Counseling Clients on Credit
Of 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 receive scant attention because the traditional approach planners take does not start with the assumption that a client need, 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. 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 or $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. …