Your Personal Finances and “The Broken Window” Theory

Managing my family’s finances and investment portfolio, I enjoy applying abstract economic theories to everyday decision-making. I came across renowned economist, Henry Hazlitt, twenty years ago. In his seminal book, Economics in One Lesson, he lays out a theory that I encounter in my personal finances every day.

The Broken Window Theory looks at every economic transaction in three steps instead of two. There’s the seller and the buyer, of course, engaging in trade. But there is also the third person, the one who wasn’t there, the trader whose goods the buyer didn’t buy because he bought something else.

In my personal finances I make buying decisions every day. Will I buy organic milk or regular milk? Apples or oranges? Meat or chicken? I make these financial decisions because I need these products and because I have a limited amount of money to spend on food. Every time I buy organic milk, the regular milk vendor loses a potential sale.

In a free market environment, The Broken Window theory is even more interesting because competition offers you a range of vendors and products to choose from in the same field. In that case, The Broken Window Theory relates both to the item you buy and the person you buy it from.

The Broken Window theory becomes even more relevant to your personal finances when you consider financial decisions that are forced on you. To use Hazlitt’s example, if someone throws a rock through your window and breaks it, you find yourself suddenly forced to spend money on a new window. You gain nothing that you didn’t already have, and yet you spend money in the transaction. If the window hadn’t been broken, you might have bought a new coat or gone out to dinner instead.

In my personal finances I come across the Broken Window theory in several ways. When I make a bad financial decision, for example buy a beautiful dress even though I have several in the closet, I end up with less money to spend on the things I truly need.

If I buy the dress on a credit card because I don’t really have the money anyway, I not only wipe out the potential for buying something useful, but I commit my future earnings to paying off both the dress and the interest on the loan.

Thinking of my financial decisions with the three-layered perspective of The Broken Window theory keeps me from getting tempted to buy things I shouldn’t. This is especially helpful when I see items on sale, which increases the temptation to buy even more.

The Broken Window theory also applies to my personal income. My salary takes me a fixed number of hours to earn. I could be spending these hours doing something else. This leads me to question whether my lifestyle is too expensive, whether earning the livelihood I need is consuming too much of my free time.

In short, The Broken Window theory keeps me on my toes when it comes to my personal finances. That something else, the unidentified commodity that I lose when I choose one path over another, always reminds me that every decision wipes out a slew of alternative options. I have to make sure that I don’t break windows in my life. In other words, that I don’t end up spending my limited resources on things I already have and don’t really need.

 

Bankruptcy Alternatives: Debt Relief Orders (DRO)

Due to the long-term problems of bankruptcy filing, which go beyond the mere consideration of a ruined credit record, many will seek one of the alternatives to bankruptcy. One key way to avoid bankruptcy is to consider applying for a debt relief order.

Avoid Bankruptcy: What are Debt Relief Orders?

Debt relief orders came into effect in the UK in April 2009 as an alternative to bankruptcy. A debt relief order is designed to help those who can not pay off their debts seek refuge from creditors and restore financial health within a 12-month period.

Should a court decide to issue a debt relief order, then the individual is protected from further actions from the listed creditors for the period of the debt relief order, which usually lasts for 12 months. Further more, at the end of the period all those debts which have been listed in the debt relief order will be written off.

 

Despite the benefits of a debt relief order, during the period of the debt relief order the individual will still have to make payments to any creditors which have not been listed on the debt relief order. In addition, at the end of the debt relief order any debts which where not listed will still have to be paid off in full.

Bankruptcy Solutions: Who Can Apply for a Debt Relief Order?

One can apply for a debt relief order as an alterative to bankruptcy if the following circumstances exist:

Level of Debt – The level of debt should not exceed £15,000. These debts must be considered as “qualifying debts”. Qualifying debts are usually unsecured forms of debt including rents, credit card debts, overdrafts and other unsecured personal loans.

Disposable Income – In order to apply for debt relief orders one must have a disposable income of less than £150 per month.

