Debt and credit management for the family

Key topic

In this lesson we present the basic banking operations that most closely relate to your family’s needs and discuss the different banking risks associated with credit, debt, and credit history. We take a brief look at the banking system and its mechanics before moving to the differences of debit-credit cards and the broader concept of credit and its meaning and relevance.  Moreover, the lesson discusses the risks of loans and being in debt, especially for a prolonged period of time.  Finally, we discuss ways and techniques for keeping your debt obligations under control to sustain your financial wellbeing.

Learning objectives

• Understand the basic banking operations and how they affect your family
• Figure out how to keep your debt under control
• Develop proper spending habits by distinguishing between good and bad debt
• Discover the risks associated with bad loans and collaterals
• Create readiness at home to adhere to the family financial plan and monthly budget

The banking system in a nutshell

In previous lessons we discussed how your family should prepare its financial standing in order to avoid hardships and secure a good quality of life. We have also discussed how your family could approach the possibility of having to put your kids through college, in the absence of a scholarship, and how to help your family facilitate the kids’ academic goals. In this lesson we discuss several issues pertaining to the banking system in general, so as to enhance the family’s general understanding and readiness for the challenges ahead.

As you are already aware, a bank is a financial institution that handles money, including keeping it for saving or commercial purposes, and exchanging, investing and supplying it for loans.  Banks offer safe, secure, convenient services so you can save money and build a better financial future.

Working closely with your bank can become an advantage for the following reasons:

• Safety:  Storing your money in a bank is much safer than holding cash. Deposits are also protected up to a certain amount by the FDIC in the USA.
• Earning Capacity:  The bank pays you interest every month just for depositing your money, therefore your money creates more money.
• Convenience:  You can receive your salary electronically, make electronic payments, organize your finances online, etc.
• Organization:  Bank accounts help you track spending, manage savings, and stay on target with your family budget.
• Alignment of Incentives:  It is in the best interest of both the bank and yourself, if you are financially sound.  If your personal finances are doing well, then you will save more (more money for the bank), spend more (greater line of credit) and utilize more of the bank’s services.

When choosing a bank though you need to take into account the following:

• Despite the fact that your money is safer, it still loses value due to inflation because it stays “inactive”. Let’s take a step back and talk about inflation for a bit. You might have heard politicians, journalists and economists talk about inflation or the rate of inflation. Inflation is a rather simple concept: it is the rise in the prices of goods and services. Inflation usually occurs in two cases. When there is marked decline in supply or a sharp rise in demand of let’s say bread. Let’s assume that in country X the population is 100 people and we have 100 loaves of bread costing $1 each. If suddenly 50 people are born then there will not be enough bread for everyone and therefore prices will rise due to this shortage. The same will also occur if 50 loaves of bread are destroyed and we will only have 50 loaves left for 100 people.  If let’s say, the price goes from $1 to $2 then you will spend more on bread.  Therefore, your money has lost some of its purchasing power; its strength. Now this concept applies to all goods and services.
• Banking systems are country-specific. There are countries with solid and efficient banking systems but there are also countries with unstable banking systems.
• There is always the possibility of a bank run during times of recession. Such events occurred in the US during the Great Depression and in both the US and Europe during the Great Recession.
• Depending on whether you have a savings account or a checking account (explain the difference) then you are vulnerable to fluctuations in interest rates.  Let’s briefly explain interest rates as well because they will be useful for the rest of the class. Interest rates apply to both lenders and borrowers. If you get a loan of $100,000 and you are also charged a 10% interest rates, it means that by the time you repay your loan you will have to give back to the bank $110,000 (assuming you repay it back on time). Now, if you place your money in the bank and the annual interest rate is 10% (which will never be that high), then at the end of the year those $100,000 will become $110,000.

All in all, the benefits of saving/placing your money in banks outweigh the costs. You should definitely use banks but choose your bank wisely.  It is always good and handy to have liquid assets but you should avoid having all your money in the bank, rather than invest some, because they continually lose value.

Remember that how you manage your money today determines whether you achieve financial freedom tomorrow.  Your checking account will help you organize and keep track of your finances whereas through your savings account, you can take advantage of the power of compounding interest.  Compounding interest is defined as the process by which the value of an investment increases exponentially because it earns interest both on the principal and the prior interest payments.

As a business model, the banking concept is pretty simple: banks use your money to make loans to other accountholders.

• Savers deposit money and earn interest.
• Borrowers borrow money and pay a higher interest rate to the bank, so the bank makes money.

