Americans and Credit Card Debt

There is a fine line between credit card use and abuse: the deadline.

In the hands of careful shoppers, the responsible use of credit cards can be both useful and rewarding, earning them cash back, air miles, and other bonuses.

But the irresponsible use – or outright abuse – of credit cards can end up adding a substantial mark-up to the cost of everything you purchase by some 18-22% per year in interest charges on unpaid balances.

Recent debt studies show that today’s youth are recognizing that. To their credit, they are developing good spending habits at an early age, which could make them much wealthier than their parents’ generation by the time they retire.

A Test Score That Really Matters

Parents are correct in being keenly interested in their children’s education scores. But they tend to neglect one of the most impacting scores of all: their children’s FICO score.

As defined by Investopedia, the Fair Isaac Corporation’s FICO score covers “a substantial portion of the credit report that lenders use to assess an applicant’s credit risk and whether to extend a loan.” It has a tremendous impact on a person’s ability to purchase property or procure loans at lower rates.

Everything your teenagers or young adult children do with their money can either benefit or damage their FICO scores, since the rating “takes into account … payment history, current level of indebtedness, types of credit used, length of credit history and new credit,” Investopedia explains.

Starting Off on the Right Foot

Recent data provided by the Fair Isaac Corporation shows that the number of American youth aged 18 to 29 without credit cards has doubled from 8% in 2007 to 16% by the end of 2012. One in every six has already developed perhaps the best consumer habit of all – paying by cash.

This new generation knows something about cutting expenses. The average credit card debt for the group has fallen from $3,073 to $2,087 per person, a decrease of nearly a third in five years. As a result, 11.2% of this group now has the “excellent” credit rating of 760 or higher, up from 8.6% in 2005.

One measure helping to improve the debt situations of many youth is more stringent credit card qualifications. The 2010 CARD act requires persons under 21 years of age to either have a co-signer or earn enough monthly income to afford minimum card payments. These tougher requisites have turned many youth onto pre-paid cards instead.

Your Children are Watching You

Youth are often known by older generations for their rebellious nature. But debt accumulation is one area where today’s youth should be commended for rebelling against their elders. The older generation’s debt situations are examples to be avoided.

CardHub.com published its recent report showing that Americans are continuing to accumulate debt at hyper-speed. While Q1 of 2013 saw new credit card charges of $47 billion, pay-downs during the same period lagged at a distant $32.5 billion. And that pay-down rate has shrunk by 7% over last year’s first quarter repayments.

Card Hub CEO Odysseas Papadimitriou summarized his team’s findings to the San Antonio Business Journal:

“The numbers indicate that we’re starting to regress a bit, and that’s something that must be addressed before debt levels rise to the point where consumers can no longer sustain them and we default in droves.”

Papadimitriou stresses that it will take more than just self-discipline – it will take changes in attitudes and expectations as well. “That’s going to ultimately require a shift in perspective from the belief that living off credit is acceptable to an approach that emphasizes saving and responsible spending in the context of post-recession income levels.”

Credit is intended as a temporary spare tire to help you get to your destination when needed. It is not intended to be driven on continuously. When you’re done with it, put it back in your trunk, fully inflated, ready for future use only when absolutely required.

Show Them the Impact

We need to give today’s youth more credit as keen investment planners. By helping them identify financial goals and work out clear paths for reaching them, parents might be surprised at how determined their children can be at sticking to them.

Whether that goal is tuition for college, the purchase of an automobile, or the down payment on a home, sound financial planning and debt reduction will become much more meaningful if they can visualize a tangible incentive for staying with the plan.

Equally important is helping them review their progress regularly so they better appreciate their advancement to date and gain ever more enthusiasm for maintaining their pace to the end.

The graph below presents one example, using the average credit card balance of $2,000 among persons in that age group, with the average interest rate of 1.66% per month (20% per year).

The pink line represents an unchanged debt balance with just the minimum payment of the interest alone, some $33.20 per month.

By increasing the payments to just $74.25 per month, that $2,000 debt balance would be completely paid off in just three years (blue), where payments of $101.71 per month would see it paid off in just two years (green) and monthly payments of $185.19 pay it off in as little as one year (yellow).

As a comparison, that $2,000 debt would end up costing less each time – some $2,673 (blue), some $2,441 (green), and $2,222 (yellow) – thanks to the interest saved.

But don’t forget the next step; paying off debt is just the first. Once your child has developed the habit of setting aside that $74 or $101 or $185 per month, the next step after paying off debt is to continue setting aside that same amount into an investment plan – preferably a tax-reducing retirement plan.

As the graph above shows, continuing the same monthly payments into an investment plan earning an average of just 6% per year would in 20 years grow into as much as $78,443 (yellow) for just $44,445 invested – fairly close to double the amount set aside.

After all, they have already become accustomed to living without that $X amount every month. If they continue living without it for now, they will have much more to benefit from later when their investment plans mature into redeemable college tuition, a down payment on a house, or a sizable retirement nest egg.

Impact on the Economy

Companies may not like the idea of consumers reducing their dependence on credit for fear it will reduce spending and thus hurt the economy. But rather than reducing economic activity, paying down debt merely shifts economic activity from one sector to another.

While sectors providing credit – including lenders and retailers – would indeed see their profits reduced, other sectors would see their revenues increase. As consumers grow their savings, large ticket items would become more attainable, such as homes, vehicles, furnishings, even vacations. And the money saved from reduced interest payments would either be invested, benefitting investment companies, or simply be spent shopping, with a benefit to retailers after all.

Bringing debt under control would not harm an economy at all, but would simply shift profits from the lending institutions to other sectors.

What is more, lighter consumer debt burdens would ultimately lighten the burden on governments and taxpayers, who currently lose billions each year on financial assistance programs and personal bankruptcies.

Rest assured, if a penny saved is a penny earned, that penny will eventually be spent at some point. The only difference between spending it now and spending it later is the growth that savers will enjoy in between.

Joseph Cafariello

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