Counseling Clients on Credit

f the 76 million baby boomers, almost 40% owe more than they own. That means many of the clients a CPA financial planner counsels have trouble paying their bills. The greatest need of clients who walk in the door looking for investment or estate planning advice is often debt management. Yet this critical element of any financial plan often receives scant attention because the traditional approach planners take does not start with the assumption that a client needs debt counseling. Investment return doesn’t mean much, however—and there won’t be anything left for heirs—if the client’s solvency is at issue.

Consumer debt is at an all-time high. According to the Federal Reserve, Americans owed $1.33 trillion, excluding mortgage debt, at the beginning of 1999. With the average American now spending more than 10% of his or her discretionary income on monthly interest payments, excluding mortgages and car leases, CPAs can provide clients with a valuable service by helping them better manage their resources.

Causes of Financial Problems

Source: Consumer Credit Counseling Service client profile.

WHAT IS DEBT MANAGEMENT?

Debt management is a broad term whose meaning varies depending on the debt status of the individual to whom it applies. For those overburdened with debt, debt management means paying down what they owe. For others, it means increasing debt, particularly low-interest debt that is tax deductible and favorably leveraged (“good” debt). Such debt is critical to any strategy for creating personal wealth. It also is essential for meeting short-term cash needs when the six-month emergency cash reserve commonly called for by financial planners is not available.

While the techniques discussed here focus on clients who are overextended, they can be adapted for those needing to increase their good debt.

HOW MUCH IS TOO MUCH?

Most lenders and credit counselors recommend that families limit debt payments to 36% of gross income, mortgage payments to 28% of income and installment payments to 20%. All of these benchmarks, however, have increased in recent years largely because of better secondary markets for these types of loans. For some clients, the benchmarks may be too high because of their propensity to overspend.

Other indicators of excessive client debt that CPAs and other financial planners may look for include

• Purchasing many items on extended payment plans.
• Having only a vague idea of how much they owe.
• Being able to make only the minimum payments on credit cards and other revolving debt.
• Reaching the maximum limits on credit cards.
• Borrowing from one source to pay another debt (for example, using cash advances from one credit card to pay off the balance on another).
• Borrowing to pay for things that normally are purchased with cash, such as groceries.
• Skipping some debt payments to make other payments.
• Making late payments on basic obligations, such as rent or utilities.
• Making bill payments by either taking out a new line of credit or using unused lines of credit.

GOOD DEBT

A client’s home mortgage, which normally carries the lowest interest rate of any consumer debt, may be the best debt he or she incurs. It creates favorable leverage to the extent a home financed with low-interest, tax deductible debt appreciates in value.

Under IRC section 163(h)(3), interest on qualified residence debt of $1 million ($500,000 for married persons filing separately) or less is tax deductible if (1) the debt is used to buy, build or substantially improve the taxpayer’s qualified residence or to refinance debt originally used for one of these purposes and (2) the loan is secured by the qualified residence (that is, by a recorded mortgage or deed of trust on the property). A qualified residence includes the taxpayer’s principal residence and a second residence if it meets the statutory personal use requirements. If the taxpayer rents the second residence to others, IRC section 280(d)(1) requires that his or her personal use exceed the greater of 14 days or 10% of the number of days during the year the property is rented at fair rental. If the second residence is not rented to others, IRC section 163(h)(4)(A)(iii) exempts the unit from this personal use requirement.

How much down? Taxpayers often make down payments that exceed lender requirements or pay extra amounts each month. To pay off mortgages as quickly as possible, however, they may find it more beneficial to minimize the equity in their homes and invest the difference in a faster growth vehicle such as a mutual fund. For example, consider a client who purchases a $300,000 home by putting 10% down, rather than the 50% she can afford, and signing a 7.5% mortgage for the balance. If the client invests the $120,000 difference (10% down vs. 50% down) in a long-term growth mutual fund, where returns historically have averaged in the low double digits, she will be better off. As the fund grows at a double-digit rate, it can be used to pay off the single-digit mortgage.

