Bankruptcy, Insurance, and Charitable Giving

Bankruptcy: a legal fresh start

Personal bankruptcy is a legal process, run through a federal court, that lets a person who cannot pay their debts either wipe out many of them or pay them off under a court-approved plan. It is a last resort, not a first move.

There are two main types for individuals.

Many basic items, such as a modest amount of equity in a home, a car, clothes, and household goods, are usually exempt, which means you keep them. Exemptions vary by state.

Bankruptcy does not erase everything. Most student loans, recent taxes, child support, and alimony usually survive. It also does real damage to a credit score, which makes loans and credit cards harder and more expensive to get for years.

Bankruptcy has a cost too: court filing fees and often an attorney's fee. Before filing, people are required to complete credit counseling from an approved agency.

Alternative: a debt management plan (DMP). A nonprofit credit counseling agency negotiates lower interest rates with your creditors. You make one monthly payment to the agency, which pays the creditors, usually over 3 to 5 years. You repay in full, but you avoid a bankruptcy on your record.

Insurance: paying a little to avoid a big loss

Insurance is a contract. You pay a small, certain amount, and the insurance company agrees to cover part of a large, uncertain loss. This works because of risk pooling: many people pay in, and only a few have big claims.

Key terms:

• Premium: the regular payment (monthly or yearly) to keep the policy.

• Deductible: the amount you pay first, before the insurer pays anything.

• Copay: a fixed fee for a service, such as $\$30$ for a doctor visit.

• Coinsurance: after the deductible, the share of costs you pay (for example $20\%$) while the insurer pays the rest.

• Out-of-pocket maximum: the most you pay in a year for covered care. After that, the insurer pays $100\%$.

Expected loss and why insurance can still be worth it

Expected loss = probability of the loss $\times$ size of the loss. Suppose Sofia's belongings could suffer a fire loss of $\$9{,}000$ with a $1\%$ chance each year. Expected annual loss: $0.01 \times 9{,}000 = \$90$. Her renters insurance premium is $12 \times 15 = \$180$ a year.

The premium is larger than the expected loss, since the company has costs and must make a profit. But the average hides the risk: a $1\%$ event could cost Sofia $\$9{,}000$, which she might not be able to pay. With insurance and a $\$500$ deductible, she pays $\$500$ in a fire (and $\$180$ in premiums). Insurance buys protection from a catastrophe, not a profit.

Charitable giving

Charitable giving means donating your resources to help others or a cause. You can give in three ways:

• Money: a cash donation or monthly gift.

• Time: volunteering.

• Goods: clothes, food, books, furniture.

Gifts to registered nonprofits (called 501(c)(3) organizations) can be tax-deductible. A deduction lowers the income that is taxed. But only people who itemize deductions (list them instead of taking the standard deduction) can benefit, and only when their total itemized deductions exceed the standard deduction. For example, a person in the $22\%$ tax bracket who itemizes and gives $\$1{,}000$ saves about $0.22 \times 1{,}000 = \$220$ in tax.

Giving has costs and benefits. Costs: money or time you can't use elsewhere (an opportunity cost). Benefits: help for others, a stronger community, personal satisfaction, and sometimes a tax saving.

Summary

Back to the start: Sofia's $\$180$ a year costs more than her $\$90$ expected loss, but it protects her from a $\$9{,}000$ hit. That is why many renters buy it.