Personal Assets – To apply for a debt relief order an individual must not have assets greater than £300. This excludes motor vehicles; here an individual can only qualify for relief if they own a motor vehicle worth less than £1,000.

Residence – To apply for a debt relief order one must have resided, worked or owned a property within England or Wales for the last three years.

In summary, if one has personal unsecured debts less than £15,000, seeking a debt relief order may be a cheaper and less stressful option than going bankrupt. However, whilst debt relief orders offer a credible alterative to bankruptcy solutions, a debt relief order may not be suitable for everyone, especially where significantly large levels of debt have been amassed.

Debt-to-Income Ratio (DTI): Using Financial Statements to Determine Financial Health

When a person’s personal economy is in turmoil, it is common for debt to mount while income either drops or stagnates. When the going continues to get tough, more credit may be needed either through extended lines, or new ones.

Potential creditors, such as Bank of America or the local car dealership, will offer or deny such lines based on a person’s debt-to-income ratio, or DTI.

Figuring a Person’s Debt-to-Income Ratio

The average person might think of debt as the entire amount borrowed compared to the entire amount earned. For example, if a person earning a yearly income of $90,000 has the following debts:

  • Home mortgage – $210,000
  • School Loan – $30,000
  • Auto loan – $20,000
  • Credit card – $3,500
  • Credit card – $2,500

Then it could be falsely concluded that their debt ($266,000) to income ($90,000) ratio was just under three, meaning $3 borrowed for each dollar earned.

Creditors, however, look at it in terms of the monthly obligations (also called a minimum payments) versus monthly income. Using the example above, it might look more like this:

  • Home mortgage – $1,500
  • School Loan – $300
  • Auto loan – $420
  • Credit card – $42
  • Credit card – $35

This means that the person above has a DTI of $2,297:$7,500, which is just over .3, meaning that 30% of this person’s earnings are called for at the start of the month, and he has the rest to live off of.

What is a Healthy Debt-to-Income Ratio?

Lendingtree.com’s article titled “Calculating Your Debt-to-Income Ratio” notes that a lender’s maximum DTI is not to exceed .64, meaning that a person should not borrow more than $64 for each $100 earned.

It goes further to explain that a home payment should not exceed 28% of a person monthly income and that other debts should not total to exceed 36%, though there are some exceptions in cases of VA home loans.

But these numbers are subjective. For example, if one was to ask financial guru Dave Ramsey, he would strongly urge the person in the example above to utilize a debt snowball to bring his DTI down to zero.

Flaws in DTI

Debt-to-income ratios are flawed, and in a way that could prove harmful to someone calculating without the following knowledge.

The income used in DTI measurements is income before taxes. So, while the $7,500 used above may be the money that that person actually earned, he’ll only be able to access 72% of it since 28% will be taken out in federal income taxes, leaving his DTI to be $2,297:$5,400, or about .45.

Despite his high income, $45 of every $100 (at a minimum) will go to creditors.

Knowing one’s DTI is crucial for understanding short-term financial health. It can be found by keeping cash flow statements, which will help one keep a closer eye on the long-term financial health found in a balance sheet.

Where is a Good Place for Savings? With Interest Rates Declining, Where Should You Save Money?

The average interest on savings accounts in the UK has now gone below 1%, with some giving savers far less than that. When one considers inflation, this means that any cash in ordinary savings accounts is now decreasing in the real sense! So where should savers keep money in the current economic climate? Here is the advice of some experts.

Pay off as Much Debt as Possible

No matter how low the interest rate on any current debts people may have, it is better to pay it off and reduce the money in savings accounts. This is particularly true for those who have credit card and similar debts at a high rate of interest, but applies equally in the present climate to things such as mortgage debts. Experts advise keeping a small emergency savings fund, but suggest that this should not be more than three months salary; any more should be used to pay off any type of debt.

