Debt

by | Jul 7, 2020

A “loan” is a sum of money that is borrowed and paid back with interest. Loans are usually taken out when you currently don’t have enough money to buy something. If you want something expensive but don’t have enough money, you could possibly look into taking out a loan (from a person, financial institution, or agency). Be aware though; while loans can be a quick solution, they can become a long-term problem. Once you take out a loan, you’re in debt, and you must eventually repay that money PLUS the determined interest fee. Interest is an extra charge added onto the money, denoted as a percentage of what the institution has loaned. Hence, financial institutions can give individuals and companies money and get more money in repayment. Loans can be extremely problematic if they aren’t paid back in time. You may have to pay late fees and face an increased interest rate for failing to pay the loan on schedule. So make sure that the thing you are buying is worth the risk and always be responsible and aware when dealing with loans.

Let’s discuss credit card debt. By now, we know that you won’t be charged for your credit card unless you leave “outstanding debt” (you don’t pay the full amount you owe at the end of the month). But how is interest calculated on this outstanding debt? And how do interest rates, compounding frequency, and loan length affect it? For credit cards, the interest rate is usually an annual interest rate, also known as an “Annual Percentage Rate (APR)”. For example, if your interest rate is 10% and you carry a $1,000 balance from month to month, you would owe $100 in interest after a year. The higher the interest rate, the more you will pay for your debt! Recall that a higher compounding frequency (how often interest is calculated) will result in more interest paid. For credit cards, interest is compounded (calculated) on a daily basis. This means that every day your outstanding debt will be increased by your outstanding debt times the APR divided by 365. The longer your loan takes to be repaid, the more times the interest will be compounded – and the more interest you will pay in the end. If you pay off a loan in 10 months instead of 5, you will have paid for 5 extra months of interest. Credit card debt is considered to be one of the most expensive debts to have. This is because compared to other loans, such as mortgages, the interest rates are much higher (averaging almost 20%), and the compounding frequency is greater. When credit card debt is paid off quickly, it’s not as bad, but when it takes years, it can be disastrous.

When making a credit card payment, you may see several payment amounts to choose from. The statement balance is the total amount you owed when your last billing cycle ended. The minimum due is a minimum monthly payment your credit card company is willing to accept to not mark your account as "past due." Every time you carry a balance from one billing cycle to the next by paying less than the statement balance, you’ll be charged interest on the amount that wasn’t paid off yet. When you’re charged an interest fee, it’s added to your balance.

For example, suppose Lily has $1,000 in credit card debt and she chooses to only pay the minimum amount due every month. The interest rate is 12.99% and the minimum monthly payment is $30. In this scenario it would take Lily 42 months to pay off the debt, it would cost $1,260 total, and she would have paid $260 in interest. Now suppose Lily has $1,000 in credit card debt, but she chooses to pay more than the minimum amount due every month. The interest rate is 12.99% and the minimum monthly payment is $30, but she pays $50. In this scenario it would take her 23 months to pay off the debt, it would cost $1,150 total, and she would have paid $150 in interest. When Lily paid more than the minimum amount due, she paid off her debt 19 months earlier and saved $110. If Lily had paid less than the minimum due, she may have had to pay a late fee and her late payment may have been reported to the credit bureaus.

How about the true cost of a loan? To calculate it you have to know the outstanding debt, the interest rate, the compounding frequency, and either the length of the loan or the repayment amounts. Let’s calculate the total cost of a simple loan which you pay all at once at the end. The outstanding debt is $10,000 to begin with. The interest rate is 10% and it’s compounded annually. Finally, the loan must be paid back after 5 years. To calculate the total cost, multiply the outstanding debt by 1.10 (1+10%) every time it’s compounded, that is, 5 times. Therefore, the total cost is ($10,000)*(1.10)*(1.10)*(1.10)*(1.10)*(1.10) = $16,105.10. Another way to write the calculation above is by using powers. Plug the following calculation into a calculator and you will get the same number as before! ($10,000)*(1.10^5) = $16,105.10. This will help for loans which are compounded more times. If the loan from before had a lower interest rate, what would the total cost be at the end? If the interest rate is 5% instead of 10%, the new total cost would be ($10,000)*(1.05^5) = $12,762.82, proving that lower interest rates means lower total loan costs.