Banks make money by lending money to people at higher rates than they pay the people who deposit money. For example, you deposit your money in a savings account and earn 2.25% interest and the bank then lends your money to other customers at an interest rate of 6%. The bank makes a profit from the difference between the saving and lending rates.

In order to decide which bank is right for you and your money, first you need to consider your expectations and purpose for opening an account. Is it for business, for pleasure, for savings, salary-depositing, eventual loans, or something else?”

You should choose a bank that offers online banking because in today’s economy it is a feature you can’t do without.  With online banking, you can do transactions and check balances from wherever you are!

You should also look at banking costs.  Banks have to be competitive, so it pays to compare fees for opening and running an account. There are often fees for both checking and savings accounts. The bank may also charge separate fees for such things as receiving statements in the mail; online banking; and multiple checkbooks.  Make sure to ask and compare all potential fees before settling on a particular bank.

It is also important to use a bank that’s convenient to where you work or live and it is equally important, to check out the convenience of ATM locations.

Remember that you want to build a long-term relationship with the bank you choose. You’ll find that, the longer you remain a good customer, the more benefits you’ll receive. Then the next time you need a car loan, investment account, business loan, or home loan you may get better terms because of that positive relationship.

In summary, opening and automating your accounts is the first step toward building a     financial foundation. Find a bank with which you can grow over time. Look for one that offers the services you need now, as well as those you may need in the future. Be a good customer and grow with your bank. As that relationship grows, so will the benefits you receive.

Let’s complement everything we just explained with a short video clip:

Banking Explained- Money and Credit

Debit cards Vs credit cards

There are two different types of cards issued by banks.  In the case of a debit card, the bottom line is that transactions happen with the use of your money. Your debit card charge will be deducted from your bank balance as an outflow without creating any liability towards the bank. Basically, a debit card is the alternative to carrying cash.

The characteristics of a debit card are that it is linked to a bank account, that the money available for use is equivalent only to the available amount in your account and that after the transaction, this money is automatically added or removed from your account.

Credit cards on the other hand, utilize the bank’s money for a transaction, which automatically creates a liability from your side towards the bank. It is like having money available from the bank, which is not yours, in the form of a small loan that you have to repay with interest every month. Credit cards have different characteristics than debit cards. Credit cards form a type of a loan from a bank to your family, which helps the bank make money off of you from interest and fees, especially if you don’t repay your balance in full or you are constantly late with your payments.

However, if you are educated and informed with respect to the credit system and punctual with your monthly payments, you can utilize the offers provided from credit cards and their associated organizations, in saving money and reducing costs of other purchases (for example airplane tickets, amusement parks entrance fees etc). It should also be noted that generally credit cards tend to offer greater protection in case of theft. As we will discuss in the next part of this lesson, the fees and interest rates on your credit card are directly associated with your credit history, which in essence is your past record of paying bills and handling credit.

Credit cards are convenient; most businesses accept them and they’re easier to carry than cash. Credit cards can be a handy tool for your purchases as long as you pay the bills in full each month and avoid paying sizable interest fees.  However, when faced with an emotional or impulse purchase, pulling out the plastic can be far too easy to do. If money is tight, it’s easy to talk yourself into thinking “charging it” is no big deal. But if you don’t take spending seriously, receiving that credit card bill can be a painful experience.

The best way to manage a credit card is to repay it in full on a monthly basis. Credit card companies make their money when customers carry a balance from month to month. Plan and budget for your purchases properly so you can pay your credit card bills in full each month.  You may think it’s okay to pay just the minimum payment the credit card company calculates for you. That’s a common misunderstanding.  In fact, the minimum payment just represents the minimum amount that will keep your account active. It’s not enough to actually retire the debt in a reasonable time.

Carrying a small debt for two, maybe three months is not ideal, but it is no big deal either.  If you start carrying credit card balances longer than three months, it may be a good indicator that you’re developing a debt management problem.  If you can’t handle credit card debt, you need to literally “cut it out”— cut your plastic cards into pieces before you get into real trouble!  If you understand the dangers of using credit cards, you can learn how to use them to your advantage. For instance, traveling with a credit card is much safer than carrying a pocketful of cash. Credit cards allow you to rent cars easily and, in an emergency, a credit card can be a lifesaver.

You should be aware that as you build your credit status, credit card offers will begin flooding your mailbox. Credit card offers vary a lot, so read them carefully.  Just because they send you a “pre- approved” application with a sizeable credit limit doesn’t mean you should apply, much less consider this money offered as available for your financial plan.

