Consumer Debt - The Enemy Of Saving And Investing

FORECASTS & TRENDS E-LETTER
By Gary D. Halbert
October 17, 2006

IN THIS ISSUE:

1. A Historical Perspective

2. A Few Debt Statistics

3. How Did Americans Get So Far In Debt?

4. How To Slay The Debt Monster

Introduction

In my June 13 E-Letter, I presented the third article in a series dedicated to teaching adult children to save and invest. That particular E-Letter discussed how to help adult children begin a regular program of investing. I received a number of favorable responses from readers regarding this basic advice, and as always, I appreciate all of the feedback I get.

I also heard from other readers who said they would love to use the advice I gave in that E-Letter, but their adult children were so overwhelmed by debt that saving and investing were both out of the question. I mentioned this briefly in my May 30 E-Letter when I said that many young adults are engaging in “negative savings,” meaning that they had a negative net worth because of extensive debt.

While mortgage debt, student loan debt and auto loans can usually be justified, there are other types of obligations, such as credit card and installment debt, that represent an easy way for some adult children to live beyond their means. In essence, they are mortgaging tomorrow for instant gratification today.

In this week’s E-Letter, I’m going to address the subject of what I call “non-essential debt,” which includes much of the credit card and installment debt out there today. I’ll cover the history of how we became a nation of debtors, what factors drive us to go into debt, and what you can do about it.

If you or your adult children are struggling with credit card debt, this information should be invaluable. As always, feel free to forward this E-Letter to anyone you feel may benefit from it.

A Brief History Of Consumer Debt

Buying on credit in the US has been around ever since the Pilgrims landed on Plymouth Rock. However, early borrowing tended to be store credit, and was usually paid off with the next purchase and not according to a structured repayment schedule. The birth of the modern “installment plan” is generally credited to the Singer Sewing Machine Company that pioneered this method of payment back in 1856. Their “dollar down, dollar a week” program provided for a regular series of payments and put their sewing machines within reach of virtually anyone.

As industrialization and consumer goods boomed in the 1920s, installment credit went along for the ride. Consumers in the “Roaring 20s” loved credit and used it wherever possible (including in the stock market, which some say was a big contributor to the crash of ’29). One estimate I read said that by 1924, 75% of automobiles, 80% of phonographs, 75% of washing machines and 65% of vacuum cleaners were purchased on credit. Americans were living large, as they say.

The Great Depression came along in the 1930s and severely curtailed the use of credit – primarily because it severely curtailed Americans’ ability to buy anything. After World War II, returning GIs and their families once again embraced the use of installment credit. Though these individuals had also endured the Depression, many came back from the war optimistic about the future, and perhaps too young to remember the abuse of credit prior to the crash. Once again, US industry was put to work making consumer goods, many of which were bought on credit.

Even so, up to the 1950s the installment plan was usually tied to a specific retailer or consumer good. You couldn’t use your Maytag washing machine credit line to buy lunch at the local restaurant. Though credit cards were used as early as the 1920s, they had been issued by individual companies and could be used only at their outlets.

All that changed in 1950 when Diners Club offered the first universal credit card that could be used at more than one establishment. In the late 1950s, Bank of America issued the first true bank card (the BankAmericard) that allowed the holder to obtain a short-term loan up to a pre-set credit line, secured only by the cardholder’s promise to repay.

According to one source, there were only about five million bank cards in existence in 1965. Yet the September 2006 Nilson Report says that there are now over 800 million MasterCard and Visa cards alone, not counting American Express, Discover or any of the cards issued by individual retailers. It’s probably safe to say that there are now well over a billion credit, debit and charge cards in existence in the US today.

Debt Statistics

I’m sure all of us are aware of the statistics of how much debt the average family carries, as the financial media loves to paint a picture of an overburdened consumer base. Their reports imply that the “average” American household is awash in debt. An August 2006 Newsweek article estimates that the average American family now owes more than $9,000 in credit card debt. This number is based on the total credit card debt of over $800 billion divided by the 87+ million households estimated to have at least one credit card.

The Federal Reserve’s 2006 update of the Survey of Consumer Finances seems to dispute the $9,000 average debt statistic. This tri-annual study based on 2004 data states that the median credit card balance was only about $2,200, while the mean was about $5,100. While these numbers are based on 2004 data, I would not think that the average had jumped from $5,100 to $9,000 over the course of only two years. However, I have seen articles from 2004 stating that the average household credit card debt was around $8,000 at that time, so the $9,000 figure may be correct.

Based on the Fed’s 2006 update, it would appear that most American households are not as bad off as some of the financial media would have us believe. Even so, there are still many households who are slaves to credit card debt, and things just recently got worse for them, at least as far as monthly payments go. At the end of 2005, most bankcard issuers increased the minimum monthly payment as a result of pressure from federal regulators. In most cases, minimum payments increased from 2% of the outstanding balance to 4%, a 100% increase.

The effect of this change can be seen by assuming a $10,000 credit card debt at 18% interest (all too common today). At only a 2% minimum payment, it would take over 57 years to pay off the debt, and total interest paid would be almost $29,000. Under the new rules, minimum payments are now in the 4% range, so the same $10,000 would take just under 15 years to pay off, and total interest paid would be only $5,915.

The above payoff numbers were obtained from an Internet website sponsored by CardWeb.com. You can track how long it will take you to pay back your credit card balances by going to the following web address:

http://www.cardweb.com/cardtrak/calc/payment.amp?results=1&balance=9000&apr=18&mpd=4&mon_pay=

Transferring Debt – Not Always A Good Idea

Over the past few years, many individuals have chosen to consolidate credit card debts by refinancing their homes or taking out a home equity loan or line of credit. This usually results in lower interest rates, and thus lower payments. However, this really amounts to debtors transferring unsecured debt to debt secured by their homes. If payments are not made on this type of debt, foreclosure could result.

The Federal Reserve survey documents this trend, showing that the median amount of home-secured debt rose 27.3% from 2001 to 2004. The report states:

By eliminating the deductibility of interest payments on most loans other than those on primary and secondary residences, the Tax Reform Act of 1986 created an incentive for homeowners with a need for additional liquid funds to borrow against their home equity.

Couple the tax incentives with rapidly appreciating home values, low mortgage rates, and an aggressive mortgage loan industry, and you have a massive amount of home equity going to pay off credit card bills. Of course, this may be OK as long as households cut up their cards and do not charge them back up again. However, it remains to be seen whether this will happen.

How Did We Get In This Predicament?

Whether or not credit card debt is a problem for the “average” household, we know from our readers’ responses that there are some individuals and households that are drowning in debt. So, the question becomes how do some people build up such a huge amount of debt?

While there are volumes of articles and many books dedicated to theorizing how some Americans get so deeply in debt, as an Investment Advisor I have a first-hand opportunity to observe why some people get in debt, and why others do not. What follows are my own personal observations about why some households struggle with excessive credit card debt.

First of all, it is important to note that there are some people who get into a credit crunch because of external factors beyond their control. Some have unexpected legal or health costs that cannot be met from current income or savings, and have no choice but to incur credit card debt. Others may be laid off of their job, or have children or elderly parents with pressing needs that cannot be ignored. It is definitely a mistake to assume that anyone with a credit card balance is a failure at budgeting. However, there are many others who carry credit card balances for reasons that are totally within their own discretion. My list of observations is as follows, in no particular order:

Living Beyond Your Means – I have found that the most common reason for people incurring credit card debt has been the decision to spend more than they make. Thus, it sounds like it would be an easy thing to fix. However, that’s not always the case. The reasons for living beyond ones means vary, and may include some deep-seated psychological rationale.

Some people are “impulse buyers” while others try to keep up with the Joneses. Some must have the “best of everything” and a lower-cost alternative just won’t do. Whatever the motivation, the net effect is the same – living beyond your means will likely result in credit card debt.

Parents’ Failure to Teach Financial Responsibility – This is one of my pet peeves. It amazes me how some parents feel it is not necessary to teach their children to be financially responsible. I know of parents who set up a checking account for their teenage children, and then just deposit whatever is necessary to cover checks written by their child. In some cases, they never even teach the child to reconcile their bank account, so the child has no idea what his/her actual balance is. However, since good ol’ mom and dad will pony up whatever is necessary, it’s literally a situation where “I have money because I still have some checks left.”

I have two teenagers, so I know how hard it is to tell them “no” when they want something. However, as I mentioned in my May 16 E-Letter, my wife and I have said NO many times, even though we could easily afford the items our children wanted. Unfortunately, there are some parents who feel it is their duty to provide their child with everything they want with no strings attached.

