The Spontaneous Combustion of Your Loan Management
If you own a garage or remember high school chemistry, you should be familiar with spontaneous combustion: when something like oil-soaked rags burst into flames without a spark or flame igniting them. If you’re not familiar with the concept, you may want to read up on it to avoid accidentally starting a fire. Just as dangerous is spontaneous debt, which can have as damaging an effect as a fire spontaneously starting in your garage.
Spontaneous Business Debt
Similar to spontaneous combustion, spontaneous debt financing happens without prior planning or forethought. When I teach entrepreneurship or advise business owners, we discuss the sources of and problems created by spontaneous debt financing. One place we look is at the accounts payable they accrue from buying raw materials on credit terms. As the business’ sales grow, there is a greater need for more and more inventory, and a corresponding increase in debt.
The danger of this type of debt is it isn’t planned for. Worse, because it is created by increasing revenues, the true costs of the debt can be hidden by a growing income statement. When circumstances change, however, the business can be put in a situation where it can no longer handle the increased debt and interest payments.
Spontaneous Personal Debt
Business owners aren’t the only people in danger of succumbing to unplanned debt. Even those who are skilled at debt management can be impacted because spontaneous debt isn’t planned. If it isn’t controlled, however, this debt can become a significant drag on achieving your financial goals.
The most common sources of spontaneous debt in your personal finances include life emergencies, lines of credit, and those attractive 0% APR loan offers for purchases.
Life Emergencies
No matter how debt averse you are, an unexpected life emergency can easily add debt to your net worth statement. The best way to manage life emergencies is with an emergency fund, but unfortunately many don’t know how much money should be in an emergency fund. As a result, unexpected emergencies can quickly burn through savings and begin accumulating debt.
A broken car results in a quick need for a new car and a new car loan. Even if the car can be fixed, the cost may be more than your emergency fund can handle. Similarly, not withholding enough for income taxes or being subject to the Alternative Minimum Tax can result in a significant unexpected tax bill come April. Without a significant emergency fund, these expenses will quickly turn into a climbing debt burden.
The most devastating spontaneous debt stems from unexpected medical bills. Health care costs are consistently the most common cause of bankruptcy, accounting for over 60% of bankruptcies according to a study in the American Journal of Medicine. A Kaiser Family Foundation study found 53% of people without insurance will struggle paying medical bills. Even one in five families with health insurance reported struggling with paying medical bills.
Dealing with life’s emergencies isn’t as simple as ‘acting responsibly.’ To solve the problem, beef up your emergency fund to include more than just a few month’s expenses. And to deal with medical emergencies, keep a separate emergency fund for medical bills. The fund should be at least large enough to cover the annual-out-of-pocket limit on your family’s health insurance.
Lines of Credit
If you have a line of credit, there is significant risk the balance can creep up on you. Most people have a story of credit card creep, especially when they first began using their credit card. Everyday purchases like gas and groceries began the creep. But as you found it so painless to use the card, you began making larger grocery trips than you would with cash. Then you began putting dinner with friends and drinks on the card. Before you knew it, you had a much larger balance than you could pay off in a month and a downward spiral began. You may have found a way to manage credit card creep, but that doesn’t mean you are out danger.
When you get a Home Equity Line of Credit (HELOC), you are in much the same position of danger as when you got that first credit card. Many begin using a HELOC for the kitchen remodel it was originally intended for.
Of course, when you remodel the kitchen you may also want new dishware and chairs to match the fancy new look. Since technically it’s stuff that goes in the kitchen area, you rationalize it as being a part of the remodel and use HELOC money to make the purchase.
Additional purchases follow for upgrading the living room, finally finishing the garage, and taking the family on vacation. Before you know it, your ‘moderate’ HELOC loan becomes a significant drain on your finances, and the higher interest rate makes it significantly more costly than the same dollars borrowed on your home.
To stop this creep, minimize the maximum loan amount for any HELOC or other line of credit. Also, develop a plan for repayment which includes a maximum repayment period. (Credit cards should be repaid in full each month). Keep track of the monthly payment it would take to repay the loan in that time period and as it approaches an amount which would strain your budget, stop using the line of credit. Finally, other than a credit card you pay off each month, don’t carry any line of credit debit cards or check books with you. Place them in a locked safe or filing cabinet so you have an opportunity to consider the decision before you use the line of credit.
0% APR Purchase Offers
It seems nearly every store now offers financing on purchases, and most of them offer zero interest and/or zero payments for a year or more. As you make these purchases, you’re slowly increasing your debt. And the amazing credit terms hide the potential debt crisis which could be looming over your family. You may think you are getting a great deal as an incentive to buy the store’s goods, but in reality you are getting deeper into debt.
The truth is, retail stores aren’t in the business of lending money. When you make a purchase utilizing one of these offers, you are signing up for a loan tied to a credit card. And the credit card company isn’t in the business of giving free money.
Offers at 0% have a lot of hidden catches to them, and the credit card companies expect a significant portion of the buyers to get caught. Making a late payment, forgetting a minimum payment, or not paying off 100% of the loan on the exact date the offer expires will all cancel the 0% APR. The credit card company will charge a surprisingly high interest rate, and they will do it retroactively to the day you purchased the good. That’s right, you’ll end up paying all the back interest for the entire “0% offer” period.
You can easily avoid increasing your debt by avoiding these 0% APR offers and instead saving up for the item. If you do utilize the offer, set a payment schedule for yourself where you transfer monthly payments into a savings account to be used to pay off the card. Then, send the entire payment amount at least one month before the offer expiration date. Finally, if there is a minimum payment required, set up automatic payments through your bank’s online bill pay so you can ensure every payment will be made on time. Learn how to automate your bills.
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Joshua Escalante Troesh is a tenured professor of Business at El Camino College and the founder of Purposeful Finance. His career provides him with a unique insight on personal financial, having been a VP at a financial institution leading up to 2008, and involved with technology and internet stock research leading up to 2000. He can be reached for comment at info@purposefulfinance.org