If the first loan had a greater compounding frequency, what would be the total cost? If interest is compounded monthly instead of annually (60 months in 5 years, 10%/12 = 0.83% per month ), the new total cost would be ($10,000)*(1.0083^60) = $16,453.09. This proves that a higher compounding frequency means higher total loan costs. The compounding frequency is as important as the other factors when calculating the cost of a loan.

Easy access credit refers to very short-term loans that have very high interest rates. Some examples of these include payday and title loans. People usually take these loans out when they need money immediately and seemingly have no other option. At the same time, providers of these loans don’t actually care about your borrowing reputation and will just hand over the money to you.

The problem with easy access credit is that you end up paying a ridiculous amount of interest on these loans. For example, in California, a 14-day payday loan has an average interest rate of 459%! (Meanwhile credit card debt has an interest rate of around 20%, which is already considered to be pretty high!). Payday loans are given out by lenders based on the borrower’s income. They’re usually a portion of the borrower’s next paycheck, so it’s as if they’re receiving their paycheck early. To calculate the total cost of the loan, multiply the initial principal by 1 + 20% (or 1.2) to the power of 26 (26 sets of 2 weeks in a 52-week year) to get $500*1.2^26 = $57,200. This crazy amount is why you should steer clear of payday loans. You might be biting off more than you can chew. Title loans require the borrower to use an asset as a collateral. This means that if the borrower fails to pay back their loan, the lender will take the asset for themselves. Say a borrower uses a title loan to pay for a car and uses that car as a collateral. If she doesn’t repay that loan, she will lose the car to the lender.

Something to always look out for with loans is Predatory Lending, which is defined as any action that tempts, deceives, or coerces borrowers to take out a loan that carries high fees, high interest rates, and places the borrower at a disadvantage. Predatory mortgage lending is known to cost American families close to 9.1 billion dollars a year. People who use predatory lenders are those that are in dire need of immediate cash and are unable to get it through conventional means. Predatory lenders target people who have a low credit score, who are unemployed, or who aren’t financially literate. Predatory lenders can usually be identified by their fees/rates which are significantly higher than the norm. They also use their loan to keep borrowers locked into a contract for as long as possible under terrible terms, exploiting them for as much money as possible.

For example, take Bob, who just lost his job but needs money to pay for his medical bills. He gets an email from a lender that claims to offer loans regardless of his employment status. The catch is that the interest rate is 3 times the national interest rate and the entire amount needs to be repaid with interest in 2 weeks. This is a classic example of how predatory lenders target those in dire need of money. You should actively avoid predatory lenders! Only some states have laws against predatory lending and even then, there are ways around such laws. Vigilance is always advised when dealing with lenders as they always have new ways of gaming the system.

Another type of loan is P2P Lending or peer-to-peer lending is a form of online lending that enables individual investors to connect directly with potential borrowers (individuals or businesses) seeking financial loans. Unlike traditional methods of borrowing-and-lending, this alternative approach removes the need to obtain a loan from financial institutions like banks. Some of the top lending platforms include LendingClub, Prosper and Upstart. Each platform has its own set of features and guidelines for P2P loans. For example, LendingClub doesn’t allow loans to be used for gambling, investments or higher education costs. Most loans are used for debt consolidation, home improvement, medical expenses and other major purchases. To borrow money from a P2P lender, borrowers apply for loans through a P2P lending platform and wait for an investor to review it (check your credit) and decide whether to fund it. Investors can choose to fund an entire loan or just a portion of it. As a result, a borrower may receive funds from numerous individual investors. Although P2P lending has a lot of benefits, there are some possible fees as well. P2P lending platforms can charge fees to both the borrowers and lenders. For instance, borrowers may need to pay an origination fee of 1% to 5% for the lending platform to process and disburse the funds. If you’re an investor, the platform may charge a 1% “service fee” on every loan payment received.