Fast forward to when these kids graduate from college and are out on their own. Mom and Dad are now enjoying the empty nest and their child is supposed to suddenly become financially astute. In some cases, credit cards take the place of Mom and Dad, providing a source of money with only a small minimum monthly payment.

Call me old-fashioned, but I believe it is a parent’s duty to teach their children to be responsible citizens, financially and otherwise. I personally believe that giving a child everything they want without requiring any participation or responsibility is a big reason why we are seeing so many young people with credit problems today. They do not know what it’s like to go without something they want, so they seek immediate gratification, without a thought about having to pay the piper later on.

Succumbing to Countless Credit Card Promotions – If you’re like me, you receive a ton of credit card solicitations in the mail every month. Some of these make it sound so easy to get a credit card, and offer such low initial interest rates, that they are hard to pass up. In fact, some promotions make it sound like it would be financially unwise if you didn’t take them up on their offer.

Individual stores have also jumped on the bandwagon, often offering 10% or more off of purchases at the checkout counter if you will just apply for one of their store credit cards. Of course, to qualify for the discount, you have to put the remaining 90% of the purchase price on the card. Like casinos, the stores play the percentages, knowing that many individuals will not pay off the balance the next month.

Some cards that once required full payment upon the next billing cycle are now allowing minimum payments with the remainder financed. Remember when gas cards required you to pay the full balance each month? Most now allow you to pay only a portion, with the remainder subject to high interest rates.

Failure To See Debt As Debt – This one goes beyond the realm of credit card offers, but home equity loan promotions are sometimes just as alluring as those from credit card companies. While home equity loans can have advantages as I discussed above, some mortgage loan promotions talk about how homeowners can “unlock” the value of their homes for use to buy something they want or consolidate other debts. As strange as it may sound, some homeowners borrow against their home equity, convinced that they are simply using their own money.

I recall a television commercial from a well-known home equity lender that featured a voice-over testimonial from a satisfied customer who said something along the line of being grateful to be able to consolidate her credit card bills and be out of debt. Sadly, she’s not out of debt, she just transferred the debt from one type of loan to another. I noticed that the lender quickly pulled the ad with this testimonial, but I wondered how many people responded to this ad while it ran so they could “get out of debt.”

How To Erase Credit Card Debt

The Internet, TV and radio have many promotions from organizations promising to help you gain control over your debt, with some even promising to have your interest rates and payments reduced to a more reasonable level. If you or any of your family are thinking about going to one of these firms, my advice to you is BE CAREFUL – they are not all what they appear to be.

Some credit counseling agencies advertise that they are non-profit, leaving the impression that they are merely good Samaritans trying to help you out. However, a May 16, 2006 article in the Wall Street Journal reported that the IRS is auditing many so-called non-profit credit-counseling companies, seeking to revoke their tax-exempt status. The IRS alleges that many of these agencies do not provide meaningful education or objective advice, and some don’t even try to get consumers out of debt. Instead, they generate leads for related for-profit debt management firms that charge high up-front fees.

Thus, I believe it is always best to try to gain control of your debt yourself, rather than relying on someone else to do it for you. After all, if you rely on a third-party and don’t learn how to manage your finances effectively, you may end up back in the same situation later on. There is no easy way out, financial management takes discipline, and there are no shortcuts.

The Internet and bookstores are full of information about how to get out of debt. There are also a number of programs and packages that you can buy that will provide written material, computer software and even telephone counseling to help people pay off their debts. However, the key to all of the programs I have reviewed revolves around gaining control of spending, and then having the discipline to pay off credit card balances. From my research on the subject of debt management, I have come up with the following steps to help you or an adult child to get out of debt:

1. Track your expenses. This is different from budgeting, and I will discuss this in more detail below. Tracking expenses relates to knowing exactly where all of your money goes. This doesn’t mean just checks or online bill paying, but also the cash in your pocket. How much do you spend in cash for the many miscellaneous items you purchase? Keep a journal and keep track of all of your expenditures. The information will be important in the next steps.

2. Identify Non-essential Expenses. Can you live without coffee from Starbucks? How about regular gas rather than premium (assuming your car doesn’t require premium)? Do you buy things at the store that you don’t really need? Must you see a movie in the theater, or can you wait until it comes out on DVD? Document all of these unnecessary expenditures, and add them up.