Cash-out refinancing. The 10%-down client may further benefit by withdrawing the home equity via cash-out refinancing and investing the proceeds in a long-term-growth mutual fund. A client might do this anytime he or she qualifies for a long-term variable-rate cash-out loan with no points or costs. Realistically, however, the terms of the loan or the client’s desire to build home equity may limit the frequency of this transaction. The drawback to this strategy is that interest on the new loan in excess of the balance of the old mortgage is not deductible as qualified residential interest. The excess interest is investment interest (deductible) or passive activity interest (deductible only to the extent of passive activity income), depending on the nature of the investment made.

Home equity loans. An alternative, or perhaps complementary, strategy is a home equity loan. IRC section 163(h)(3)(C) permits a taxpayer to deduct interest on home equity debt (second mortgage or home equity credit line) secured by a qualified residence that does not exceed the lesser of (1) $100,000 ($50,000 for married persons filing separately) or (2) the taxpayer’s equity in the home (fair market value reduced by the debt used to buy, build or substantially improve the home). The deduction generally is permitted regardless of how the taxpayer spends the proceeds.

Cash-out refinancing combined with home equity loan. Assume Jim and Mary Bates buy a $300,000 home in 1995, putting $30,000 down and signing a $270,000 mortgage for the balance. In 2000, when the home’s fair market value is $400,000 and the remaining mortgage balance is $220,000, they refinance with a $360,000 mortgage. Jim and Mary invest the $140,000 remaining after repaying the old mortgage ($360,000 – $220,000) in a mutual fund. Interest on the new mortgage is fully deductible: $270,000 is acquisition debt and the $90,000 balance is home equity debt. The $90,000 qualifies as home equity debt because it is secured by the Bates’ personal residence and the amount is below the lesser of (1) $100,000 or (2) the Bates’ equity in their home ($400,000 fair market value less $270,000 acquisition debt).

A home equity loan also can be used as an alternative to cash-out refinancing. The arbitrage relationship, however, may not be as beneficial because a home equity loan normally carries a higher interest rate and has a shorter amortization period. Still, for overall debt management, a home equity loan can be a good way to pay off or consolidate debt. Compared with credit card debt, auto loans and other types of personal debt, it offers the advantages of deductibility and lower interest rates.

Reverse mortgage. A reverse mortgage (also called a home equity conversion mortgage) may be an effective debt management tool for senior citizens. It allows a client who has built up equity in a home to borrow against it and delay paying both interest and principal until he or she sells, leaves or transfers title to the property—usually at death. A disadvantage of this strategy is that the interest is not tax deductible.

Historically, lenders have marketed reverse mortgages to senior citizens needing cash for emergencies such as home or auto repairs, medicine, groceries and insurance. Wealthier clients, however, can find the reverse mortgage an effective estate planning tool, say, by using reverse mortgage proceeds to purchase life insurance in an irrevocable trust. The insurance death benefit can exceed the amount borrowed, enjoy a step-up in basis and not be subject to income or estate taxes. Moreover, the transaction can provide the liquidity needed to pay estate taxes.

Less wealthy clients also can find estate planning uses for the reverse mortgage. If most assets are tied up in a closely held business, for example, a client can use the mortgage proceeds to buy life insurance for estate equalization among heirs. Other uses include paying estate settlement costs, supplementing a retirement plan or providing the liquidity to make cash gifts.

AUTO LOANS

Escalating new car prices (the average is $22,000) can leave clients with auto-related debt exceeding their home mortgages. Total U.S. automobile debt at the end of the 1999 first quarter was $465.7 billion. While lower interest rates and a strong economy have made it easier to meet monthly payments, many consumers still need help to afford the vehicles they want. Longer loan terms, prudent car and loan shopping and leasing are options to consider—as well as areas where CPAs can offer valuable advice to clients.

