Debt Management, Bankruptcy, and Alternative Financial Services
Daniel's credit card bills keep growing, he pays one card with another, and he dreads opening the mail. Is he in trouble? What can he do before things get worse? And what are the options if he truly cannot pay? This page gives you a map: warning signs, a repayment plan, where to get help, what bankruptcy really is, and which "quick cash" offers to avoid.
Warning signs and a repayment plan
Debt itself is not bad. A car loan or a student loan can be a smart choice. The problem starts when payments take over your budget. Here are common warning signs of too much debt:
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You only pay the minimum payment on your credit cards, and balances do not go down.
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You use one card or loan to pay another.
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You are late on bills, or you skip bills to pay others.
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You are near your credit limits.
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Your debt-to-income ratio (DTI) is high.
A common rule of thumb is that a DTI above about 36% is a warning sign, and above about 43% is serious trouble. These are guidelines used by many lenders, not an official law.
A repayment plan has four steps: list every debt (balance, APR, minimum payment); stop adding new debt; pay at least the minimum on everything; send any extra money to one chosen debt. When that debt is gone, move its payment to the next one.
Which debt gets the extra money? There are two popular methods:
| Method | Order | Advantage |
|---|---|---|
| Avalanche | Highest APR first | Saves the most interest |
| Snowball | Smallest balance first | Quick wins keep you motivated |
Describe two warning signs that a person has too much debt. Then list two actions that could be part of a plan for repaying debt.
Describe two warning signs that a person has too much debt. Then list two actions that could be part of a plan for repaying debt.
Priya has three debts: a credit card with a $\$3,000$ balance at 24% APR, another card with a $\$1,200$ balance at 18% APR, and a car loan with a $\$6,000…
Priya has three debts: a credit card with a $\$3,000$ balance at 24% APR, another card with a $\$1,200$ balance at 18% APR, and a car loan with a $\$6,000$ balance at 7% APR. She has an extra $\$200$ per month beyond the minimum payments.
(a) Under the "avalanche" method, which debt gets the extra money first? Why?
(b) Under the "snowball" method, which debt gets it first? Why?
(c) Name one advantage of each method.
Getting help: credit counseling
If you cannot make a plan alone, you can get help. Credit counseling agencies advise people with debt problems. There are two very different kinds.
| Nonprofit credit counseling | For-profit debt settlement | |
|---|---|---|
| Typical service | Free or low-cost budget advice; a debt management plan (DMP) | Negotiates to pay less than you owe |
| Fees | Small monthly fee | Often a large percentage of the debt |
| How debts are repaid | You make one monthly payment to the agency, which pays your creditors in full, often at lower interest | You are told to stop paying and save in an account |
| Effect on credit | Accounts may be closed, but payments stay on time | Missed payments, late fees, collections, even lawsuits |
| Risk | Low | High: creditors may refuse to settle |
Nonprofit agencies are often members of groups such as the National Foundation for Credit Counseling (NFCC). Warning signs of a bad company: big fees up front, promises to erase your debt, or telling you to stop talking to your creditors.
Your rights as a borrower
Federal laws protect people who borrow. The Truth in Lending Act requires lenders to disclose the APR and fees before you sign. The Equal Credit Opportunity Act bans discrimination in lending based on race, sex, religion, national origin, marital status, or age. The Fair Debt Collection Practices Act (FDCPA) limits what debt collectors can do: they cannot harass you, call at unreasonable hours, or lie about what you owe, and you can ask them in writing to stop contacting you. To learn more or report a problem, visit the Consumer Financial Protection Bureau (CFPB) at consumerfinance.gov or contact your state attorney general.
Jayden is considering two options for his debts: working with a nonprofit credit counseling agency to set up a debt management plan (DMP), or hiring a for-profit debt…
Jayden is considering two options for his debts: working with a nonprofit credit counseling agency to set up a debt management plan (DMP), or hiring a for-profit debt settlement company that tells him to stop paying creditors and save money in an account.
Compare the two options, mentioning at least three differences, such as fees, effect on credit, risks, and how debts are repaid. Which seems safer, and why?
Bankruptcy
Bankruptcy is a legal process, run by federal courts, for people who cannot repay their debts. It gives a fresh start but has serious costs. Individuals usually file one of two types.
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Chapter 7 (liquidation): a trustee may sell certain assets that are not protected ("exempt") and uses the money to pay creditors. Most remaining unsecured debts, such as credit cards and medical bills, are discharged. There is a means test: if your income is too high, you may not qualify.
