Consolidate debt consumer credit counseling

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. 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 $360,0(10 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.