Understanding Debt

At its simplest, debt is nothing more than money owed. Depending upon how much money is owed and the ability of an individual to repay that debt in a timely fashion, debt can also be a source of anxiety. Debt can result in a lower credit score that affects an individual’s ability to get a mortgage, credit card, or auto loan. It can make it difficult to meet current expenses because the money being earned is already spoken for.

Debt can also be a positive thing when it is planned for and managed. Student debt can allow those who are not able to pay tuition and other college expenses right away to be able to afford a higher education. Debt can allow an individual to buy a home or a car and make the payments over the time the house is lived in or the car is used. Debt can also be used to pay for an investment property that produces income in excess of the payment due each month. Sometimes debt is unavoidable, as when an unanticipated medical need costs more than an individual has in savings but must be met.

It is important to understand the different types of debt, the solutions when debt gets out of hand, and the impact of being in debt. It is also important to make a plan to manage debt effectively so that it can be used to an individual’s advantage.

Introduction

One of the most common forms of debt is credit card debt. Credit cards make it possible for an individual to delay payment when making a purchase. Depending upon the type of credit card and credit limit on the card, an individual can quickly charge enough so that the minimum monthly payment due is more than can be paid without throwing the monthly budget into disarray.

The positive side of credit cards is that, if managed effectively, they make it possible to buy items, even food, when one does not have enough money up front to purchase those things outright. In general, if the amount being charged cannot be paid off in full within three billing cycles, it is probably best to save some more before the purchase is made. That is because the money due is subject to interest charges. Interest is a percentage of the debt owed to the credit card company. With each billing cycle, interest compounds on the unpaid debt and is added to the balance owed, which increases the total amount the credit card holder has to pay back to the credit card company. By paying the minimum on a credit card, it will take many months, or even years, to pay the balance in full—and most of what is paid will go to the interest on the debt rather than to pay the debt itself.

Auto loans are another common form of debt. With an auto loan, payments are made over the life of the loan. Interest is charged on the loan, and the interest is collected in the monthly payment. By using a loan to purchase a car, an individual can have a reliable vehicle.

The ability to get around without worrying about the problems that come up with an older car that is less reliable and requires additional maintenance is a strong argument for a car loan. The down side of an auto loan has to do with the length of the loan. Automobiles become less valuable as mileage accumulates, which is the reason a used car costs less than a new car. The rate at which the value declines is very fast. If the length of the loan is longer than the car is in running condition, the borrower will have a useless car, yet still owe on the car. Also, if the car needs to be sold before the loan is paid in full, the entire amount due still has to be paid. For this reason, matching the length of the loan to the life of the car is imperative.

Consumer debt can also be used to buy furniture or other expensive objects with an installment plan. An installment plan is not much different than a credit card since it has to be paid on time and interest is part of what is due each month.

Overview

Sometimes an individual encounters problems with debt management. It could be that there is a loss of income or a dramatic increase in an expense that is beyond the individual’s control. For whatever reason, an individual finds that payment of the debt as planned is not possible.

In some cases it is possible for the individual to contact the company directly to arrange a payment plan. A payment plan usually includes some amount of interest to be added to what is due, along with a longer time to pay the amount, as well as lower payments. To have such a plan, it is sometimes necessary for the individual to agree to have the amount automatically deducted from a bank account or paycheck each month.

Medical providers are often willing to work with a patient to extend the payment terms by establishing a payment plan. It may be less costly for these providers to collect the amount due over time than it is to send the account to a debt collection agency that will keep a portion of the money recovered as a fee. It also allows the medical practitioner to keep a patient who will pay, rather than have the expense of attracting a new patient who may or may not pay.

Consolidation is a process in which an individual works with a credit adviser to combine all of the debt into one amount. Often, there is a reduction in the overall amount due because the vendors involved will agree to less, as it is less risky to work with the credit adviser than to depend upon payment from an individual who has become overwhelmed.

Sometimes this can be done without damage to the creditworthiness of the individual, although this is not always the case. If consolidation is the goal, it is imperative to work with a reputable adviser. The individual’s credit score and overall ability to obtain credit for many years is at stake if the consolidation is not handled properly.

Working with a consolidation adviser will require the individual to provide a complete financial picture. This will include all savings and investment accounts. As the consolidation is put into place, vendors or collection agencies may continue to call, which can add to the overall stress of the situation.

Declaring personal bankruptcy is usually seen as a last option. While bankruptcy makes it possible to "walk away from your debt," there are serious consequences to consider. Bankruptcies are reported to all credit agencies and remain part of the debtor’s credit report for either seven or ten years, depending on the type of bankruptcy declared. Having a bankruptcy on one’s credit report can make it nearly impossible to obtain loans or credit. Questions about bankruptcy may be included on job applications and during security clearances. Bankruptcy is not a quick fix or an easy way to solve the problem of overwhelming debt.

Chapter 7 bankruptcy is a type of arrangement in which a debtor uses some of the readily available assets such as money in checking and savings accounts to repay a part of the debt due. These readily available, liquid assets are considered nonexempt assets because they must be used to help pay the debt. Other assets are exempt, meaning the individual cannot be forced to use them to pay the debt due. The types of assets that are considered exempt and nonexempt vary by state, but once the nonexempt assets have been used to pay the debt, the rest of the debt is discharged. Chapter 7 bankruptcies remain on credit reports for ten years.

Chapter 13 bankruptcy is a type of arrangement in which a debtor pays the debt over a three- to five-year repayment plan. A repayment plan must be filed with the court when the bankruptcy filing is made. Payments are then made to the court, who in turn makes payments to the creditors. The court decides if the plan is to be approved. The creditors can object, but the court’s decision is final. Chapter 13 bankruptcies stay on credit reports for seven years.

Impact

Debt can be constructive or destructive for an individual. The key factor is the amount of debt in relation to the individual’s ability to repay it. The more difficult it is to meet the payments or pay off the debt, the more onerous the debt will seem. Once an individual is in the position of being unable to meet living expenses as well as the payments for current debt, it quickly becomes stressful and damaging to the person’s present and future financial position. Although consolidation and bankruptcy are options for people who have incurred more debt than they can reasonably pay back, both can have serious negative consequences for one’s ability to obtain further loans and credit.

The best approach to debt is to view it as one tool in an array of financial options available. Debt is best used with the understanding that anyone may have a reversal of finances for reasons beyond that individual’s control at any time. By managing debt successfully, one can establish and maintain a good credit score, making it easier to obtain credit and loans for homes, cars, and other significant purchases.

Bibliography

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