Charles Phelan

I’m writing this post to cover a subject that comes up frequently when people are exploring the debt settlement strategy. I’m referring to the arithmetic of debt settlement. Many consumers get hung up on the math involved, and this topic usually comes up as a concern or an objection to using the settlement strategy. It often gets expressed as a question: “What happens to all that extra interest and the late fees the bank will keep charging me? Will they waive that when I settle with them?”

The short answer is: “No, they won’t. But you shouldn’t care anyway!”

In order to understand why, it’s necessary to dig into the mathematics of credit card debt. Let’s say you have $50,000 of credit card debt, and you have reasonably low rates on all the accounts because you haven’t hit the wall yet and starting missing payments (although you’re about to fall behind or you probably wouldn’t be reading this). A normal level of minimum payments on $50,000 of credit card debt would be around $1,250 per month. That translates to around $15,000 in minimum payments on an annual basis.

At that minimum-payment pace, it will take 10 years or more to pay off the debt, depending on your interest rates. Let’s assume it would take “only” 10 years to pay off the debt this way. That means the total payout would be $150,000 ($15,000 per year for 10 years). Bear in mind that a 10-year payoff scenario via minimum payments is very unrealistic. The reason is because one missed payment during that entire time is enough to trigger sky-high interest rates across the board, resulting in a much longer payoff period, like 20-30 years or more.

The key point to understand in the above figures is this: Basically, you’re paying $15,000 per year for the privilege of STAYING IN DEBT, to the tune of $50,000. Now, if you get off the payment train, you can certainly expect the train to continue rolling down the tracks without you! So, if you temporarily suspend payments, the total debt level will inflate quickly, simply because you’re not sending in enough to cover the finance charges that will continue to accrue.

Let’s say your average interest rate climbs to 28% and you also start getting hit with $39 late fees. Let’s also assume the $50,000 is spread across 6 different credit card accounts. Over the initial period of 6 months, the $50,000 of debt will inflate by around $8,400 based on these figures, and now you’ll owe $58,400, not $50,000. Around $7,000 of that inflation is due to interest ($50,000 at 28% APR for six months) and the rest is late fees ($39 per month on 6 accounts for 6 months).

But hold on a minute! You haven’t been making payments, right? Remember the $1,250 per month you were shelling out, just to stay in debt for the next 10 years (or worse)? Well, save up 6 months’ worth of that minimum payment moolah and now you have $7,500 sitting in the bank. So the TRUE inflation is around $900, and NOT $8,400, because you have to factor in the $7,500 that you have set aside.

OK, so how much debt can you get rid of for $7,500? If you settle one or two of your accounts at 50%, that $7,500 will clear out $15,000 of debt, leaving you $43,400 in debt, not $58,400. And if you do better, with an average settlement of 40% (which is very realistic in many cases), then your $7,500 will retire $18,750 of debt, leaving you with $39,650 of debt remaining to settle. So over the course of six months, you’ve already made a HUGE dent in a total debt load that would have otherwise taken at least 10 years to pay off, if not much longer.

Now, at the end of that initial 6-month period, the accounts you were unable to settle (for lack of funds) will go through the standard charge-off process and get assigned to collection agencies. Normally, the late fees and interest will stop at that point, although in some cases the inflation will continue. It’s mostly the debt purchasers that try to inflate the debt by back-dating interest to the point of charge-off. But the worst of the inflation of debt stops after charge-off, which allows consumers to continue repeating the above process until they have successfully eliminated all their debt in a 1-3 year time-frame. The program duration is dictated by the pace at which you can accumulate funds toward settlements.

Any way you slice it, settlement makes sense mathematically. Once you realize that your $50,000 debt problem is NOT a $50,000 problem, but really a $150,000, $200,000, or $250,000 problem (when paid back via minimums only), then you’ll see that the inflation factor (while you’re waiting to settle) is no big deal. Even if you end up paying out $50,000 over a 3-year program, isn’t that a whole lot better than paying out $150-250k over the next 10-20 years?

