By Doug Hoyes
Bankruptcy can happen to anyone. In fact, the average bankrupt person looks a lot like you. They can be married or single, young or old, male or female. So what makes one person a high-risk debtor while their neighbor seems to be able to stay afloat?
The truth of the matter is, there are a variety of risk factors that can lead to insolvency. In no order of importance, let’s look at the top six reasons people file bankruptcy and what you can do to reduce your risk.
Risk Factor No. 1: Divorce
Let’s start with a picture of the average bankrupt person. My bankruptcy firm, Hoyes Michalos & Associates, conducted a study of our clients to gain a deeper perspective on why people go bankrupt. While the results are specific to Ontario, Canada, where we work, the profile of an average bankrupt person is actually pretty similar in both the United States and Canada.
The average insolvent person is a 43-year-old male, is most likely to be married, but has a higher-than-average chance of being divorced.
That brings us to risk factor No. 1 — divorce. While it’s not true that bankruptcy leads to divorce, it is true than divorce can cause bankruptcy. Almost one in three insolvent debtors were separated or divorced when they filed, and almost one in five listed a relationship breakdown as the cause of their bankruptcy.
The financial impact of divorce extends beyond the initial divvying-up of assets and lawyer’s fees. Debt often accumulates after the divorce as ex-spouses find themselves running two households instead of one. Living expenses double. Many people end up using credit cards in the aftermath of divorce to pay the bills previously handled with two incomes.
The solution? Plan for the fact that your income will have to stretch further once you are divorced. If you had joint credit cards or other joint debt, cancel these debts and take out new loans individually. Keep your finances separate but share costs where you can.
Risk Factor No. 2: Using Credit for Living Expenses
Looking again at our average insolvent debtor, they are likely to owe more than $61,000 in unsecured debt, more than three times the average person.
The common assumption is that a bankrupt person misused credit because they were big spenders, going on shopping sprees and living extravagant lifestyles. While this does occasionally happen, it is the exception, not the norm. What typically happens is that, for one reason or another, at-risk debtors rely on credit cards to make ends meet. They are paying for food, clothing and living costs with credit because they run out of money at the end of every week or every month. What starts out as a short-term solution leads to a massive accumulation of unsecured debt over a period of time.
The average bankruptcy in our study had an average of 10 unsecured debts including more than four credit cards. The more credit you have available, the more likely you will be to use it.
There are two things you can do to avoid running up credit card bills over time.
- Create some form of budget. It doesn’t matter whether it’s a formal spreadsheet or the old-fashioned envelope system. Find a way to monitor your income and expenses so that you spend no more than what you bring in.
- Use credit wisely. Never use credit to pay for items that hold no long-term value. Always pay your credit card balances in full. When you do borrow to purchase something like a car or a home, make your payments as high as you can and keep your amortization as short as possible. This will ensure that you pay off that debt sooner and keep your interest costs low.
Risk Factor No. 3: Job Loss and Income Reduction
Contrary to popular belief, the average bankrupt person is not unemployed. In fact, nine in 10 insolvent debtors were working or had some form of income. Only 8% were unemployed at the time of their filing, although many had a spouse who was working.
Though employed when they went bankrupt, the underlying cause of bankruptcy for four in 10 people was job-related. At some point, they may have lost their job or experienced a drop in income due to economic conditions or illness. Many turned to the use of credit to pay the bills not covered by unemployment or disability insurance. While their debt was affordable before, once they returned to work, the at-risk debtor found themselves with newly acquired debt that could no longer be serviced on their new income.
Anyone can experience a sudden drop in income. Even if your job is secure, you may get into a car accident or become ill, necessitating some time off work. The best protection against having to use credit during this period is to set aside an emergency fund. It’s also a good idea to cut back sooner, rather than later, on unnecessary expenses in these circumstances, as you may not know how long you will have to survive on a reduced income.
Risk Factor No. 4: Carrying Debt into Retirement
One of the fastest-growing groups of bankrupt people is seniors. People over the age of 60 accounted for 10% of all insolvency filings in our study, and that percentage has trended upward. Seniors had the second-highest unsecured debt-to-income ratio at 273%, second only to pre-retirement insolvent debtors who owed almost $3 for every $1 they earned.
Seniors are particularly vulnerable to unexpected life events that can jeopardize their financial status:
- Half of all senior debtors live on their own and have to support debt payments on one income.
- Most are living on a fixed income, thus have no ability to pay off their debts once they retire.
- Few had significant savings, as much of their pre-retirement income was used to meet their ongoing debt payments.
- Seniors are more likely to cite illness, injury or health-related problems as a further cause of their financial problems.
Approaching retirement without the safety net of savings, combined with higher debt, is a significant risk factor for bankruptcy. It is important to plan ahead for retirement, cut back on lifestyle costs sooner rather than later and pay off debt early during your working years.
Another concern in regard to seniors’ financial health is their willingness to support adult children. Seniors should not co-sign debt or offer to support their children or grandchildren financially if this will put their own retirement at risk.
Risk Factor No. 5: Student Debt
The average student debtor takes more than 14 years to repay their student loans. When you consider the difficulty many recent graduates have had finding a good-paying job, it’s not unexpected that student debt can be a significant bankruptcy risk.
Almost 13% of insolvent debtors in our study still owed student loans at the time they filed. And in case you think this number is low, it’s important to understand that in Canada, student loans cannot be included in a bankruptcy until a person has been out of school at least seven years. That means that seven years after finishing their studies, a significant percentage of bankrupt people are still struggling with student loans.
The high cost of tuition makes student loans a necessary evil for most young people. My advice is to make sure you borrow only what you need. Be careful not to rack up additional high-interest credit card debt while you are a student. Make loan payments your top priority upon graduation. It is wiser to pay down your student loans than to increase your living costs just because you are earning more money.
Risk Factor No. 6: High-Risk Mortgages
The last significant risk we will address is the high-risk mortgage. The debt crisis and resulting recession in the United States in 2007 were a prime example of what can happen when mortgage balances outweigh home values.
Despite this history, the temptation of historically low interest rates can be very alluring. Even when housing prices are on the rise, carrying a high-ratio mortgage places a significant risk on your financial health. In our study, the average insolvent debtor carried a mortgage equal to 92% of the net realizable value of their home. Add in a little credit card debt and a car loan, and it only takes a small change in circumstances to push you over the edge into insolvency.
The underlying causes of insolvency are wide and varied. As mentioned before, bankruptcy can happen to anyone. If you’re not yet convinced, I will leave you with a few quotes from our study:
- “Obtained credit to help grandson.”
- “Health problems. Hours reduced at work. Decrease in income.”
- “Returned to school. Unable to find work since finishing school. Relied on credit to cover living expenses.”
- “Family illness and care giving responsibility that resulted in job loss.”
- “Separation and struggling with finances on single income.”
- “Accident at work, period of no income.”
- “Living paycheck to paycheck. Difficult keeping up after divorce, and birth of child.”
Doug Hoyes has extensive experience resolving financial issues for Canadian citizens. A Licensed Bankruptcy Trustee and co-founder of Hoyes, Michalos & Associates, he is also a Chartered Professional Accountant (CPA), Chartered Insolvency and Restructuring Professional and Business Valuator. He regularly comments on a variety of TV, radio, and other media outlets on topics surrounding bankruptcy and writes a column for the Huffington Post. Hoyes has been a Licensed Trustee since 1995 and testified before the Canadian Senate’s Banking, Trade, and Commerce Committee in 2008.