Preventing Over-indebtedness

Before the COVID-19 pandemic, a large portion of the country was struggling with debt and many estimate that one in ten people were either over-indebted or on the verge of being so. To clarify, someone is considered over-indebted when they can’t face their non-professional debts anymore and struggle to keep up with daily expenses on a reoccurring basis. According to the Urban Institute, roughly 64 million people with a credit record (about 28% of Americans) had debt in collections on their credit report.

A few months into the pandemic, the unemployment rate hit a peak of 14.8% (April 2020), the highest level since 1948, and although that has come down, Americans are now seeing the cost-of-living rise at a much faster pace than income in recent years. In fact, for the last two calendar years, median household income fell 3%, while the overall cost of living was up 7%, according to a study by NerdWallet. The study also found that roughly 18% of Americans relied on credit cards to pay for necessities during the pandemic, and 17% relied on them for emergencies.

According to the Quarterly Report on Household Debt and Credit from the Federal Reserve Bank of New York, total household debt rose $266 billion, to $15.84 trillion, during the first quarter of 2022, and balances now stand $1.7 trillion higher than at the end of 2019, before the COVID-19 pandemic. Credit card balances were $71 billion higher than in the first quarter of 2021, representing a substantial year-over-year increase. Meanwhile, along with rapid price increases, the average credit card interest rate rose by two percentage points during 2021, which has put further strain on households that are already struggling.

Given the continued challenges that we as consumers face with rising prices from shortages and supply chain issues, we wanted to provide some valuable tips for how to deal with a tightening budget and prevent over-indebtedness.

Good planning is never a bad idea

1. Create a budget: Current expenses and include any debt payoff goals.
2. Mortgage coverage: When you take out a mortgage, make sure to take out a credit insurance as well which will protect you in case of financial difficulties that could potentially disrupt your budget.
3. Balance your budget: Especially during tighter periods:
   • Reduce your current standard of living and only buy the necessities.
   • Don’t make unnecessary purchases and take advantage of special offers when shopping for essentials.
   • Look at all the opportunities to increase your income (wage increase, overtime, claiming all the allowances to which you are entitled, etc.).
   • Take advantage of the benefits of all the insurances you have taken out (disability, job loss, etc.).
   • Reduce your over-indebtedness and earn some cash by selling valuable goods.
4. Start saving now: Put aside as much as you can now to make incidental and unexpected expenses easier.

What not to do

1. Avoid late payments: They are expensive and can impact your credit score.
2. Don’t take out new loans
3. Avoid using revolving credit
4. Be wary of combing loans: It may reduce your costs immediately by lowering your monthly payments but could increase your overall debt by extending the loan period.

What to do if you’re currently in debt

1. Create List of all debts: It might be painful, but you need to see the full picture.
   1. Include the interest rates and required monthly payments.
   2. Mint.com and Ramsey Solutions have good online tools to assist with this.
2. Start an emergency fund
   1. Before tackling debt, put aside somewhere in the range of $1,000 to $2,000.
   2. Unplanned expenses (flat tires, parking tickets, medical bills) will happen and if you don’t have cash set aside, you will be tempted to use credit cards and go further into debt.
3. Immediately contact all creditors
   1. Contact all nonmortgage creditors to negotiate additional time to repay or reschedule your loans.
   2. Ask about any other promotional offers.
4. Choose best payoff method: Highest interest rate first, or snowball method
   1. The math might lean towards paying down higher interest rate nonmortgage debt first, but unless the rates on the various debts are widely different, we recommend the debt snowball method.
   2. Here you try to tackle debt from smallest to largest. Once one debt is gone, you put all the money you were throwing at it onto the next smallest debt, with the point here being about momentum and staying motivated.
5. Get help along the way and don’t give up: You’re not in this alone!
   1. There are plenty of free resources online, as well as in person pro-bono financial advisors.
   2. Call us (202-887-8135) or the Financial Planning Association (FPA) (800-322-4237)