The true tragedy of credit card debt is that most people have sufficient cash flow to settle out their accounts. In our example, you were paying $15,000 a year in minimum payments, but not getting anywhere. Three years of that equals $45,000, and is plenty to retire the full debt load even after it inflates significantly due to interest and fees. It’s just that the banks have people caught in the spring-loaded steel trap of relentless credit card mathematics. But it’s only a trap when you play the game the way the banks want you to, that is, to be hostage to minimum payments for the rest of your life. Once you take charge of the situation, suddenly the math starts to turn around and work in your favor again.

In my previous post, I debunked one of the pitches used by settlement company sales reps, namely that such companies supposedly bundle numerous accounts together so they can get a lower overall settlement percentage. In this post, I’ll tackle another commonly heard sales tactic. This one usually comes from “debt elimination” firms which I consider to be nothing more than scams, as well as debt settlement company reps. Here’s the basic pitch:

“The credit card banks don’t actually lose any money when you stop paying them. The reason is because they recover 60% of the money through insurance claims, another 30% through tax credits, and the remaining 10% by selling the account to a debt purchaser.”

Sure, right. If you believe this claim, then you might be interested in a nice bridge that I’d be willing to sell you for a very reasonable price!

Before I expose the reality behind this nonsense, let’s ask the obvious question. Why would a debt company allow its reps to make this claim to a prospective client? I can certainly understand why the scam operators would allow it, because 99% of what they say is bogus anyway, and also because they are actively trying to convince people that it’s OK to walk away from their obligations.

But there are also debt settlement companies that peddle this particular brand of horse manure to the public. Why? Simple. It’s an easy way to overcome sales resistance. There is a key fact about debt settlement that must be understood. No bank will settle with you if you are making regular monthly payments, period. Yet most people are reluctant to stop paying their minimum monthly payments.

Now, it’s one thing to adopt this aggressive debt reduction approach if you simply can’t keep up your minimum payments, and your only other option is bankruptcy (especially Chapter 13 bankruptcy). It’s another thing entirely to use this method when you have better options. But the larger debt settlement companies are volume driven, and their success often depends on getting people who are “on the fence” to go ahead and enroll.

The average person is honest and used to paying their bills on time every month, even when it’s a struggle. It’s a big decision to get off the payment train and let the train roll down the tracks without you. Sometimes a little push is required, and that’s where this sale pitch can come in handy. When a person resists the idea that they should stop paying their minimums, the rep assures the client that it’s really no problem at all.

Let’s not kid ourselves, people. When you don’t pay a credit card debt and the bank is forced to write off the account (at charge-off), they take a loss. There are no ifs, ands, or buts about it. A loss is a loss, period, and wishful thinking will not make it otherwise. Debt settlement involves a compromise where the creditor gets back *something* – less than the client owes on the debt – but probably more than they would receive if the client chose to file bankruptcy. So debt settlement represents an opportunity for the bank to “lose less.” But there is still a true loss involved.

What about the sales pitch described above? Is there any truth at all to it? Nope. Let’s take this claim apart one piece at a time. For starters, the average selling price of a debt account is less than 4 cents on the dollar, not 10 cents. A debt purchaser that consistently paid 10 cents on the dollar would quickly go out of business, simply because they never collect anything on most of the accounts purchased. Second, there is no “tax credit” when a creditor writes off a bad debt. Only someone who flunked accounting would make such a claim. Sure, if a bank loses $10,000 in writing off your account, they may pay $3,000 less in taxes (assuming a 30% corporate tax bracket). But this is not a tax *credit* at all. Rather, the loss reduces the tax owed, but that’s because it was a LOSS!

Finally, what about this notion of “insurance”? Folks, there is no such thing as an insurance policy that protects a credit card bank from customers who default on their obligations. The reason is simple enough, really. The COST in premium payments for the policy would be greater than the amount of losses involved, by definition. Otherwise, the insurance company could not make any money on the product, and insurance companies do not operate for charitable purposes! Unlike life insurance, where a company can spread the statistical risk of a single person dying early (before life expectancy) against a pool of thousands of people, there is no way to spread the risk of credit card defaults. Where would the insurance company spread the risk to? This myth probably originated when someone confused insurance with the concept of a “reserve” account. Creditors do create reserve accounts against losses in order to smooth out their cash flow, but this is not the same thing at all as insurance, any more than a smaller tax bill (caused by a loss) represents a tax credit.

