Time for a Clean Slate : Sometimes, Bankruptcy Is the Best Solution

In the arsenal of weapons that a financially troubled family can use against ballooning debts and out-of-control spending, a personal bankruptcy filing is like a massive missile attack--it should be used only as a last resort.

For the Garcias, it may be time to launch the missiles.

Even though the Carson couple earn an income that many would envy, their finances are in dire straits. Their house is worth about $50,000 less than the outstanding balances of its three mortgages, and they owe more than $47,000 in credit card charges and personal loans, many of which are delinquent. Even though they earn more than $90,000 a year, they are falling deeper in the hole each month. The burdens of their debts, spending habits and various other financial missteps are threatening their marriage, their two children’s college prospects and their own retirement.

“I try to live within a budget, but then I just get overwhelmed and give up,” says Rochelle Garcia, 39, who handles the family’s finances. Just juggling the bills and payments each month, she says, is enough to leave her feeling frustrated and defeated.

The solution proposed for Rochelle and husband Reginald by Los Angeles financial planner Margie Mullen isn’t “nice”: either a Chapter 7 bankruptcy, which would wipe out all unsecured debts, or a Chapter 13 filing, which would allow them to discharge most debts by paying all or a portion over a three- to five-year period. Either way, the filing would tarnish their credit-worthiness for years and could stigmatize them among friends, co-workers and family members.

“As a former lender, I don’t take a bankruptcy lightly,” says Mullen, who spent 10 years in the banking industry before becoming a financial planner. “But I don’t see any other way around those bills.”

The Garcias are hardly alone. The sea of American consumer debt is swelling, fed by easy-to-get credit and undisciplined spending. According to the Federal Reserve Board, the nation’s consumer debt topped $1.17 trillion in September 1996, a staggering $98 billion more than the year before. A study shows that more than a quarter of the nation’s households have not yet paid off credit card debt from the 1995 holiday season.

Not surprisingly, personal bankruptcy filings are surging, although many critics contend that people are too quick to take this route. According to forecasts by the American Bankruptcy Institute and Visa USA, at least 1.1 million households, about 1 in every 100, will file for bankruptcy at some time.

Overwhelming indebtedness is pervasive at all income levels. As the Garcias’ experience shows, even a couple with a substantial income can get themselves into serious trouble. Reginald, 38, a maintenance supervisor for Metropolitan Stevedore, and Rochelle, a computer technician for Metropolitan Life Insurance, earn a combined annual pretax income far above the average.

How did the Garcias get here? Apparently through a combination of generosity and poor choices over the last decade.

Proceeds from second and third mortgages on their home went toward two home remodelings and to make cash gifts to several needy family members. Over the last two years, even as their debts were mounting, the couple leased a sporty Toyota four-wheel-drive vehicle and put their $1,200 1995 federal tax refund into a mutual fund recommended by their tax preparer. Throughout, they have continued to contribute $200 each month to their church, even though it has meant skipping some payments on their overstretched credit cards. “I know I’m easily swayed when it comes to money,” says Rochelle. “My husband says I’m just too nice.”

A successful petition for either Chapter 7 or Chapter 13, which would take about three to six months to complete, would reduce or cancel the credit card debts and personal loans that seemingly keep the Garcias in permanent financial distress and allow them a chance to begin accumulating the money they will need for the college educations of Joannie, 15, and Kawena, 11, and their own retirement.

Although the Garcias would be able to keep their home, on which they are current in their mortgage payments, a bankruptcy would require them to give up their leased Toyota and perhaps put other belongings up for sale to repay creditors. In addition, it would expose them to intense scrutiny by the Bankruptcy Court and leave a scar on their credit record for 10 years.

Mullen believes the potential benefits of bankruptcy to the Garcias will outweigh its negatives, but she worries that unless the couple permanently change their spending patterns, they are doomed to repeat their missteps.

“I’m very concerned about the psychology of the family’s spending habits,” Mullen says,

Mullen favors a Chapter 7 bankruptcy because, however drastically, it would wipe the slate clean, it is to be hoped once and for all.

Here’s the Garcias’ current monthly payment situation: Mortgages total $2,100. Minimum required credit card and loan payments amount to $1,275, which cover the interest but virtually none of the principal. Family living expenses, including food, taxes, insurance and utilities, amount to $2,750. The grand total is $6,110. Take-home pay is $5,800, and when Reginald gives up his $500-a-month second job later this month--the stress became too much--monthly income will be $5,300. The resulting deficit: $810 per month. And almost nothing is being saved for the future.

Bankruptcy was not the only option considered. Initially, both Mullen and Richard M. Pittman, director of counseling for the nonprofit Consumer Credit Counseling Service of Los Angeles, evaluated whether the Garcias should sell their home, let it fall into foreclosure or attempt a short sale--the home would basically go back to the lender for the lender to sell--to get out from under the monthly mortgage payments.

But in the end, both realized that because the Garcias had refinanced their home twice, each time pulling out cash, they would be liable for taxes on any amount of debt left unpaid or forgiven. Why? Because they had already received the money from the refinancings. Furthermore, in California, refinanced home mortgages are considered “recourse” loans, allowing lenders to attach other assets of the borrowers for repayment.