The one thing that stands out from this part of the lesson is the need to discuss these concepts with your children. Never forget the fact that you, as parents, are at the same time educators for your kids, for the things that are basic life knowledge and skills. Teaching your young ones these facts can help prepare them for life ahead, but also helps them realize the true financial facts in the family, as well as the actual family financial capabilities, making your kids more receptive to the word “NO”, the need to save money, or skip some luxuries that they would otherwise expect from you, as parents, to offer to them.

Action steps – Exercise 1 (5 minutes):

1. Have you ever thought about how you use your credit card?
2. Have you ever used one, and subsequently struggled to pay your debt? Alternatively, do you have friends/ family who struggled to repay their credit card debt?

Credit card usage can lead you down a dark path if it is not done properly. This next video explains the pitfalls:

Credit Card Debt Explained with a Glass of Water

Credit and credit history

Having watched this video, let’s take a closer look at credit and how it works. Credit is an arrangement that defers payment for borrowed money or a purchased item until later. In other words, you get money or stuff now, and you agree to pay it back later. When you buy or borrow on credit, you generally end up paying back more than the original amount, in interest. How much interest you pay depends on your credit history, which is your record of paying bills and handling credit in the past. The percentage of the debt that you’re charged on top of the original amount is called interest and it is determined by the interest rate.  Learning how credit works is the key to building an outstanding credit history.

Credit refers to your ability to borrow money to pay for something. Such borrowed money also includes credit cards. Credit is used to buy cars, houses, and major appliances. Simply defined, good credit means you keep all your financial agreements in good faith; you honor your commitments and pay all your bills on time. Your credit score is similar to a report card in school; it will open doors if it’s high and close them if it’s low.  If you don’t pay your bills on time, carry a high debt load, and have bills that you stopped paying, you probably will have a bad credit score.

Your credit history, or credit report, is a detailed account of all the information about your credit situation: how much you owe, how you pay your bills, and whether your payments have ever been delinquent. Credit bureaus track and analyze this information to calculate your credit score. Credit scores are expressed in numbers between 300 and 850; the higher your score, the better your credit.

The key point to be made here is that as a family you should strive to have the highest possible credit score. Not only it will imply that you have managed to stay safe from financial hardships and failures, it will also mean that, if need be, you can fall back on it and use this good credit score to help you. It can be utilized for a car loan, as your kids reach the driving age, or a student loan for college and of course it will help you qualify for lower interest rates and therefore lower payments in the long run.

Keeping debt under control

In today’s world, debt has become unavoidable, almost a necessity, in various stages of life, especially for young families trying to set up a new start in their life, or families with kids that grow up and have specific needs in starting their lives too.

Before discussing how exactly to exercise good control over your debt, it should be mentioned that there are two types of debt, the so called “good debt” and “bad debt”. It is easily understood that good debt is highly preferred over bad debt, because on top of everything else, you need good debt in order to have a positive credit history.

Good debt is the kind we use to buy assets. The goal of good debt is to purchase items that will eventually lead to asset value being appreciated (increased), which in turn can lead to the family’s wealth or good financial standing being increased over time.  For example, if you purchase a rental property in an up-and-coming area using a loan, it will probably prove to be a good debt.

Bad debt refers to loans that the family takes out to purchase consumable items or items whose value depreciates (decreases) over time. Good or bad debt, the family should make it a point to take out loans and carry debt within the overall capabilities and strategy of the family financial plan, as well as treat all debt with a healthy respect. Even loans used to purchase good investments can lead to financial problems, if we don’t handle them properly.

Examples of good debt are:

• Investment Loans, which produce added income for the family
• Loans for Real Estate, if that produces an income for the family, which in turn can help repay the loan and create added financial value for the family
• Business Loans for creating or expanding a business
• Education Loans, given that the average income of an educated person far exceeds that of the uneducated, hence it is considered an investment
• Home Loans for a property you live in – This may be considered good or bad debt, depending on your investment strategy. Purchasing a home may be a good investment because instead of paying rent, your payment goes towards the mortgage and the house will end up being yours after you have repaid the loan.  However, it all depends on the location of the house, the type of mortgage and interest rate that you pay and the purchase cost of the house.  If you bought an expensive house when real estate was high, in a neighborhood with high real estate taxes, with little down payment and a high mortgage interest rate, while shortly after real estate prices are beginning to fall, then you are in for some real trouble!