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Chapter 13 (reorganization): you keep your property and follow a repayment plan, usually 3 to 5 years, based on your income. Remaining eligible debts are discharged at the end.
Consequences: a bankruptcy stays on your credit report for years (about 7 years for Chapter 13 and up to 10 for Chapter 7), your score drops, and loans cost more. Some debts usually survive, such as most student loans, child support, and recent taxes. There are also court fees and often attorney fees.
Name the two main types of personal bankruptcy that people file as individuals: Chapter 7 and Chapter 13. Match each description to a chapter: (a) liquidation, in which…
Name the two main types of personal bankruptcy that people file as individuals: Chapter 7 and Chapter 13. Match each description to a chapter: (a) liquidation, in which certain assets may be sold to pay creditors; (b) reorganization, in which the debtor follows a court-approved repayment plan over several years.
Daniel has $\$38,000$ in unsecured debt, mostly credit cards and medical bills. He earns $\$2,600$ per month after taxes, and his essential expenses are $\$2,300…
Daniel has $\$38,000$ in unsecured debt, mostly credit cards and medical bills. He earns $\$2,600$ per month after taxes, and his essential expenses are $\$2,300$. He owns a car worth $\$7,000$ with no loan and has no other significant assets. He is falling behind on payments and is considering bankruptcy.
(a) Explain how Chapter 7 and Chapter 13 would each work for his situation.
(b) Describe two long-term consequences of filing for bankruptcy.
(c) Before filing, name two alternatives he should consider and explain why each might be better or worse.
(d) Recommend a course of action with reasoning.
Alternative financial services and the debt cycle
Some businesses offer fast cash outside of banks: payday lenders, check-cashing stores, and pawnshops. They are convenient and often do not check credit, but they are very expensive.
A payday loan is a small, short-term loan, usually due on your next payday (about two weeks). The lender charges a flat fee. To compare it with other loans, convert it to a percent and then to an annual rate.
Compare that with a credit card at about 25% APR or a credit union loan at 18% APR. Payday loans cost many times more.
The debt cycle happens when you cannot repay on time, so you pay another fee to roll over (renew) the loan, or borrow a new loan to pay the old one. The fees pile up, but you still owe the original amount.
Better options for a small emergency: a small loan from a credit union, a payment plan with the company you owe, an emergency fund, or asking an employer about a pay advance. Even a credit card cash advance (about 28% APR, plus fees) usually costs far less than a payday loan.
A payday loan lender gives Marcus a two-week loan of $\$300$ and charges a fee of $\$45$. How much must Marcus repay at the end of two weeks? What is the fee as a…
A payday loan lender gives Marcus a two-week loan of $\$300$ and charges a fee of $\$45$. How much must Marcus repay at the end of two weeks? What is the fee as a percent of the amount borrowed?
Emma borrows $\$400$ from a payday lender with a $\$60$ fee for a two-week term. She cannot repay on time, so she pays the $\$60…
Emma borrows $\$400$ from a payday lender with a $\$60$ fee for a two-week term. She cannot repay on time, so she pays the $\$60$ fee to "roll over" the loan for another two weeks, and she does this 4 times before finally repaying the $\$400$.
(a) How many total fees does she pay, and how much is that in dollars?
(b) How much does she pay in total, including the original $\$400$?
(c) Explain how this shows a debt cycle.
Aiden needs $\$500$ for a car repair. A payday lender offers a two-week loan with a $\$75$ fee. A credit union offers a small personal loan of $\$500…
Aiden needs $\$500$ for a car repair. A payday lender offers a two-week loan with a $\$75$ fee. A credit union offers a small personal loan of $\$500$ at 18% APR to be repaid over 6 months, and a credit card has a cash advance at 28% APR.
(a) Compute the effective cost of the payday loan as a percent of the amount borrowed for the two weeks, and estimate the annualized rate by multiplying by 26 two-week periods.
(b) Estimate the simple interest for 6 months on the credit union loan, using $I = Prt$, and for the cash advance if repaid after 6 months.
(c) Rank the three options by cost and explain why a payday loan often leads to a debt cycle.
(d) Describe one way Aiden could avoid needing such a loan in the future.
Back to the start: Daniel is in trouble if his payments are crushing his budget. He should list his debts, talk to a nonprofit credit counselor, and consider bankruptcy only as a last resort, while staying far away from payday loans.