As the recent economic crisis has shown us, there are dangers, obvious and hidden, associated with the abuse of credit. Our economy, which is in large part based on the availability of credit, teeters on the brink of disaster. At present, fifty cents of every dollar spent in the United States is charged on a credit card. As a nation, our national debt has risen above $11 trillion. Thousands of people are facing foreclosure and tens of thousands more are falling behind on credit card and automobile loan payments. Now, maybe more than ever before, is the time to think about the dangers of credit.
Credit Creates An Illusion Of Wealth
Let’s imagine an average working couple. Together, after taxes, they have an annual disposable income of $60,000. That’s $60,000 per year to provide food, shelter, clothing, and to purchase needs and wants. Let’s give our average couple two credit cards, one for his wallet and one for hers. Assuming that each credit card has a $10,000 limit, we have just increased their spending power, as a couple, by $20,000. We have, in essence, created $20,000 in spending power that did not exist on the day before we gave our couple their credit cards. Our happy couple, instead of living off of $60,000, their actual income, can now, for a brief time at least, live off of $80,000. We have given them the illusion of wealth – the idea that they have more disposable income than they actually have.
Credit Promises A Brighter Future
The credit system is dependent on two things: the ability of the lender to lend and the ability of the borrower to repay. As long as these things happen, everything moves forward. What happens, however, when the lender can no longer lend? Or, what happens when the borrower can no longer repay? We have a crisis, just like the one facing our economy today.
Let’s return to our couple. Imagine that our husband, inspired by his friend’s new HDTV, decides that he too needs a new television. He heads down to the local electronics store, plops down his new credit card, and is soon driving home with his brand new prize. At the same time, across town, his wife is buying a new couch for the den. Of course, in order to get her rewards points, she’s also using her credit card. The both arrive home, happy as they can be, and they spend the evening cuddling on the new couch, watching the new TV.
We’ve just described a very typical, very normal series of transactions. Clearly, there’s nothing wrong, inherently, in using a credit card to purchase the above mentioned items. The real issue, the real danger, only becomes obvious when we take a deeper look into our couples’ finances.
Do to the availability of such good credit, our young couple haven’t given much thought to building up an emergency fund. On top of that, because of their good credit scores, they have also decided to purchase a new automobile. He wants to do the right thing, so they find a great deal on a new cross-over, with zero-down and low payments. Total cost of the new car: $25,000.
Our couple, because of their incomes, can handle their monthly payments. Sure, things will be tight, what with the new car and all, but they can make it. