WHEN CREDIT TURNS TO DEBT AND THEN PROBLEM DEBT
Sensible use of credit
For those who are disciplined with money, there are many ways to benefit from purchasing on credit. Such as cash back incentives, protection if anything goes wrong (for example Monarch Airlines), purchases on 0% credit cards are the cheapest form of borrowing as long as you pay back the full amount outstanding within the interest free period.
It is sensible to treat all spending as if it is coming out of one pot and keep tabs on how much is spent whether it is on credit or using a debit card or cash.
The key to keeping control and benefiting from credit is to work within a budget, keep your receipts and regularly transfer money to credit cards to make sure you never pay interest, miss payments or incur those dreaded late payment charges.
Budgeting using the 50/20/30 Rule
The start is to work out how much income is coming into the household net of tax. The income is then carved up as follows:-
- 50% to cover fixed costs that stay the same each month including mortgage, utilities, insurances and car payment.
- 30% to cover variable costs such as entertainment, food shopping, clothing, etc
- 20% is put aside every month to cover savings
Ideally any purchases on credit come out of the 30% still leaving you with your savings. If you have to dip into savings to cover credit purchases this is not a disaster.
When credit becomes debt
Using credit for purchases is likely to end up becoming debt if you do not have the money available to clear your credit each month. If you are not financially disciplined and use credit to make up for a shortfall in your earnings, you will end up with your debt increasing.
What is problem debt?
Problem debt is when the minimum payments become so high they exceed 25% to 30% of your income and eat into the money you need to live on.
Total Debts £25,000
Min Payments at 2.25% of balance = £562.50
Take home Pay at £1,500
Debt payments equal 37.5% of take home pay = problem debt
HOW TO TACKLE PROBLEM DEBT
Step 1 – Work out Monthly Income and Expenditure
Pull together a budget which sets out monthly income and outgoings and works out how much money you do or do not have after budgeting for all fixed and variable expenditure. Make sure you refer to your bank statements. There are tools such as Cleo developed by young tech savvy entrepreneurs in the UK which, with your permission can connect with your bank and provide an analysis of your spending which can be hugely helpful in identifying waste and economies.
Step 2 – Pull together a list of debts and the associated monthly payments
Pull together a list of all your debts which details who you owe the money to, the current balance owed and how much your minimum or statutory payments are each month. There are free tools to help you including The Debt Advisor’s debt calculator.
Step 3 – Surplus funds DO cover debt payments
If you do have enough money to cover debt payments, there are sensible ways to make your debt payments more affordable:-
- Maximising income and benefits. There are benefit checkers such an entitledto.co.uk which can help you indentify if you are missing out on any benefits or grants.
- Review your outgoings and get rid of unnecessary expense.
- Interest free balance transfers (making sure you set payments at a level that will clear your debt in the interest free period),
- low interest loans if you have a good credit record and payments are affordable
- Refinancing your property. The latter needs careful consideration as you may well pay more in the long term however, if other options are not available and you have plenty of equity in your property, the refinancing costs are affordable, this option can work.
Avoid payday or logbook loans which have hefty interest rates.
Step 4 – Surplus funds DO NOT cover debt Payments
Your finances need very urgent attention. You may well find yourself “Robbing Peter to pay Paul” with your debts increasing.
Again the options above are very relevant including making sure you maximise your benefits/ grants and income. Is a second job needed?
Dig out your bank statements. A very detailed review of your outgoings is needed to see if you can cut back on expenditure. It’s vital your figures are accurate and you arrive at a figure that you feel is affordable to pay towards your debts.
OPTIONS TO DEAL WITH PROBLEM DEBT
The relevant options depend on your circumstances, what assets you have, your total unsecured debt, level of your monthly disposable income “DI” available to contribute to your debt. There are both informal and formal solutions which are described below. All of these solutions have benefits and risks and need to be carefully considered.
Zero % balance transfers
Relevant if you can clear all your debt from your affordable DI during the interest free period. This is only available if you have a decent credit rating.
Again only relevant if the refinancing clears all your debt and you can afford the repayments. There is no sense converting unsecured debt to secured debt and putting your property at risk if you cannot afford the payments. Refinancing without a good credit score is still possible but interest rates will be higher. The market in secured loans has significantly improved over the years and could offer a very sensible solution to consolidating debt especially if you have a mortgage on reasonable rates which you do not want to tamper with.
These are managed plans offered by fee charging companies and free to client organisations regulated by the Financial Conduct Authority, “FCA”. The plans aim to get creditors to agree to freeze interest and charges and allow you to repay back your debts at an affordable rate. Your monthly contribution must be distributed to your creditors within 5 days of clearing, net of an agreed monthly charge. Free to client DMP providers are paid a “fare share” by creditors usually around 10 to 12 % of sums paid to the creditor.
DMP’s are only relevant if based on your payments, your debts will be cleared in 10 years or less. Combining a DMP with partial settlements (see below) can offer a very effective solution at clearing your debt.
DMP’s are informal and there is no guarantee that creditors will freeze interest and charges and will not taken action to collect their debt. The DMP provider must be able to demonstrate the plans are in your interest, are regularly monitored and are effective at reducing your debt. You can withdraw from your plan at any time and no further charges should apply. You must co-operate with regular reviews which aim to ensure your plan is effective and working. Your credit rating will be effected as your debts will be defaulted and the defaults stay on your record for 6 years.
An agreement reached with your creditors to settle your debt for less than the full sum due. Creditors are unlikely to discount your debt if they believe you have assets which will clear your debt. Creditors also need to see that you are struggling to pay your debts. Partial settlements are most successful when you have been on a DMP for at least 12 to 18 months, have demonstrated to creditors you are struggling and your debts have been defaulted. Organisations offering partial settlements must be authorised by the FCA.
A formal solution which can only be put forward on your behalf by a licensed Insolvency Practitioner. IVA’s are relevant for both consumer debt (credit cards, store cards and loans) as well business debt (debts due to HMR &C and suppliers). IVA’s can also include arrears of utilities and council tax.
The terms of an IVA depend on what you can offer and your creditors’ will agree. Generally they are based on 5 to 6 year payments plans with monthly affordable contributions being paid into your IVA. Fees will apply and these must be agreed by your creditors who will usually restrict the fees chargeable.
There is a protocol that governs straight forward IVA’s. The IVA protocol has ensured that IVA’s are fair to both you and your creditors. Protocol compliant IVA’s will include clauses which include:-
- Provisions for agreed payment breaks,
- The treatment of additional earnings such as bonuses and commissions
- Variations to the agreed terms
- Default clauses – what happens if you do not adhere to the terms plus many more aspects of the IVA.
Make sure when you seek advice on IVA’s you are actually speaking to a either an FCA regulated company that can offer debt counselling or a licensed insolvency practitioner.
This is a mini bankruptcy which is only relevant if:-
- Your unsecured debts are less than £20,000
- Your surplus DI each month after reasonable household expenses is less than £50
- You are not a homeowner and do not own
As the term indicates this is the process where you are declared bankrupt and a Trustee is appointed to look into your financial affairs, investigate if you have assets (excluding your personal possessions and tools a trade) that can be sold to pay towards your debts. If you are a homeowner and you have equity in your property. Bankruptcy is unlikely to be recommended as your share of equity will transfer to your Trustee who could force a sale of the property even if it is owned jointly.
You can petition for your own bankruptcy. The process is now online and there is no longer a need to present your petition to the court. The fee for petitioning for your own bankruptcy is £680. If you cannot afford the fee, there are charities who may be able to help you gain funding to cover the cost.
If you a positive disposable income, you will be required to pay contributions to your Trustee for a 3 year period. Your Trustee has 12 months from the date of your bankruptcy to apply for an Income Payment arrangement.
Bankruptcy does have a sting in the tale. The Trustee can apply for a Bankruptcy Restriction Order “BRO” if their investigations find that you have incurred debt knowing you could not pay for it, been reckless (gambling) or fraudulent. There are other reasons for a BRO. The effects of a BRO mean that certain effects of bankruptcy continue – see more information on BRO.
SCOTTISH DEBT SOLUTIONS
If you live in Scotland there are different debt solutions available including:-
A Trust Deed is a formal binding agreement between you and your creditors. The proposal normally provides for you to make monthly contributions over a pre-agreed period of time, which is usually a minimum of 4 years. You are protected from creditor action and interest and charges accruing from the date of approval. Monthly payments will be based on what you can afford. Any debts remaining at the end of the period of the Trust Deed are written off.
If you have equity in your property this will need to be realised. Depending on your debt level a Debt Arrangement Scheme “DAS” may be a better alternative, see below.
DAS is a government managed solution which allows you to repay your debts through a debt payment programme (DPP). The DPP will allow you to pay off your debts over an extended period of time while giving you protection from your creditors taking action against you to recover the debt in the DPP. The DPP can last for any reasonable length of time and, if approved, will freeze all interest and charges on the debt included, resulting in them being waived if you fully complete the DPP. The DPP is not a form of insolvency.
Bankruptcy or Sequestration is a legal order which confirms to your creditors you are unable to repay the money you have borrowed. It involves you agreeing to pay what you can afford for 48 months and your Trustee gathering in your assets which are not excluded. These assets are turned into cash to cover the costs of bankruptcy and your debts.
Bankruptcy prevents creditors being able to pursue you or take legal action against you to recover what they are owed. You will not have to make any further payments directly to creditors, although you have to pay what you can afford in to your Bankruptcy for 48 months, if this is a Full Administration Bankruptcy. You are only bankrupt normally for 1 year although this period can be longer if you do not co-operate with your Trustee.
If you find you need some help with problem debt, get in touch. As detailed above there a range of solutions depending on whether you are salaried or self employed or you are a director or shareholder of a limited company. Should you enter into a debt solution with us, fees will apply. If you would like our team to call you, please use our contact form.
All debt solutions need to be carefully considered. IVA’s are formal solutions and failure to keep to the terms can result in your IVA failing and you could end up bankrupt.
There is also free debt help and advice available through a variety of debt charities. For more information, we recommend you visit www.moneyadviceservice.org.uk.
The Debt Advisor is Authorised and regulated by The Financial Conduct Authority (reg no: 659920).
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