Here’s an analogy that will help you understand the difference. Let’s say that based on your experience from prior years, you anticipate $1,200 per year in car repair expenses, but you still have no idea as to which months the repairs will become necessary. To avoid leaving yourself short, you set up an account and deposit $100 per month into that account, so the money will be there when you need it. This is a type of reserve account, where the money is held for a specific purpose. Nothing about this is “insurance,” because it’s all YOUR money at stake. It’s no different with the reserve accounts that banks set up to better manage their cash flow. It’s ALL their money, period.

Also, the above is a gross oversimplification of what really goes on in the credit card industry. The true technicalities are very complex, involving securitization of credit card receivable portfolios, establishment of credit card trusts, and sophisticated financial arbitrage procedures. But none of this has anything to do with “insurance.”

In conclusion, any debt settlement company sales reps that tout this nonsense should be deeply ashamed of themselves. The debt settlement industry already has an image problem, and it faces an uphill battle for legitimacy in the eyes of the public as well as regulatory officials. The industry’s cause is certainly not helped when executives permit their sales reps to make false or misleading statements to prospective clients just to close the sale.

Consumers often get in touch with me after they have already talked to one or more debt settlement companies. They are attracted by the idea of using the do-it-yourself approach to debt settlement, especially when they see how much they’ll save on the fees charged by settlement companies. However, there’s one common claim made by the reps who sell debt settlement services that sometimes discourages people from using the DIY approach.

The sales claim in question is usually stated as follows:

“We have thousands of clients, and we bundle our debts and settle dozens (or hundreds) of accounts at the same time. So we can get a much better deal for you because we’re doing these settlements in large blocks. You’ll never be able to get as low a percentage on your own as you will through our service.”

With apologies to some of my friends in the settlement industry, it’s time to explode this little myth. The claim, as stated above, is marketing hype and that’s about all. Facts are facts. And the simple fact is that debt settlement companies have NO relationship with the major credit card banks. I don’t know of a single settlement company, even among the very largest firms, that “bundles” debts when they settle with the major banks. In fact, very few settlement companies actually settle with the credit card banks anyway.

The reason is because clients are mostly paying fees during the first year, and rarely have anything saved up to settle with. And since the banks write off the accounts at 180 days of delinquency, hardly any accounts get settled directly with the banks these days. The majority of these accounts are getting settled AFTER charge-off (an industry term meaning a written-off debt) through third-party collection agencies, collection attorneys, and debt purchasers.

Bear in mind, this is NOT the case at all when you do it yourself. When you’re not paying sky-high fees, usually 15% or more of the total debt, then you can build up enough savings in the first six months to handle at least some of the accounts directly with the original creditor.

Taking this a step further, use of a settlement company can actually result in a far worse settlement than the consumer can get on their own. One major credit card bank will immediately forward your account to a local collection attorney with authorization for a lawsuit if they receive ANY notice from a debt settlement company. Once that happens, you’re lucky to get an 80% settlement!

Just this morning, one of my clients reported a settlement directly with this same bank at 35%. So the sales claim is certainly false when this creditor is involved. The same problem now exists to varying degrees with several of the other top ten credit card banks. Settle on your own, and you can get settlements ranging from 20% to 50% depending on the bank in question. Use a settlement company, and expect to see 60%+ settlements with those same banks.

To be completely fair, there is some truth to this sales claim when they negotiate with smaller third-party debt collection agencies. A lot of the people who do the negotiating for settlement companies are former debt collectors, and they often have contacts with various agencies. They also know the jargon and can comfortably speak with their counterparts at these collection agencies. So it’s possible that a professional negotiator will get a 35% deal with a collection agency where a consumer on their own will get a 50% deal instead.

But – by the time you add back the 15% fee charged by the settlement company – you’re right back where you would have been anyway.

