• Consumer's Goal: The primary goal when borrowing money is to reduce the outstanding principal as much as possible, as interest is always calculated based on the principal outstanding.

Rules of Thumb for Financial Planning

• The Rule of 72 (or 70): This rule estimates the number of years it takes for an investment to double at a fixed annual rate of interest. Divide the number $72$ (or $70$ for a more conservative estimate) by the annual interest rate (without the percentage sign).
  • Formula: $\text{Years to Double} = \frac{72}{\text{Interest Rate (as a percentage)}}$
  • Example: If the interest rate is $6\%$ per year, your money will double in $72 \div 6 = 12$ years.
  • Rounding: If the result is not a whole number, a suitable whole number answer (e.g., $3.4$ years would likely be rounded up or specified according to the question's format, but typically answers are not designed to be so close that rounding significantly impacts the choice).
• The Rule of 78: This rule is a method of calculating the amount of interest paid on a loan that is paid off early. It allocates a larger portion of the interest to the early payments of the loan. It's less relevant to general personal finance education now as it's not a common method for new loans.

Credit Insurance

• Definition: Credit insurance is a policy that covers loan payments in specific circumstances (e.g., death, disability, job loss) to protect the borrower and/or lender.
• Cost vs. Benefit: While available, credit insurance often comes with very high costs and provides minimal benefits compared to its expense. Many financial advisors recommend against it due to its poor value proposition for most consumers.

Fair Debt Collection Practices Act (FDCPA)

• Purpose: This act regulates debt collection agencies, prohibiting abusive, unfair, or deceptive practices.
• Consumer Rights: If you dispute a debt:
  • You have the right to dispute the debt.
  • The collection agency must respond on a timely basis.
  • They cannot report you as delinquent while the dispute is ongoing.
  • They cannot charge additional interest or continually harass you for payment during a dispute.
• Actions: If you believe the debt is not yours or incorrect, initiate the dispute process. If the debt is legitimate, payment is the appropriate action.

Consequences of Non-Payment and Repossession

• ** repossession**: If you fail to make payments on a secured loan (e.g., a car loan), the lender can repossess the asset.
• Remaining Debt: Many people mistakenly believe that once an asset is repossessed, their obligation ends. This is incorrect. The lender will add collection fees (e.g., towing, storage, other charges) to the outstanding loan balance. If the repossessed asset is then sold for less than the total amount owed (original debt + fees), the borrower is still liable for the difference.
  • Example: Original car debt: $\$18,000$. After repossession, fees are added, bringing the total owed to $\$22,000$. If the car sells for $\$18,000$, the borrower is still responsible for the remaining $\$4,000$.

Warning Signs of Financial Trouble

• Minimum Payments: Regularly making only the minimum payments on credit cards.
• Increasing Balances: Credit card balances consistently increasing.
• Ignoring Statements: Failing to review monthly statements.
• Over-reliance on Overtime: Basing regular expenses on overtime pay, which may not be consistently available.
• Using Savings: Depleting savings to cover regular expenses.
• Borrowing to Pay Debts: Taking on new debt to pay off old debt.
• Ignorance of Debts: Not knowing the total amount owed on all debts.
• Credit/Loan Denials: Being denied credit or loans.

Dangerous Signals (Further Escalation)

• Garnishment: A court order instructing a third party (often an employer) to withhold a portion of an individual's wages to pay a debt. This is usually enforced by entities like the IRS or family courts (e.g., for child support).
  • Process: A creditor sues, wins a judgment, and the court orders the employer to send a specific amount (e.g., $\$500$ a week) directly to a trustee or the creditor.
  • Job Risk: Garnishment can signal to an employer that an individual cannot manage their personal financial affairs, potentially jeopardizing their job.

Credit Counseling

• Purpose: Organizations provide guidance on managing debt and improving financial health.
• Cost: Seek free (pro bono) credit counseling services. Many universities, local accounting firms, and non-profits offer this.
• Deceptive Organizations: Be wary of scams.
  • Red Flags: Promises of quick fixes (e.g., eliminating $\$50,000$ debt in minutes), asking for money upfront, or charging a percentage of the amount owed are signs of fraud.

Bankruptcy

• Definition: A legal process where some or all of a debtor's assets are distributed among creditors because the debtor cannot pay their debts.
• Motive: The primary goal is to provide a fresh start for debtors by discharging certain debts.
• Requirements: Debtors are required to undergo credit counseling from a court-approved provider before filing.
• Debtor's Responsibilities: The debtor (the person filing) must submit a petition listing all assets (including cash) and liabilities, and pay a filing fee.
• Types of Bankruptcy: Decisions on chapter depend on income, assets, and type of debt.

Chapter 7: Straight Bankruptcy (Liquidation)

• Purpose: For individuals who cannot make any payments and have limited income. It involves the liquidation of non-exempt assets to pay off creditors.
• Process: The court takes control of qualifying assets, sells them, and distributes the proceeds to creditors. Any remaining unsecured debt is typically discharged.
  • Example: If a person has $\$1,000,000$ in debt but only $\$700,000$ in non-exempt assets, the assets are sold, and the funds ($\$700,000$) are distributed to creditors as a full payment (often less than $100\%$ on the dollar). The remaining $\$300,000$ might be eliminated depending on the debt type.

Chapter 13: Wage Earner's Plan (Reorganization)

• Purpose: For individuals with regular income who want to repay their debts but need a structured payment plan. It's a reorganization rather than liquidation.
• Process: The debtor proposes a repayment plan (typically lasting three to five years) to the court, which, if approved, allows them to pay off debts over time, often with reduced payments. Creditors must abide by the court-approved plan.
• Key Difference from Chapter 7: Chapter 13 allows the debtor to keep assets by committing to a repayment plan, whereas Chapter 7 involves asset liquidation.

Chapter 11: Business Reorganization

• Purpose: Primarily used by businesses (and sometimes high-net-worth individuals) to reorganize their financial affairs while continuing to operate.
• Distinction: This is a business bankruptcy, distinct from Chapter 7 and 13 which are primarily for individuals.

Debts Not Forgiven in Bankruptcy

• Certain debts are generally not eliminated by bankruptcy, these include:
  • Alimony (payments to a former spouse for financial support).
  • Child support (payments for the financial support of children).
  • Most student loans.
  • Certain taxes.
  • Debts incurred through fraud.
  • Any debt that was not disclosed (listed) in the bankruptcy petition.

Filing for Bankruptcy (Costs and Implications)

• Legal Assistance: While one has the right to file for bankruptcy themselves, it is highly recommended to use an experienced attorney due to the complexity and potential for costly errors (e.g., forgetting to list debts).
• Costs: Bankruptcy involves court costs, attorney's fees, and trustee's fees for both Chapter 7 and Chapter 13.
• Intangible Costs: A significant consequence is the potential inability to obtain credit in the future. Bankruptcy information remains on a credit report for $7$ to $10$ years, making it difficult to secure new loans or credit during that period. The precise impact and duration vary based on individual circumstances and the type of bankruptcy filed.