3. Budget, Budget, Budget. I know, I know, budgeting is one of the world’s worst financial exercises. It’s tedious and boring, but absolutely necessary for you to gain control of your spending. As you budget, keep in mind which expenses are fixed and which are discretionary, such as the ones discussed in #2 above. For now, list credit card expenses at the minimum required payments. I’ll discuss later on how to go over and above these amounts.

The most important rule in budgeting is to be realistic. Budgeting an expense too low just to have a better bottom-line outcome does you no good, since your actual results will always exceed your budget. It’s also important to factor in seasonal fluctuations, such as the electric bill which will likely be greater in the summer and lower in the winter (depending on where you live).

Also be sure to budget for quarterly or annual expenses, such as property taxes, insurance premiums, etc. Set aside money for these large expenses on a monthly basis so you’ll have it available when it’s time to pay. And it should go without saying that you should eliminate all credit card spending, unless you have the discipline to pay the full balance each month.

If you decide to cancel some credit card accounts, wait until your account is paid in full before cancelling. Some credit card companies reportedly penalize cardholders who close their accounts by raising their interest rate on the outstanding balance. As a general rule, it’s not good to cancel all credit card accounts, as this might negatively impact your credit rating. However, you can cut up the card and blank checks even though the account stays open, preventing you from building up another debt burden.

4. Monitor Your Budget Regularly. I have known a number of people who will work diligently on a family budget, only to admire it briefly, and then set it aside. A budget is useful only if you compare your actual expenses to those budgeted. That way, if one expense exceeds your budget, you know that other discretionary expenses will have to be reduced to make ends meet.

On the subject of budgeting, you can always use a little help. There are probably thousands of Internet websites set up to help you budget, and thousands more books and magazine articles on the subject. However, one of my readers recently sent me one of the best basic budgeting techniques I have ever seen. He designed it specifically for his son, who didn’t have the time or inclination to keep up with a lot of spreadsheets or budget everything to-the-penny.

The “Envelope Budget” was sent to me by reader David Dopp. Tragically, Dave’s son, Eric, was killed in March of this year in a motorcycle accident. However, after reading one of my earlier E-Letters on saving and investing, Dave sent me his simple, but effective, budget technique that helped his son gain control of his expenses. Now Dave has given me permission to share it with you. To view a copy of Dave’s Envelope Budget, click on the following link:

David Dopp’s “Envelope Budget”

Just a note about Dave’s son, Eric – by all accounts, he was a great guy. He was full of life, and also one called to help others. As a professional firefighter and paramedic, Eric was on the front lines in times of crisis. If you would like to know more about Eric, his friends have set up a website honoring his memory. It can be found at the following web address: http://lt38.tripod.com/

5. Start Paying Down Debt. Up to this point, this sounds more like a budgeting exercise than a way to pay off credit card debt. However, this step starts the ball rolling toward freedom from debt. Remember those non-essential items that you identified in Step #2 above? If you cut these out of your budget as I suggested, you should have come up with a budget that had money left over at the end of each month. That money is your key to becoming debt free. Different debt reduction programs give this money left over various cute names, but we’ll just call it your “debt reduction payment” or DRP.

Each month, you should add this DRP to the minimum payment of one of your credit card bills. There are various methods to determine which bill you should add it to, and all have some merit. Some say to pay off the credit card with the highest balance first, since this is the one that costs you the most each month. Other experts tell you to pay off the smallest balance first, so you will gain a sense of accomplishment earlier. Still other experts say to pay off the credit card balance that has the highest interest rate. I like this last idea the best, since some credit card interest rates are 18-20% or more. However, the important part is to pick the method that makes the most sense to you and stick to it.

You might also consider rolling high-interest debt to lower-interest cards. Doing this and keeping your payment at the same level allows more money to go toward paying off the debt, and less to interest. Many credit cards now offer low promotional rates, and some periodically send you blank checks with low interest rates as an incentive to transfer balances. Some of these offers provide for a low interest rate for the life of the balance, as long as payments are made on a timely basis. However, be aware that these promotional offers often include significant transfer fees, and you may not always qualify for the special low rate. As always, read all of the fine print first.

6. Double Up. As you pay off a credit card bill, it is important that you take the entire amount you had been paying on the first debt, and add it to the minimum payment on the next in line to be paid off. Different sources of budgeting advice have different names for this, such as “snowballing,” etc., but the idea is the same. Adding your accumulated DRP to the next minimum payment means you’ll pay off the next debt even faster. Using this technique, you may be surprised at how quickly your debts can be erased.

Another way to increase your DRP is to identify personal items that might be able to be sold and the proceeds used to reduce debt. If you have old furniture, accessories, tools, etc. in the garage or in a storage unit that you no longer use, you might be able to sell them and use the money to pay debt. That not only helps you eliminate debt, but if you sell enough stuff, you might also be able to reduce the size of your storage unit and save money, or eliminate it entirely.

You can have a garage sale, put an ad in the paper or use e-Bay to sell just about anything. In addition, many cities have consignment shops that will sell your furniture for you, and might get a better price than in a garage sale. Just be aware that consignment shops can charge commissions of 50% or more, and may take longer to sell your items.

7. Keep On Keeping On. If “location, location, location” are the three most important words in real estate, then discipline has that distinction in relation to paying off your debts. Debt reduction is a marathon, not a sprint. In some cases, it may take several years to completely pay off your debts. During that time, you are going to have to have the discipline to continue adding your DRP to the minimum payments, to not add additional charges on your credit cards (in fact, all but one of these should have already been cut up and thrown away before Step #1), and to double up your DRP as accounts are paid off.

8. Contact Creditors. While it may or may not do much good, it won’t hurt to contact your credit card issuers and seek a reduced interest rate or a reduced payment. This is especially important if your budget reveals that you can’t make ends meet with your current level of minimum payments. You may also be able to determine if an incorrect entry on your credit report is resulting in your interest rate being higher than it should.

9. Target Other Debt or Start Investing. Once you have eliminated your credit card debt, you don’t have to stop there. You can use your DRP to eliminate other installment debt such as for major appliances or automobiles or even your mortgage. Once you are out of debt, then you can use your DRP to begin a program of regular investing, as I discussed in my June 13 E-Letter.

If Professional Help Is Required

I noted above my preference is for people to learn to handle debts on their own, without credit counseling organizations. However, I realize that some people simply do not have the discipline necessary to stick to a budget and pay off debts according to a schedule. For these people, a third-party counselor may be an option, but again, be careful when selecting such an advisor.

As a general rule, credit counselors will help you solve your debt situation by helping you develop a spending plan (budget) that includes payments to creditors. Plus, legitimate credit counseling firms often offer free educational materials and workshops, and their counselors are typically certified and trained in all areas of consumer credit, debt management and budgeting.

In many cases, a credit counseling organization can help you establish a workable solution to your debt problems. However, in some cases, they may recommend that you enroll in a “debt management” plan. In such a plan, you deposit money each month with the third-party credit counseling agency, which, in turn, makes payments to your creditors. The agency may negotiate lower interest rates and/or payments in light of using a debt management plan, but there’s no guarantee they will do so.

According to the Federal Trade Commission, you should always be careful when considering a credit counseling organization. Be wary if the organization charges high up-front fees, pressures you to make “voluntary contributions” that could actually increase your debt, tries to enroll you directly into a debt management plan with a related organization without first fully reviewing your situation, or fails to provide educational materials. You should also ask if the counselors are certified by the National Foundation for Credit Counseling or any other accredited organization.

You should also be aware that if you go through a legitimate credit counseling, debt consolidation or debt negotiation firm, your creditors may still ruin your credit rating. Though creditors may allow a lower monthly payment, they might still consider anything less than their minimum payment to be overdue, thus mounting up late payments on your credit report. It is also important to find out what organizations may also have access to your confidential personal information.

You can learn more about credit counseling options by going to the following websites sponsored by AARP and the Federal Trade Commission:

http://www.ftc.gov/bcp/conline/edcams/credit/coninfo_loans.htm

http://www.aarp.org/money/credit_debt/

Conclusion

Most of you reading this E-Letter are investors, and therefore are not overloaded with debt. However, most of us have adult children or other relatives or friends that are heavily in debt. So as noted at the beginning, feel free to share this information with anyone you feel may benefit from it. I hope it helps.

Best wishes,

Gary D. Halbert

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