So far for 2007, it’s been very busy here at ZipDebt – hence the infrequent blog posts over the past few months. One of the reasons for the increasing number of people seeking help with credit card debt is the subprime mortgage problem that’s recently been in the news.

After seeing countless people buy $700,000-$800,000 homes here in the San Diego area, and scratching my head as to how average people could possibly afford such huge mortgages, it’s now becoming quite clear that many of these folks never really could afford those expensive homes in the first place.

There’s a reason why conservative lenders still use the old 28/36 rule for debt-to-income ratio analysis. Your housing expenses (mortgage principal + interest + property taxes) should not exceed 28% of your gross income, and your total debt payments (housing + auto loans + unsecured obligations) should not exceed 36% of your gross income. When the ratios climb much higher than that, people have to start borrowing more just to stay afloat, and the household budget becomes very unstable.

So I’ve been hearing from quite a few people lately who are trying to get out from under properties that are at risk of foreclosure, after the payment on their adjustable-rate mortgage (ARM) increased to the point where they can no longer handle the higher payment on top of their existing credit card bills.

Adjustable mortgages are potentially risky enough. But I can’t how imagine anyone in their right mind would take on a “creative” mortgage, like the 1% loans that were a staple of the subprime market last year. With real mortgage interest rates at 5%, how could a 1% loan even exist? Well, it’s called negative amortization, where you make your payment but you end up owing more at the end of the month that you owed at the start of the month. That’s because the payment does not even cover the full amount of interest on the note, so the amount you owe climbs with every payment. It would only make sense to consider such a loan if you were 100% certain that the value of your property were going to appreciate much faster than the increasing debt associated with the negative amortization. And plenty of people who got into such loans assumed just that — they expected the steep rise in home prices to continue. “Hey, no problem. Our equity will be up $100,000 in a year or two, and we’ll just refinance and get a regular mortgage.”

In investing, this is called “the greater fool theory,” where a person pays sky-high prices for an investment because they are convinced a bigger fool will come along and pay an even higher price. But such run-ups never continue indefinitely. Eventually, conditions change and the market flattens out or even crashes. We haven’t seen an actual crash in the real estate market yet, but we’re certainly seeing downward pressure on prices as foreclosures mount across the country.

Add $30,000, $50,000, or $100,000 of credit card debt on top of a ballooning mortgage payment, and you have a fast track to financial disaster. I expect debt companies will have trouble keeping up with the flow of new clients as we roll forward through 2007.

Continuing our multi-part discussion of “Crazy Stuff Collectors Say,” I’ll focus in this post on a technique that frequently comes up in collection calls. I call it the “fraud” tactic. The collector may something like the following:

“Look, you knew when you used this credit card that you were not going to be able to pay. You’ve committed fraud against our client. Unless you make a payment today, we’re going to recommend that our client go after you for wire fraud.”

The FDCPA prohibits debt collectors from making false statements, including the false implication that you have committed a crime in failing to repay a debt. A debt collector simply has no way to determine what your intentions were at the time you made a purchase on your credit card. Nor are they legally qualified to determine what is or what is not a criminal offense. So this is actually a clear violation of the Fair Debt Collection Practices Act, yet it’s a tactic that is used frequently by debt collectors.

How should you respond to such a threat? I normally recommend that you try to work with your creditors in order to resolve your debt problems. And I also recommend that you work through their assigned collection agencies when necessary, which usually happens after an account has passed the point of charge-off. However, this assumes that agency representatives behave in a reasonable fashion and stay within the confines of the rules for debt collection. In other words, you should work in good faith with those collectors who are doing their jobs correctly. However, if a debt collector is prepared to falsely accuse you of a crime, there is simply no reason to continue the conversation any further.

So here’s one way to handle the bogus “fraud” accusation:

COLLECTOR: “Unless you make a payment today, we’re going to recommend that our client go after you for wire fraud!”

YOU: “May I have your full name, please, as well as the name and address of your agency?”

COLLECTOR: “Why do you want that?”