Examples of bad debt include the following:

• Credit Card debt, due to the high interest rates and fees. A credit card can be good debt only if you pay the money you have borrowed back in full each month; that helps increase your credit score and you incur no interest charges
• Personal/Consumer Loans or Bank overdrafts, which also carry high interest rates and they usually cater for the “want” rather than the “need”
• Car Loans, might not sound like a terrible idea, however, in the context of investment and debt, a car can only depreciate in value. In fact, as soon as it hits the road the car loses a substantial portion of its value instantly. On the other hand, a car might be considered a necessity in certain situations. Therefore, you should always opt for reasonably priced cars; or at least cars which are within your financial reach.
• Pay Day Loans, are extremely dangerous and should be considered as the last resort. They can charge up to 400% and missing your due dates will cause your debt to skyrocket. It is preferable to be avoided entirely.

In order for a family to experience financial growth and success, as well as meet its obligations and dreams of kids’ success and accomplishments, it is essential that parents learn how to manage their debt, despite of its size. It takes positive attitude, focus and determination, as well as extreme discipline; very similar to all the attributes your kids need in becoming elite athletes, hence it is important to showcase these skills yourselves and lead your kids by example.

If your debt is small, you have to be sure it doesn’t get out of control by keeping up with your instalments. On the other hand, if you have a large debt, your efforts towards paying that debt should be more rigorous and should be accompanied by a well-documented strategy, based on expert opinion and suitable professional guidance, which will allow you to escape legal or any other unfortunate consequences.

The following are four small, but important tips for keeping your debt under control.

TIP #1 – Be Fully Aware – “The Debt List”

Knowing to whom and how much you owe is by far the most important part of the process. In order to have the situation under control, you should create a “debt list” with all your debts, which will include:

• the creditor (who you owe money to)
• the due date (when should it be repaid and how often)
• the total amount of the debt
• the monthly instalments
• The interest rate you are charged

By making this list and considering all of your debts, you will be able to see the bigger picture and be fully aware of your complete debt position. You should make sure that you update your debt list regularly and keep tab of decreasing debt. Watching your debt go down will make you feel good and will give you the right perspective to continue paying your installments as planned. Additionally, this list is very important for your financial plan as a family, but also for the preparation of your monthly family budget, as previously discussed.

TIP #2 – Be Consistent

Being prompt with your monthly instalments, keeps the situation under control. Late payments make the situation a bit chaotic and more difficult to handle; it becomes harder to repay the debt, due to the fact that it accumulates, plus you are charged with overdue interest and other default charges. On top of things, you are unable to follow the monthly budget and this cycle affects negatively the family’s financial plan.

If it’s just a matter of accountability and not a matter of not having the funds to make the payments, you should create a standing order agreement with your banking institution, or simply use a calendar system on your smartphone with reminder alerts for your monthly payments. If you miss an instalment, it’s important to proceed with the payment prior to the due date of the next installment and not just wait it out.

TIP #3 – At Least, Pay the Minimum

As already discussed, paying the minimum is not enough to repay your obligations on time and without extra cost, rather it’s just a way to keep the obligation alive and away from implications. However, if push comes to shove, even if you don’t make actual progress towards repayment of your debt, you will at least keep your account stable and your debt will not grow further. It is noteworthy to mention that when you fail to make your monthly payments, it becomes harder to catch up and sooner or later your loan could be in default.

TIP #4 – Prioritize

Make sure you prioritize your debts.  In other words, decide which debt is best to settle first. For instance, credit cards have higher interest rates than other loans. Therefore, the best you can do is to prioritize the repayment of any credit card debt you may have. Another option is to repay the debt with the lowest balance first. In order to avoid any extra costs, use your list to rank and prioritize your debts, in the best possible way to improve your financial position.

Keeping your debt under control is not impossible. All it needs is some careful planning and lots of discipline. You have to be careful and realize that defaulting on a debt will create a multitude of financial problems, both in the present and the future. Always make sure that you follow these tips when borrowing money and make sure that you get some credible financial planning advice before proceeding with any major financial decisions.

If you’re already in any form of debt, it’s not the end of the world.  You just need to get organized and committed to servicing the debt, in order to get out of the hole. Most families find themselves in credit card debt, which is the easiest form of borrowing money. The key to getting out of credit card debt is to prioritize the payments on the cards that have higher interest rates. Once you have the rates each credit card company charges you, organize a payment structure. Pay the minimum payment on all credit cards, except for the one with the highest interest rate where you should be paying much more in order to get the debt down as fast as possible.  Once that card is paid off, take the card with the next-highest rate and pay that one down. Following this payment structure will save you a lot in interest. Keep up that plan until all the cards are paid off.

