Financial Education

Breaking the debt cycle

What is your interest rate?

Is that the real question a military family needs to ask? Not really. Some of the more important questions that come to mind are:

Do you understand the full cost of a loan?
Do you understand the repayment terms?
Do you understand the true cost of making minimum payments on credit cards?
Is a loan in your best interest?

Your answers will give an indication of whether you and the company you are considering are helping you become fiscally fit. Many consumers do not fully understand their debt, its true cost, and the route to debt-free living. As a military service member or their spouse, knowing this information is even more crucial due to long-term deployments, more restrictive pay scales, and the nature of military life. This article should help provide you with a few answers, future questions to ask, and help you make better decisions.

Understanding costs and repayment terms
Passed by Congress in 1968, the Truth in Lending Act and Regulation Z (TILA) provides a uniform manner of calculating and presenting the terms of consumer loans. TILA mandates specific disclosures that enable you to compare costs in order to help you make informed credit choices. Prior to TILA there were no generally required definitions of loan terms, and consumers were unable to compare interest rates and other loan costs.

The important thing, however, is to know how to use the disclosed information and how to ask more questions to get TILA-type information for all of your lending transactions

For example, interest rates and Annual Percentage Rates are disclosed, but are insufficient to compare true credit costs. Consider a $100 loan for 14 days, with a fee that costs $25. The disclosed annual percentage rate is 651%. This may seem like an excessively high interest rate, but the reality is simply the $25 cost. A bank might charge you the same $25 if they had to "bounce" your check for insufficient funds. This bank fee does not require a TILA disclosure, but if you calculated an APR, it would exceed 3,000 percent.

The key to understanding costs is to look at more than just the interest rate and annual percentage rate. Despite exaggerated annual percentage rate differences, $25 is the only cost for either of these unique financial choices. Neither of these choices is recommended, however, if they occur every payday-if the customer repeated this transaction every payday, they could expect an annual cost of $650 for the initial $100 loan. This would make it nearly impossible to break the debt cycle.

Understanding credit cards
Another financial myth is that "low cost" credit cards are better than "more expensive" installment loans. Again, interest rate comparisons are misleading. To fully compare interest rate or cost, you must know whether you will make full or minimum payments. Typically, a minimum credit card payment represents 3% of the balance. Statistically, that means 85% of the payment is paying interest and only 15% is going towards a reduction in the loan balance.

Let's say you had a $1,000 credit card balance with a 12% interest rate. By paying the minimum due (three percent of your account balance, or $30), it would take you eight years-for a total of 96 payments-to pay it off! You would have paid $407.48 in interest, which is significantly more than you would have expected on your $1,000 at 12% interest. Minimum credit card payments also make it nearly impossible to break the debt cycle.

Is a loan in your best interest?
Before pursuing a loan, you not only need to look at the costs, interest rates, and Annual Percentage Rates, you need to ask yourself if the loan will help you get out of debt in the long run. And a key to this is financial education.

Make sure the company you are working with has a goal of having better-educated, long-term customers who can successfully manage their finances. The company should begin by discussing the purpose for any loan application, and encourage viewing financial education videos or other materials prior to completing many applications.

The next step is making sure that the company follows professional business practices that are affirmed in annual state examinations. The loan representatives should review the request, past credit history and current financial condition before processing the loan.

They should not want to approve a loan that would result in your family's total debt payments exceeding 40 percent of your income. This percentage is a good rule of thumb-by making sure the ratio falls within the 40-percent threshold, you give yourself a better chance of making the payments you need to remain financially secure. This protects your credit history and helps you break the debt cycle.

Another question to ask is "Do they have a guarantee of satisfaction with their product?" By guaranteeing satisfaction, which should include a grace period when the money can be returned at no cost, the company is proving that it is helping the customer, rather than just trying to profit from them.

Perhaps the most important quality to look for when getting a loan is if the company is alert to younger, lower rank applicants. Are the loans they made to lower ranks lower than the company average? A company that is alert to this situation is one that is truly aware of the pitfalls that can trap younger military service members and their families into debt that they may not be able to truly afford.

Breaking the debt cycle requires discipline and rethinking many financial myths. You must also make sure to research the company you are working with to make sure they are truly dedicated to helping the families of military service members.

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