Leverage is the use of borrowed money for an investment, expecting the profits made to be greater than the interest payable. Businesses can use leverage to pay for company growth and development through the purchase of assets. Suppose a car company wants to open a new factory. The company may borrow the money for the new factory, expecting the increased car production and the subsequent increase in profit to be more than enough to pay back the loan. Let’s say the car company takes out a $100,000 loan to build the new factory. The loan has a 10% interest rate, and the company pays it back over one year. This means they pay $10,000 in interest. The cars from the new factory are sold for $150,000. The company has made $40,000 in profit by leveraging debt.

There are some benefits to leveraging. For example, interest payments on business debt are tax deductible. Also, businesses can expand faster if they can access money through borrowing, rather than having to wait to save up the cash and losing valuable time. There are also disadvantages to leveraging. If a business uses leverage to make an investment and the investment fails, the loss is much greater than it would’ve been if the business had not leveraged the investment. When companies leverage debt, they are taking on a large amount of risk.

Excessive debt isn’t something that just happens by accident. Certain habits lead to debt, and the main one is overspending. If you’re spending more money than you make, you’ll start using credit for all your purchases. Soon, this debt will pile up and interest will dig you into a deep hole. When you’ve accrued excessive debt, you might find yourself unable to escape. You lived beyond your means and spent more than you could afford, so now you find yourself unable to make many purchases outside of debt repayment. You will have less money for expenditures and emergencies, and ultimately less freedom as a result. Having excessive debt usually means that you’ve taken on more consumer debt than you can handle. Most experts say that consumer debt should never exceed 25% of your annual income; however, it would be best to have it be 0%, since consumer debt is charged at very high interest rates (i.e., payday loans and credit card debt). If the debt is still unmanageable, the best thing to do is speak with a financial advisor and work out repayment and spending plans which you must stick to if you want to escape financial ruin.

Even for ‘impossible’ circumstances, there are still some options on the table. Some legal processes, such as declaring bankruptcy, which we will discuss later, can help you even in the darkest hours. When you have excessive debt, a big chunk of your money must go toward repaying your debts.

Debt management helps people decrease and eliminate debt, and it is necessary if you have too much debt. Debt management plans can include working directly with lenders, using a consumer credit counseling agency, or taking advantage of a financial institution’s debt reduction services. One way to manage debt is by working directly with your lenders. This involves contacting your creditors and negotiating different payment plans that have reduced fees and interest rates. Most creditors will try to help you because they want you to avoid bankruptcy and be able to pay your debt. Credit counseling companies can also help you with debt management. They can negotiate with your lenders to reduce your monthly payments or total amount owed. They may also suggest creating a DMP.

What is a DMP, you ask? A “DMP”, or Debt Management Plan, is an agreement between a debtor and a credit counseling firm. Through the DMP, the debtor can consolidate their debt by making a single, regular payment to the counseling firm, who then uses that money to pay the creditors. Many financial institutions offer “consolidation loans”. Similar to DMPs, consolidation loans allow you to combine your smaller loans into a larger loan with a lower interest rate and a longer time period for repayment. Some financial institutions also offer free credit counseling services.

As you know, your net worth is your assets minus your liabilities – essentially, it’s the value of what you own minus the amount of debt you have. For example, if you have $1,000 cash and a $5,000 car, but you owe $100 in credit card debt, your net worth would be $(1,000+5,000) – $100 = $5,900.