Loan risk and collateral

A loan is a sum of money that you borrow now and which you can repay in the future with interest.  A lender is a person or organization that lends money.  Sometimes lenders may ask you for collateral, so that they minimize risk. In the world of financial management, risk refers to the possibility of financial loss.  Collateral is something you pledge as security for a loan. If you do not repay the loan, the lender keeps your collateral. Lenders estimate the value of your collateral to reduce their risk. There are high-risk loans, and there are low-risk loans.

Lenders look at the overall picture to determine whether you qualify for a loan.  They want to see that you are not high-risk.  A high-risk applicant is one whose financial situation indicates that they would have trouble repaying a loan. Credit status is the first thing a potential lender will look at, to qualify a loan applicant. If you maintain an excellent credit status, then qualifying for a loan will be much easier.  Also, the debt-to-income ratio shows lenders you are able to afford monthly loan payments given your income.

Stability is one of the factors at which lenders look when a person applies for a loan. If a person moves a lot, or has changed a lot of jobs within a short time, they appear to be unstable and instability is considered a high-risk factor to lenders.

As a family, you need to show stability and of course low-risk status, so that you can qualify for a loan, if need be. Make sure that you maintain stable jobs and living conditions as parents. Additionally, request a loan that your monthly salary can service, based on the debt-to-income ratio. If you are a single parent, you should rethink the possibility of a loan if it’s not an absolute necessity. In terms of collateral, often times people do not have any valuable assets to offer other than their actual homes or cars or other assets of vital importance to their daily lives and quality of life. Make sure that whatever you put down as collateral, you will be able to keep at the end of the loan agreement; don’t sacrifice any vital assets if you are not absolutely certain that you will maintain ownership at the end of the loan period.

What happens if you default on a loan?

You had every intention of paying back that loan you needed when cash was tight, but now you’ve fallen behind by a payment, or maybe two. Or maybe it isn’t likely you’ll be able to get caught up on those loan payments anytime soon. Whether the loan came from a traditional source like a bank or an alternative lender, here’s what happens when you default on a loan.

Lenders have their own guidelines for considering a loan to be in default. Some will take action after one missed payment and some will wait for months. Lenders will contact anyone who has let a loan slip into default, and as time passes, the communication will become more aggressive. In as little as 30 days after a missed payment, a lender might contact credit bureaus, which will cause the borrower’s credit score to start declining.

If the loan is a secured loan, you had to put up some kind of collateral to qualify for the loan. In that case, if you default, you will lose the collateral. An example of that is a car loan. If you default on the loan a lender gave you to purchase a vehicle, the lender can repossess that vehicle and turn around and sell it to recover the amount of the loan.  If the only way for a lender to recoup the loan and interest from you is to seize the collateral, they will.

If you didn’t put up any collateral for the loan, it is considered unsecured. If you’re behind on payments, the lender may begin adding fees and increasing the interest rate. If the lender considers a debt in default, the loan may be turned over to a collection agency. If the collection agency is unsuccessful in securing a loan repayment, the agency can take the matter to court and pursue avenues like garnishing your salary or putting a lien on your assets such as your home!

After defaulting on a loan your credit score will drop significantly, which will make it more difficult to secure credit in the future. Even if you find a lender who is willing to take a risk on you even though you have previously defaulted on a loan, the interest rate will probably be higher than it would be for someone with good credit.

The message here is very clear!  Making good decisions to start with, based on a financial plan and a monthly budget that you can follow and honor, is key. Taking out loans that you and your family can financially withstand is also fundamental. Don’t sacrifice your family’s quality of life for any reason and don’t gamble your family’s financial health for any reason whatsoever.

Lesson wrap-up

The key takeaways from today’s lesson are the following:

• Opening and maintaining the right bank accounts is a very important aspect of good money management. Your bank accounts are the center of your financial planning.
• There are different types of bank accounts which will help you get your finances in professional order.
• A debit card works like a plastic cheque. A credit card is a credit facility from a bank: Knowing the differences between credit and debit cards will help you use them appropriately.
• Credit is an arrangement that defers payment for borrowed money or a purchased item until later.
• Your credit history represents your financial reputation and it is very important to build a positive record with lenders.
• Any debt, as a whole, is not good. However, some types of debt are considered good because of the investment value they hold.
• Your personal circumstances and credit score are correlated with loan qualification and loan repayment ability.
• Defaulting on a loan will create a multitude of problems both in the present and the future.

At this point we will wrap up today’s lesson.  First, we will go over the learning objectives of this lesson and we want your feedback as to whether they have been achieved and then we will address any questions you may have.  Please feel free to ask anything you’d like in relation to today’s lesson and we would love to hear how the concepts we discussed today relate to your athlete kids and your family!