YOU: “So I can make sure I spell your name correctly in my complaint to the Federal Trade Commission and my state Attorney General. You just accused me of committing a crime, which means you violated the Fair Debt Collection Practices Act. Failure to properly identify yourself and your company is another violation. What is your full name, please, as well as the name and address of your agency?”

At this point, many collectors will just hang up the phone rather than continue the game. Or they may dig themselves in deeper by getting angry or belligerent.

If you feel a collector has crossed the line then you should definitely go forward with your complaint. You can file complaints against debt collectors online at the FTC website. You should also file a complaint with the Attorney General in your state as well as in the state the collector is located. I don’t recommend you complain formally unless you have good cause, but it’s important for consumers to stand up for their rights, and one way to do that is to ensure that the proper authorities are informed when a debt collector crosses the line and becomes abusive. And by any standard, a false accusation of criminal intent is certainly an abusive tactic that should not be ignored.

There has been a lot of media attention regarding the recent Congressional hearings on practices of the credit card industry. One of the subjects receiving coverage is the “universal default clause,” which consumer advocates have vocally complained about for years. This insidious provision is buried in most credit card agreements, and it permits a credit card bank to raise your interest rate sky-high if you default on payments to a DIFFERENT company.

I have in front of me a credit card agreement from one of the top ten card issuers. Here is the offending language:

“We may change the rates, fees, and terms of this Agreement at any time for any reason. These reasons may be based on information in your credit report, such as your failure to make payments to another creditor when due, amounts owed to other creditors, the number of credit accounts outstanding, or the number of credit inquiries.”

In plain English, a credit card “agreement” is not a true agreement at all. It’s a totally one-sided practical joke, and the victim is the consumer. Aside from needing an electron scanning microscope to read the fine-print, and a law degree to understand it, the language is totally in favor of the creditor and offers very little protection to the consumer against predatory banking practices.

The universal default clause is bad enough. But it gets worse, and that’s what I want to focus on in this post. Lately, I have been receiving a lot of consultation requests from consumers complaining about steep increases in interest rates, WHEN THEY HAVE NOT BEEN LATE WITH ANY CREDITOR. What gives?

This is a little-known problem, and you don’t hear about it much in the media coverage of credit card practices. While there is some slight justification for placing consumers in a higher-risk category (which results in higher interest rates) if they start falling behind on payments to other creditors, what could possibly justify an interest rate increase when there have been no missed payments to anyone?

The technical concept underlying this industry practice is called the “credit utilization ratio.”

Let’s say you have a total of $30,000 of credit available to you on three different cards, each with a $10,000 credit limit. Now let’s say you are carrying a balance of $4,000 on each card, for a total of $12,000 of debt balances. So far, so good. You are using $12,000 of credit against a total available limit of $30,000, which yields a credit utilization ratio of 40%. As long as your ratio is below 50%, then generally this will not be a problem or negatively impact your credit score. But what happens if you have borrowed $27,000 against the available $30,000 limit? That puts your credit utilization ratio at 90%. While it’s hard to determine the exact ratio that triggers interest rate increases, there’s no question that a 90% ratio will cause problems. The FICO score will probably drop, and worse, the creditors may jack up interest rates to the default rates of 28-32%.

Due to the method by which most banks now calculate minimum monthly payments, the above scenario is a recipe for financial disaster. Let’s say you have been struggling along to make the monthly minimums, even when the interest rates were under control. Most banks now calculate interest rates based on a formula of 1% of the debt balance plus the finance charge for that month. So on a balance of $10,000 at an interest rate of 15%, the minimum payment under this method would be $225. But if the interest rate suddenly jumps to 30%, the minimum payment would jump to $350! Multiply this effect across several credit card accounts, and it’s easy to see why many people are pushed over a financial cliff as a consequence of this practice. Remember, it has nothing to do with being late on any of the accounts. This situation can develop even if you have never missed a single payment! The banks justify this practice by claiming that consumers with high utilization ratios are at higher risk of default. Nothing is said about how the industry practice of raising interest rates actually contributes to an increase in defaults.

So the message is clear. Keep your overall use of credit below 50% of the total amount of credit available to you on unsecured credit cards and loans.