The following is an excerpt from the book Live Well on Less Than You Think:
The New York Times Guide to Achieving Your Financial Freedom
Copyright © 2005 Fred Brock
No discipline is taught to anyone about how to use credit.
-- CHRIS VIALE, PRESIDENT, CAMBRIDGE CREDIT COUNSELING
You can make hefty cuts in your expenses without the draconian measures promoted by advocates of "cheap" living. You don't have to buy used clothes at yard sales, cut your own hair, make guitar picks out of old credit cards, or reuse tea bags. What you do have to do is practice smart spending, the art of getting the most value out of your money. That will often mean looking with a skeptical eye at the "money-saving" products -- especially credit cards -- offered by a range of financial services companies. You also need to set up a list of priorities for spending and think long and hard about parting with your money the lower you go on the list. After all, the goal is to hang on to and save or invest as much as you can while continuing to live relatively well. Subsequent chapters will deal with various categories of spending and suggest ways to cut back.
GOOD DEBT, BAD DEBT
Chapter 8 will look specifically at credit card debt, but first we need to consider the subject of debt in general and how it can hobble your efforts to achieve financial freedom. Most financial advisers agree that there is good debt and bad debt. Good debt is money you owe on assets that are appreciating, like a house or other property. Bad debt is for things with little lasting value -- like entertainment, vacations, or restaurant meals--that are often charged on credit cards. it's important not to be too hard on yourself when you have a lot of debt or to go to extremes and refuse to have any debt whatsoever. Saving money while living well may entail some types of debt -- employed prudently.
Most of us, however, need to pare down our debt, especially bad debt. In recent years Americans have been living in an environment of low interest rates and easy credit, and as a result many people have taken on more debt than they should have. Although they may be able to handle it now, rising interest rates win make it much more difficult to pay down or pay off that debt. Good debt usually has a fixed rate of interest that will stay the same even if interest rates rise, and it is paid on an underlying asset that will most likely increase in value. Most home mortgages fit the bill; even many variable-rate mortgages have upward limits on rates. Automobile loans usually have fixed rates--a hallmark of good debt -- but most financial advisers would consider them bad debt since the underlying asset, the car, is depreciating. Unsecured revolving debt like that related to credit cards carries interest rates that increase as interest rates in general rise; as is all too familiar to many people, the rates can also shoot up for other reasons, including a late payment. This is very bad debt indeed.
Recent figures from the Federal Reserve Board and other sources put the total amount of unsecured consumer debt at about $750 billion, or $8,900 per household; total consumer debt is more than $2 trillion (excluding home mortgages). Personal savings rates, meanwhile, have been on a downward trend in recent years as debt has increased. The amount of unsecured consumer debt per household, however, is actually much greater than $8,900, according to Chris Viale, the president and chief operating officer of Cambridge Credit Counseling, a nonprofit group based in Agawam, Massachusetts, which publishes the monthly Cambridge Consumer Credit Index survey. "The eighty-nine-hundred-dollar figure is based on the total amount of debt divided by the total number of households", he said. "The problem is, thirty percent of households do not carry any credit card debt from month to month. So if you divide the debt by a number that represents seventy percent of households, the amount of debt per household is more like fourteen thousand dollars."
A March 2004 survey by the Cambridge Consumer Credit Index shows that more than four out of ten Americans, 42 percent, were making minimum payments or no payments on their credit cards; an astounding 39 percent paid their balances in full each month, down from 43 percent in March 2003. In a similar survey in January 2004, the top New Year's resolution was getting out of debt (28 percent); it beat losing weight and exercising more (27 percent) for the first time in the history of the survey. (The Cambridge Consumer Credit Index is a monthly telephone poll of 1,000 randomly selected American consumers; it has a margin of error of plus or minus 3 percentage points.)
A June 2004 article by Mathew Ingram in the Toronto Globe and Mail pointed out that in both Canada and the United States, the ratio of household debt to annual disposable income is approximately 115 percent, up from 100 percent three years ago and 85 percent a decade ago. In the first quarter of 2004, household debt in the United States rose at the equivalent of an annual rate of 10.9 percent, the second fastest pace in fifteen years. Such debt has risen 30 percent since 2000.
A Matter of Interest
Household debt is a very serious problem that is likely to get worse, according to Viale. "Of the households carrying such debt month to month, one-third are behind in their payments or over their credit limits. Many are receiving penalty rates or fees because of that. These rates can be upward of thirty percent because of the usury laws in the states where many credit card companies are based. It's almost impossible for people to pay off their credit card debts with those kind of interest rates. The average household that's carrying credit card debt month to month is making in interest payments the equivalent of a car payment on a car they don't own."
The danger of higher interest rates can easily be demonstrated by using an online credit card calculator like the ones found at www.bankrate.com. Assume you owe $10,000 -- a little more than the household average of $8,900 -- your credit card company is charging an interest rate of 5 percent, you make no more charges, and your monthly payment is $200. Under those circumstances, your bill would be paid off in 57 months, or 4.75 years, and you would have paid a total of $11,400, or $1,400 in interest. At a rate of 15 percent, it would take 79 months, or almost 6.6 years; your payments would total $15,800, or $5,800 in interest. At 28 percent, the $200 monthly payment would not even cover the interest charges. Increasing the payment to $250 means the debt would be paid in 117 months, or 9.75 years; your payments would total $29,250, or $19,250 in interest! You probably don't even remember what you spent the $10,000 on. Bad debt? You bet. (Figure 1 includes these and some other interest rates.)
"Credit card debt is going to be an even bigger problem as interest rates go up, which they are doing," Viale reported. He said a lot of people have been refinancing their homes and taking out some of the equity to pay off credit cards. Using low interest rates to pay off higher-interest debt is wise, but, according to Viale, "statistics show that two-thirds of households that take equity out of their homes to pay off credit cards wind up with the same amount of credit card debt within two years."
He also stressed the danger of tapping home equity with an adjustable-rate equity loan: "You might get a real good rate for a couple of years, but it might not be ideal when that rate goes up five or six percentage points. In five years, the payment on these loans could double."
Viale complained that it is too easy for people to get credit: "It's so easy for people to refinance in today's world. But the problem is that there's no consumer education requirement for these lending institutions. They snap a finger and pay off your debt. Then people have their credit cards available to them again, so they build up more debt. No discipline is taught to anyone about how to use credit."
The above is an excerpt from the book Live Well on Less Than You Think: The New York Times Guide to Achieving Your Financial Freedom by Fred Brock (Published by Times Books; January, 2005; $15.00US; 0-8050-7725-1)
Copyright © 2005 Fred Brock
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