Monday, July 6, 2015

Debt! I curse at thee!

When you work in collections, the most important part of any conversation is understanding the customer’s financial situation. Often the person on the phone has a picture in their mind of how their finances look. This picture may or may not have any basis in reality—humans are funny like that.

I collected for a major financial institution for over a decade. During that time I saw the industry move from a free form model to one where every aspect of my interactions was scripted and regulated. That scripting was designed to get the customer to a place where they were reducing their debt with an affordable payment without taking food off their table or the roof from over their head. So I spent a lot of time talking to people all over the U.S. about their financial problems. It surprised me how many customers didn’t understand how debt works. In some cases you could tell they just didn’t like the situation they created for themselves. In other cases, the customer genuinely didn’t “get it.”

Simply put, debt means you owe someone money. The amount borrowed is called the principal. The profit is the interest and fees collected while you are paying that principal back. Those fees are the lender’s incentive to make the loan and their cost of doing business. The riskier the lender thinks the loan will be, the higher the fees. This means that if the lender is paid back, they make a large profit to offset their risk. The larger fee structure also encourages the borrower to pay back the debt faster to avoid mounting interest and penalties—or at least that’s the way it’s supposed to work. In practice many Americans don’t think of credit, especially credit cards, as loans. You can attribute this phenomenon to our growing materialistic focus or the degradation of civic values; but I really think it’s that people aren’t taught what holding debt means any more. How many people do you know with $50,000 in student loans, $200,000 mortgages, or $20,000 in credit card debt? Owing the bank money just doesn’t have the stigma it used to.

My grandfather’s generation grew up mixing canned chili with dog food. They lived through one of the worst economic periods in United State’s history. WWII gave us the boost we needed out of the great depression, but it was a close thing. That experience scarred him. I can remember him railing at the idea of paying anyone interest for anything. Whenever he found a hat he liked he bought enough to last him the rest of his life. He did his own home repairs and ground work. Every vehicle he bought cheap and sold at a profit. He worked his entire life expecting to have to pay for his retirement out of pocket—which he did. He hated debt in all forms because owing money was inextricably tied up with the memory of those dark times.

My father isn’t much different. Maybe it was my grandfather’s influence, maybe it was living through the financial crash of the 1980s, but he saves and pinches every possible penny. My mother and mother in law are always looking for new ways to save a buck. Growing up, Dad budgeted everything. Notably, my parents were able to retire comfortably despite raising three kids and putting two of them through college without student loans. I grew up with the unspoken understanding that if you worked hard you could earn a good living. It might take discipline and sweat, but it was absolutely possible.

Flash-forward to the present and my understanding of how life works has been seasoned with a healthy dose of experience. You can certainly earn a good life for yourself if you are willing to work hard and improve your resume. Of course, the financial landscape of 2015 bears little resemblance to the one my parents negotiated. Part of that difference comes down to changed attitudes regarding debt and credit. Recent generations expect to borrow money to go to college, to buy a car, to fund their lifestyle—all the things that used to be luxuries in days gone by. On average American households have four credit cards revolving a combined balance of $7,500. However, only about half of American households carry credit card debt; meaning the average family debt for those that carry a balance is almost $16,000.00. 70% of 2014 college graduates took on student loans averaging $33,000.00 a piece. The average U.S. mortgage runs $156,000.00. In fourth quarter 2013 the average new car loan was $27,500.00 with those holding subpar credit coming in at a staggering $30,000.00. Used car loans came in at $18,000 on average—I say again, used car loans. Per this article:

“According to the U.S. Census, there are 115.6 million American households in 2010. That means that if we divide the total revolving credit outstanding by the number of households, the average family has $7,630 in revolving debt. The U.S. Census also reports that in 2010 there were 234.56 million people over the age of 18 years old, which suggests that the average adult owes $3,761 in revolving credit to lenders. Across the average household, American adults also owe $11,244 in student loans, $8,163 on their autos, and $70,322 on their mortgage.”

So the average American household holds over $96,000.00 in debt. Note that I said household. Not every college graduate will have a mortgage. Not every car owner will have a credit card balance. The average household debt figure shocked me; but it was the follow-up analysis that really got my attention:

“If we look at total debt divided by the total number of accounts outstanding for that debt, we get a slightly different picture. The New York Fed reports that there are 410 million credit card accounts, which suggests that the average balance on the average credit card in the average American's wallet has a $2,151 balance on it. Multiply that amount by the average 3.7 credit cards that estimates each person has open and the average American with a credit card owes $7,950 in revolving debt. According to the Kansas City Federal Reserve Bank, the average person carrying student loan debt owes $25,745, and dividing total auto debt and mortgage debt by the total number of open accounts for those types of debt, as reported by the New York Fed, indicates that the average American with this type of debt owes $10,392 on their car and $100,197 on their home, respectively.”