Increasing the term of a car loan lowers the monthly payment but can raise the interest rate. Even if the rates are the same, a client will pay more total interest and still be making car payments when repair costs begin to mount. Exhibit 1 compares the monthly payments and interest costs for four loan terms. If the client drives the car 15,000 miles a year, repair costs may be significant enough during the last year of a 72-month loan (when mileage goes from 75,000 to 90,000) to negate the advantage of the lower monthly payments.

Finding the best vehicle deal and the best loan terms are independent activities. A client should negotiate the purchase before considering financing sources. Although searching the Internet provides a rough estimate of current interest rates, those rates ordinarily are negotiable. Exhibit 2 lists several financing sources and briefly describes what consumers can expect from each.

Leasing rather than buying an automobile also produces a lower monthly payment and now accounts for one-third of the vehicles transferred from dealers. Since a lease is a form of financing, clients must be as diligent in evaluating auto leases as they are in evaluating other debt transactions. Exhibit 3 highlights the advantages and disadvantages of leasing compared with buying a car. (For a complete discussion of how CPAs can help clients make the lease vs. buy decision, see “Buy or Lease: The Eternal Question,” JofA, Apr.99 page 25.)

CREDIT CARD DEBT: CONSUMER NEMESIS

Newspapers, nightly news clips and other sources lament the staggering burden consumers put on themselves and the nation with their use of credit cards. At the end of the 1999 first quarter, a Federal Reserve report showed outstanding revolving credit—which includes credit card and department store accounts—had reached a record high of $562.8 billion, with the delinquent rate on accounts 30 days or more overdue at 5.11%. Personal bankruptcy filings, the natural offspring of delinquent accounts, set new records in 1998—1 bankruptcy for every 68 households and total bankruptcies of 1.4 million. The only positive trend is that the rates of both new revolving debt and bankruptcy filings showed some signs of slowing in early 1999.

Some blame credit card companies for these soaring statistics, because they make credit sound tempting and are relentless in their efforts to sign up new customers. College students are particularly vulnerable, as indicated by the sharp increase in the number of such students with cards in their own names and the growth in account balances. In response, many colleges and universities have banned or restricted credit card marketing on campus.

An even more disturbing trend to CPAs is the financing of business operations by credit cards, now the number-one means used by small business entrepreneurs. If a credit card balance is paid in full each month, the card is merely a convenient form of business financing. But if the balance is not paid in full, the interest charges can be prohibitive and eventually erode the capital that could be reinvested in the business.

Clients also may now use credit cards to pay their federal income taxes, although they must pay a 1.5% to 2% fee for the convenience because by law the IRS can’t absorb the fees merchants normally pay. Some clients pay that fee willingly because of the perks, including frequent-flyer miles or cash-back rewards, attached to their cards. In advising clients on this practice, CPAs should caution them that not all companies (VISA, for example) participate in the program and those that do may not honor their perk commitments (or may limit them). Moreover, unless the client pays the balance in full when billed, the interest charges—at the normally steep credit card rate—begin accruing. At 17%, the interest on a $50,000 tax bill can be more than $700 for just one month.

Exhibit 4 lists some tips CPAs can pass along to their clients to help them use cards more wisely. However, if a client’s credit card debt, or total personal debt, greatly exceeds his or her available cash, these tips may not be enough. More drastic measures—borrowing against retirement funds, tapping a “cheaper” debt source such as an investment margin account, changing spending habits, negotiating with creditors and, as a last resort, bankruptcy—may be needed to restore solvency and, if possible, savings.

BORROWING AGAINST THE FUTURE

Borrowing against retirement funds—401(k) plans in particular—is a tempting, but not necessarily wise, option for those who need cash to pay debts. There’s no application fee or credit check, the interest rate usually is favorable (close to the prime rate), the employee pays himself or herself the interest and the loan normally can be repaid through payroll deductions. IRC section 72(p) allows a taxpayer to borrow one-half of the amount in his or her 401(k), subject to a maximum of $50,000.

