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Credit Proofing in Bad Times: Assessing Your Risk

Posted by admin on April 7, 2008 in Misc.

Even though the title of this blog is credit proofing, this post deals with the much larger topic of risk management in bad times. The term credit proofing in this context refers to both credit proofing in the conventional sense of the term (protecting yourself against creditors using legal means) and risk management in bad times. In other words, creditor proofing, for this post, is short-hand for minimizing personal finance risk. Just as the birth of a new child or marriage should prompt a reassessment of one’s personal affairs, the on-set of bad times should similarly trigger an analysis of how much risk any individual or household has and what steps, if any, should be taken to protect themselves from such risk.

I noticed recently that I am writing tomes as posts (and Thursday’s post is just massive- so much so, it spills onto another blog). Thus, I am going to split this post into two section. Today’s post deals with assessing the level of risk one may have and tomorrow deals with options one may take to minimize risk and to credit-proof one’s self.

Let me start by an observation. The financial industry has hood-winked you into thinking you cannot handle risk and, only by buying their product or advice, can you sleep well at night. However, we deal with risk every day of our lives. We drive. We drink. We cross busy intersections. We incur debt to buy a home. We let our kids run in the park. We fly. These are all risk taking endeavors and there is risk in everything (risk cannot be completely eliminated)- but we handle it because we condition ourselves into incorporating it into our lives and adjusting accordingly. The point being- don’t be scared, you deal with risk everyday and you do just fine. Remove the emotion from the equation and you can tackle the issue.

For simplicity’s sake, let me divide the general population into broad categories:

1. Employees with manageable debt: I define manageable debt as any employee who uses less than 40% of take-home income to service debt whether in the form of mortgages, line of credit, credit cards etc. I realize this is above the recommended ratio of 36% the banks use but, from what I have been told, 40% seems to be the maximum you can push this.
2. Employees with unmanageable debt: By implication of the above, this is any employee who spends more than 40% of their take home on paying off debt.
3. Entrepreneurs/Self-Employed: this is pretty self-explanatory.

I have left the retired out of this for brevity and, to be honest, the number of corrective measures one can take if someone is retired and older is limited.

Let’s look at the risks of all three categories and, more important, assess the probability of risk factors not being contained to the individual and spreading to others (after all, a good credit proofing strategy contains risk or moving it to another source other than the household). These are not exhaustive- just the big ones every category faces.

Employees with manageable debt

Job loss or any event that would stop income production (accident, illness and disability) is the primarily risk for this group of individuals. Health risk is a related risk which I take for granted as being a risk factor for everybody.

The largest issue with this risk factor is whether it is contained to that individual or affects the household significantly. In other words, is there only one bread-winner in the family and, if so, have you put all your eggs in one basket with no risk mitigation in the event of job loss? Most households with dual incomes can muddle along financially in the event of job loss until the job-seeking spouse can find a new position. Households with no incomes cannot survive financially for long.

Employees with unmanageable debt

In addition to the above, the largest risk is that paying down the debt is eating up too much of the household’s resources and the household is basically keeping its head above water financially at the end of each month and no more than that. If the responsibility for the debt is shared between the household legally- for example, the credit card or mortgage is in both spouses name- now you have a real issue since you do not have the option of one spouse declaring bankruptcy in a worse case scenario and keeping the other spouse’s credit record clean. The worse risk management strategy one can do is to bring other members of the family to share the risk. Good credit proofing requires the risk to be isolated and by making everyone responsible for the debt, one has only spread the risk without any corresponding benefit.

Entrepreneurs

You may have noticed that I did not separate out entrepreneurs with manageable or unmanageable debt. Most employees would consider the amount of personal resources used in a business to be shocking- the old saying in entrepreneurship is never enough money and never enough time. Most businesses of a certain size require leveraging to debt levels which an employee would balk at but such is the life of a business owner.

Entrepreneurs have business risk which is a very board category for risk factors such as: litigation risk, loss of business/income, debt management risk and regulatory risk are those that come to mind immediately.

Is the life of an entrepreneur risky compared to an employee? Yes and no. It is risky in that the risk factors are significantly larger than an employee and, since lenders typically require some type of personal guarantee, cannot be isolated to the business itself but the risk is voluntarily incurred and controllable in the sense no one but the entrepreneur is telling them to incur more risk. Employee’s primary risk of job loss is not a controllable factor in one’s life even if the employee is in upper management. At the end of the day, it is a third party that determines when the risk becomes real for an employee.

It is basically a trade-off between how much risk you incur and the probability of it being controlled by you. Employees face smaller risk but relatively less control than the entrepreneur. There is no right or wrong risk management- just different degrees.

Having set out this framework, tomorrow I will get to the good stuff- how to credit proof yourself against these primary risk factors.

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As usual, I update my monthly financial goals at Geezeo’s blog.