You can infer just about anything you want from the above numbers. Some people will see them as good; some will see them as impending doom for U.S. consumers. I see a financial market in which more and more people are borrowing money while the amount borrowed per category continues to skyrocket. All this while the cost of living continues to rise, wages remain stagnant, and there is real concern over what “unemployment” even means any more.

It looks like many people are choosing to finance their lifestyles on the banks' dime. That’s good news if you’re a responsible lender, not so great news if you’re a twenty something looking to buy a house, car, and/or a college education. There are some situations where credit is beneficial. Buying a home is near impossible now a days without bank financing. Sometimes credit cards are the only way to solve a short term problem. College loans let economically disadvantaged youth gain critical skills and degrees. Car loans let you buy your own transportation. Credit, used sparingly, is a valuable tool. The challenge comes when borrowing ceases to be a way to defer short term financial issues and becomes a form of supplemental income. The brunette and I have paid off almost $40,000 in debt over the last 15 years. We incurred some of that helping family, some of it making unwise choices, and some of it was a deliberate choice where the financial cost was offset by long term benefits—and yes, I know how ironic it is that I’ve had to pay back that much debt given my profession. I can say with the weight of extensive personal and professional experience that long term debt is bad—really really bad.

To illustrate this, I’m going to discuss several of the most common misconceptions I hear regarding debt. “I can afford some credit card debt as long as I’m saving for retirement.” According to, the average credit card fixed interest rate is running 13% as of May-June 2015. The stock market returns 2%-6% depending on fund—we’ll call it 4%. So your investments are currently returning a quarter the rate your cards are losing—and that doesn’t take into account late fees and risk based pricing. Worse, credit cards compound their interest monthly, while the 4% figure is a weighted metric assuming your investments compound yearly. That means credit cards are actually losing you more than just 4% investment+13% interest because the interest is calculating in and moving your balance every 30 days—and of course there is no guarantee that your investments will actually pay off but you can be sure your credit card balances are going to be costing you money until the very end.

“I’ll pay off my student loans/afford my mortgage/consolidate my credit cards when my career inevitably improves/I sell my house for a profit/this thing I’m working on finally pays out.” I hear this a lot, especially from people like mortgage brokers who rely on commission. There are certainly situations where it’s reasonable to carry some debt with the expectation that all accounts will be paid off once ‘X’ happens. The challenge is that for most people ‘X’ is far from certain. Assuming ‘X’ will happen because historically it always has is betting your financial future that life is reliable and predictable. There’s a temptation here to succumb to wishful thinking, a temptation that is as compelling as it is self-destructive.

“I can afford to buy this on credit because it is an investment.” We’ve already discussed how you’d need at least a 14% annual return before any “investment” would be financially viable re-credit card debt. There are some investments like college that can actually pay out long term. This comes down to a sense of scale. Is the investment going to increase your income to the point where you’ll be able to pay it back, /realize a profit before interest, minimum payments, and fees make life financially unpalatable? If you graduate college with a degree you never use, $40,000 in loans, and no job prospects how much of an investment is that sheep’s skin? Be very sure you know the answers to these questions before signing on the dotted line.

“It was totally worth putting that purchase on credit; Look at all the money I saved!” Say I want 6 eggs. A dozen eggs is $0.20 per ovum while the half dozen is $0.25 each. The 12 pack costs me $2.40 and the 6 pack costs me $1.50. Buying the 12 pack gets me a better per-unit rate, but I still end up spending $.09 more than I need to. You only save money you don’t spend. Don’t get me wrong, I think comparison shopping, coupon clipping, and unit pricing are highly undervalued skills in today’s market—especially when it comes to daily essentials. My point is that money spent is money spent. People should be looking at the end result rather than the bragging rights on their discount.

I recently spoke to a group regarding credit and finance. I tried to articulate that debt is a contract, an agreement, a Burdon—something to be avoided unless absolutely necessary. 50 years ago, bankruptcy filings were printed in local papers—publicly shaming those unfortunate enough to have filed. Now, not so much. Credit is the power to buy on someone else’s dime. Debt is someone else’s profit at your expense. Cultivate the first; avoid the second like the plague.

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