The normal loan repayment period is 5 years, but if the taxpayer uses the loan to buy a house, the repayment period is 15 or 30 years. The application period, however, may be as long as two months. To obtain the loan funds, the employer sells the employee’s investments in the same proportion in which the money was invested (for example, 60% from a growth mutual fund, 30% from a balanced fund and 10% from a bond fund).

Despite the attractiveness of borrowing from a 401(k), employees generally should avoid this option. The borrowed money loses its potential for growth from interest or dividends and market appreciation. The employee also pays income taxes twice on loan payments: the loan is repaid with aftertax dollars and the repaid amount is taxed when it is withdrawn for retirement. An employee changing jobs must repay the loan in 90 days or pay tax on the amount owed, plus a 10% penalty if he or she is under age 59 1/2. Unless the employer permits the employee to continue making regular pretax contributions while the loan is outstanding, he or she forgoes the earnings on the contributions as well as on the employer’s match and related earnings.

TAPPING A MARGIN ACCOUNT

A margin account is a revolving line of credit against the value of the securities in a nonretirement brokerage account. Clients who normally use margin accounts to purchase additional securities also can use them to consolidate debt or finance the purchase of other assets. Once an individual establishes a margin account, he or she can access it by writing a check or having the broker withdraw the money.

The account is charged interest monthly, but there is no set repayment schedule. However, if the securities’ market value declines below the brokerage’s minimum required amount (usually around 30% of the portfolio’s value), the individual may have to deposit more money or securities to maintain the same borrowing potential. To reduce this risk, CPAs should advise clients to borrow less than the maximum (25%, for example) and borrow against less volatile securities.

The interest rate on a margin account is generally competitive and tied to either the prime rate or the brokerage rate. An individual usually can borrow up to 50% of the value of his or her nonretirement securities and deduct the interest under IRC section 163(d). To do this, however, the taxpayer probably needs to keep tax-exempt securities out of the margin account. The combination of tax-exempt securities and an interest deduction—even on a loan against a taxable security—usually attracts IRS attention (IRC section 265).

CUT SPENDING TO REDUCE DEBT

The best way for most clients—the only way for some—to reduce their debt is to reduce their spending. First, however, a client needs to understand his or her current financial situation, as captured in exhibit 5. To obtain the monthly expense information, ask the client (and his or her family) to track all expenses—from the purchase of a cup of coffee on the way to work to the payment of the mortgage—for at least a year. For expenses that are paid semiannually or annually (for example, car insurance or magazine subscriptions), use a monthly average.

Shortly after the tracking begins, the CPA should help the client prepare a budget. The client’s check register and credit card statements can provide the information to complete this task until the one-year expense tracking is complete. The CPA should also help the client establish a mechanism for comparing actual and budgeted expenditures and develop a plan for living within the budgeted amounts. Many CPA firms either have or can develop software to do this. If not, both Intuit’s Quicken and Microsoft Money have good programs to track expenses and prepare budgets.

While living within the budget ultimately is the client’s responsibility, the CPA can help in a number of ways.

• Direct the client toward discretionary expenses (movies, magazine subscriptions, compact disks, country club or health club memberships) that can be reduced or eliminated.
• Use one of the client’s planned consumer product purchases to show the benefits of saving and investing to purchase the product rather than buying it on credit.
• Obtain a copy of the client’s credit card report (see sources and consumer rights in exhibit 6) to ensure its accuracy as well as the accuracy of the debts the client listed in exhibit 5.
• Develop a debt reduction plan that sets priorities for debt (first, child support, taxes, mortgage, rent, car loans and utilities; second, credit cards and unsecured debts; and third, medical and hospital bills), directs the savings in discretionary expenses toward outstanding debt and channels any additional sources of income to debt reduction. (Both Quicken Deluxe 2000 and Microsoft Money 2000 have debt reduction plans that work well, particularly if the client uses these programs to track expenses and budgeting.)