Suppose Torin has no assets and no liabilities. He goes to a financial institution and takes out a $3,000 loan, which he deposits into his checking account. He now has $3,000 in assets and $3,000 in liabilities. His net worth remains at zero. If Torin’s loan has a high interest rate, and he leaves the money in his checking account earning no interest, his net worth will soon be negative. Torin could also use that $3,000 to splurge on designer clothes, but this would bring his net worth down significantly. On the other hand, if Torin invests the money in a way that earns him more than the interest he pays on that loan, then his net worth will be positive. For example, he could use the $3,000 to buy a reliable used car that allows him to drive to a job where he earns much more than $3,000 a year.

Your debt to income ratio is all your monthly debt payments divided by your monthly income. Debt can be good if it increases your net worth or has future value. Otherwise, it’s bad debt. Your debt to income ratio should never go over about 30%. If you invest money from a loan that earns you more than the interest you pay on that loan, then your net worth will increase. For example, if you take out a mortgage on a house, your payments will go toward building equity, which can increase if your house appreciates in value.

When people owe money they are known as debtors, and the person or company they owe money to is called a creditor. Creditors and debtors both have rights when an overdue debt goes unpaid. Creditors, for example, have the right to garnish wages and repossess property. A wage garnishment is when a court orders your employer to withhold a certain amount of your paycheck and send it directly to the creditor, person or institution you owe. Debtors have rights in the wage garnishment process. There are limits on how much of your wage can be garnished, you must be notified of the garnishment, you can file a dispute, and you can’t be fired for having one wage garnishment. Repossession occurs when a creditor claims an asset from a debtor who has failed to make her loan payments. For example, if you take out a loan to buy a car and then don’t make the monthly payments, the creditor can repossess the car and sell it to make up for the missed payments. The creditor does not need a court order to begin repossessing property. Debtors’ rights related to repossession differ depending on the state. Creditors cannot break the law to repossess property, and in most states, this means repossessors can’t come onto your private property. Also, in some states, creditors must notify the debtor of the repossession beforehand.

The Fair Debt Collection Practices Act (FDCPA) is a federal law that prevents debt collectors from engaging in unfair, deceptive, or abusive practices while collecting debts. The FDCPA covers mortgages, credit cards, medical debts, and other personal debts. It does not, however, cover business debts. Debt collectors can’t engage in unfair practices. The FDCPA makes it illegal for debt collectors to contact you before 8 am or after 9 pm unless you give consent. They also cannot contact you while you are at work if your employer does not allow you to take calls. It is illegal for debt collectors to threaten you with violence, use profane language, and repeatedly use the phone to annoy you. They also cannot lie about the amount you owe or falsely claim that you will be arrested. They can’t collect interest or fees on top of what you owe or deposit a post-dated check early. Also, they are required to send you a "validation notice" that states the amount of money you owe, who you owe it to, and what to do if you don’t think it’s your debt. Collectors are required by Fair Debt Collection Practices Act to send you a written debt validation notice within 10 days of first contacting you.

An option that a debtor can take in extreme situations is bankruptcy; you may have heard the term before, but what does it mean? It’s a legal process through which a person or business that cannot repay their debts is able to get some or all of those debts forgiven. When a debtor files for bankruptcy, they must explain to the judge how they got into debt. The debtor’s assets are then measured, and these assets can then be taken and sold to repay some of their debt. Following these proceedings, the debtor is relieved of their debt obligations. The assets that can be seized to pay off some of your debt differ in each state. Typically, property that is not your primary home, musical instruments, investments, jewelry, and artwork can be taken. Luckily, clothing, household appliances, and necessary household goods usually cannot be seized. So then, why doesn’t everybody struggling with debt file for bankruptcy? One reason is that it may affect your employability. Although government agencies cannot consider your bankruptcy in hiring decisions, private employers can and often will run credit checks on potential hires. Having a bankruptcy on your file will send a red flag to employers who will assume you aren’t responsible. Furthermore, bankruptcy can stay on your credit report for up to 10 years and will lower your credit score by 160 to 220 points, making it difficult to get credit in the future, as lenders will be wary of loaning money to someone who has bankruptcy on their report.

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