That left bankruptcy as the only realistic alternative.

But even if the Garcias wipe out their debts through a Chapter 7 filing, Mullen says, their problems will be far from over.

The critical next step is devising a family budget built on disciplined spending. Mullen’s budget proposal leaves unchanged the Garcias’ current monthly expenses for mortgages, property taxes and insurance, food, utilities, entertainment, children’s activities, clothing, life insurance, personal care and transportation--a total of $3,480.

Mullen also left untouched the Garcias’ $480 monthly “walking-around money”--an amount equal to $60 per adult per week. However, Mullen strongly advises the couple to keep close track of these expenditures.

She recommends making a single withdrawal of a predetermined amount on the same day each week, and says the couple should write down each of their cash expenditures to prevent the cash from slipping through their fingers. Another alternative would be to eliminate cash spending in favor of check writing, which provides a clear record.

“Relying on cash helps us to be in denial about our spending habits,” Mullen says.

Mullen found three places to trim spending. By turning in the leased 1995 Toyota for an older, less flashy model, monthly auto costs would be reduced to $200 from $376, and auto insurance premiums to $150 from $250. She also would halve the Garcias’ church contributions to $100 per month and eliminate the $50 that Rochelle says she spends each month for home decorating items. The total monthly savings amount to about $425.

Combining that with the $1,275 no longer owed on the credit cards and other loans wiped away by the bankruptcy filing, the Garcias would have about $1,700 more per month at their disposal, bringing their monthly budget from a deficit of $810 to an estimated surplus of about $890.

Although their children’s college education is their first savings priority, Mullen recommends that the Garcias start increasing their savings by doubling their contributions to their 401(k) tax-deferred savings plans at work, from $270 to $540.

Next, Mullen recommends that they create an emergency fund, contributing $200 each month to cover unexpected catastrophic expenses. The account, Mullen says, should be housed in nonvolatile liquid investments such as a money market fund. Further, she says, the Garcias should try to have the funds deducted automatically from their paychecks each month to ensure that the money actually arrives where it’s supposed to.

“The interest rate is not as important as its lack of accessibility,” Mullen says.

Finally, Mullen says, $400 can be applied toward the children’s educations. She recommends investing it in Janus Worldwide, a no-load mutual fund, for this purpose.

In three years, when their daughter is ready for college, there should be more than $16,000 in the account, according to the most conservative estimates of the fund’s growth potential. That amount would cover two years at a state college if Joannie lives at home. The remaining costs for a four-year education could be covered through a combination of student loans, Joannie’s own earnings and perhaps through scholarships. Meanwhile, funds would be accumulating for Kawena’s education.

Will this plan work for the Garcias? Mullen, still unhappy about recommending bankruptcy for a family with a $90,000 annual income, isn’t entirely sure, given the couple’s track record. To improve their chances of getting back on their feet, Mullen says, the couple should increase their financial savvy by enrolling in economics and consumer courses at their local community college. In addition, she says, the couple should jointly share the responsibility for handling the family’s finances, rather than leave it to one partner.

For her part, Rochelle is anxious to try Mullen’s program.

“I am ready for anything that will get us out of our problems,” she says. “I know if we can find a way out, we won’t repeat our mistakes.”

Carla Lazzareschi writes the Money Talk column for The Times. She can be reached at carla.lazzareschi@latimes.com

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This Week’s Make-Over

Investors: Rochelle and Reginald Garcia

Occupations: Rochelle, 39, is a computer technician; Reginald, 38, is a maintenance supervisor.

Annual income: $90,000+

Primary investment goals: Get out of debt, save for retirement and establish a college fund for their two children, now 15 and 11.

Recommendations

Financial advisor Margie Mullen says that if the Garcias file for personal bankruptcy and follow her new spending plan, they will move from a monthly budget deficit of $800 to a budget surplus of $900. That amount can be invested to achieve the family’s goals of saving for their retirement and their children’s college educations.

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Monthly Spending Current Recommended Mortgage $2,100 $2,100 Taxes/insurance 200 200 Food 300 300 Utilities 230 230 Credit card and loan payments 1,275 0 Car insurance 250 150 Personal care 100 100 Church contributions 200 100 Entertainment/school activities 200 200 Clothing 150 150 Life insurance 100 100 Transportation 100 100 Auto payment 375 200 Cash needs (lunches, misc. expenses) 480 480 Home decorating 50 0 Total expenses: 6,110 4,410 Take home pay: 5,300 5,300 (Deficit)/surplus (810) 890

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How surplus should be saved:

* Increase Rochelle’s and Reginald’s 401(k) retirement savings contributions from $270 to $540 a month.

* Set aside $200 a month for emergency fund.

* Set aside $400 for children’s educations.

Meet the Planner

Margie Mullen is a fee-only certified financial planner in Los Angeles with more than a decade of experience. She specializes in retirement planning and portfolio management using no-load mutual funds.