In paying down credit card and unsecured debt, the client should start with the highest interest debt and consider a debt consolidation loan. Debt consolidation is an option often touted by financial institutions. To maximize its benefits, the client should be wary of the marketing ploy of making lower monthly payments and going deeper into debt. A home equity loan usually is the best loan consolidation vehicle if the client satisfies the requirements for deducting the interest.

If it’s clear from the debt reduction plan that a client will be unable to make debt payments on time, the CPA should offer to contact or go with the client to talk to creditors. Many creditors will renegotiate loans and make other concessions if the client has a repayment plan. Creditors are well aware that the alternative—forcing bankruptcy—may leave them with nothing.

A LAST RESORT

Bankruptcy is not a panacea for debtors, although in some cases it cannot be avoided. In others, it simply is the best option. Under existing bankruptcy laws, individuals normally file under Chapter 7 (over 70% of the filings) or Chapter 13. Chapter 11 also is available to individuals but is more commonly used by businesses.

Chapter 7 wipes the slate clean except for alimony, child support, student loans and three years of back taxes. To obtain this fresh start (available only once every six years), the debtor must give up most assets. Federal law provides a list of exempt property, but the individual may choose, or in some cases be forced, to follow state guidelines. The exemption for the individual’s personal residence varies widely—from a low of $5,000 in Alabama to an unlimited amount in Texas and Florida. Generally, the individual can keep one car, basic clothing and household items, life insurance and a limited amount of jewelry. Chapter 7 also protects future income and future assets as well as tax-deferred retirement accounts.

Chapter 13 reorganizes an individual’s debts instead of eliminating them. To qualify, the individual cannot have more than $250,000 in unsecured debts, such as credit cards, or $750,000 in secured debt, such as a mortgage or car loan. In a reorganization, the emphasis is on the debtor’s repaying as much as possible (normally during a three-year period) while retaining a reasonable amount of income. Under Chapter 13, the debtor also keeps most of his or her property.

Bankruptcy reform bills passed by the House and Senate in 1998 will push more debtors toward Chapter 13. Under both bills, the debtor who exceeds specified income levels will be ineligible for debt relief under Chapter 7 and will have to repay part of his or her debts under a Chapter 13 repayment plan. The bills also change the property exemptions under Chapter 7 but differ on how this should be done.

For a complete analysis of existing and proposed bankruptcy provisions that CPAs should be familiar with to advise clients, see “A New Chapter in Bankruptcy Reform,” JofA, Feb.99, page 47. As that article emphasizes, CPAs play a secondary role in advising clients on bankruptcy. Individuals need to seek the counsel of a bankruptcy attorney to file the bankruptcy petition and direct the process.

After the courts close a client’s bankruptcy case, the CPA should advise the client to reestablish his or her credit. Generally, debtors who file under Chapter 7 find this more difficult than those filing under Chapter 13. Because of this, some jurisdictions offer debtor education programs in conjunction with Chapter 13 filings. If that option is not available, the CPA should advise the client to obtain a “secured” credit card, which requires the debtor to deposit money as collateral for the credit card charges. Each use of the card gives the debtor an opportunity to prove he or she can use credit responsibly.

CONSIDER ALL THE OPTIONS

Like many other personal financial planners, CPAs often ignore debt management when developing personal financial plans for their clients. Yet, given the number of individuals—even some high net worth clients—who have trouble paying their bills, it cannot be ignored. When clients are overloaded with debt, they usually fail to consider all of the available options. They tend to think first of the obvious—borrowing from a 401(k) or declaring bankruptcy—which may be the least preferred options. CPAs familiar with the pros and cons of each alternative are better able to provide their clients with the advice needed to develop solutions.