Put Extra Savings into a Cash ISA

Everyone is allowed to put £3600 per year into a cash ISA (Individual Savings Account). The interest on these is tax-free, and some are still offering a reasonable rate of interest. This should be the first place for any spare money. Many people only put money into cash ISAs at the end of the tax year, but one can do it at any time. It would be sensible to do this now, and if possible find one where the rate is fixed, before interest rates drop any lower.

Regular Savings Accounts

Some banks and buildings societies still have good rates for Regular Savings Accounts, where the saver puts in a set sum each month. The maximum is usually relatively small, around £500 at most. However the rates are usually fixed for the year, so this is worth doing now for those who have any spare cash. At the present time Barclays Monthly Saver, Close Brothers Premium gold Account, and Abbey Monthly Saver, were all offering rates over 5%.

Premium Bonds

Those with a significant amount of money in Premium Bonds usually have small wins at regular intervals, and of course there is always the possibility of winning a large amount. So this could be a sensible place to save at present, even for those who do not usually do anything approaching gambling. And since Premium Bonds are government owned, the original amount of money is always safe.

Perhaps the most important thing to do is keep an eye on savings rates and be prepared to move accounts if a better deal comes along. In the present economic situation this could make the difference between making a small gain at the end of the year, and losing money in real terms.

Why Choose an Individual Voluntary Arrangement? Debt Free with an IVA Debt Solution – No More Creditor Harassment

Those struggling with serious debts are able to choose between two main debt solutions: personal bankruptcy and an Individual Voluntary Arrangement. Both debt solutions result in a debt write-off, although the negative effects and percentage of debt written-off vary considerably.

What is an Individual Voluntary Arrangement?

An Individual Voluntary Arrangement is an agreement between a debtor and his creditors to write-off debt. How much debt can be written off is a matter of some conjecture, but it can be close to 75% for a small percentage of insolvents. Unlike a debt management plan, an IVA is legally binding on all creditors. The term of an IVA is normally 5 years and involves a pre-agreed monthly payment for the duration.

An Individual Voluntary Arrangement Prevents Creditor Harassment

Due to it being legally binding, it is against the law for a creditor to pursue someone for debts once they enter an Individual Voluntary Arrangement or declare personal bankruptcy. Should any creditor harassment occur, this should be reported to the Insolvency Practitioner immediately as it can be stopped.

An IVA Protects the Family Home

Unlike personal bankruptcy, an Individual Voluntary Arrangement serves to exclude the family home from the agreement. This means that someone with serious debts, such as credit card debt and unsecured loans, can continue to live in their home.

However, there is a clause drawn into almost all Individual Voluntary Arrangements that requires the insolvent to get a remortgage at the end of year 4. The terms of the IVA require that a remortgage be taken out for up to 80% of available equity although this will be based on affordability.

Professional Occupations and the Individual Voluntary Arrangement

Declaring personal bankruptcy would lead to the loss of a professional occupation. Those affected include: accountants, solicitors, government officials and financial advisors. It is believed that an Individual Voluntary Arrangement allows someone to maintain their professional status, although this is arguable.

Personal Bankruptcy and Money Lost through Speculation

Those who have lost money they have gained from unsecured loans, personal overdrafts and credit cards may find that they are affected by a Bankruptcy Restriction Order (BRO). This can mean that a bankrupt isn’t discharged for up to 15 years if he has been involved in stock trading or gambling. An IVA isn’t nearly as intrusive and doesn’t place further restrictions on an insolvent.

The IVA and Anonymity

Unlike personal bankruptcy, an IVA doesn’t result in an insolvency being published in the local newspaper and the London Gazette. An Individual Voluntary Arrangement is placed on a publicly available insolvency register, but few people tend to look at it.

An Individual Voluntary Arrangement is a suitable debt solution for those who have serious debts and are a home owner. Whilst it can help someone become debt free in 5 years, it isn’t suitable for everyone. Those with more modest financial difficulties should consider an alternative debt solution, such as a debt management plan.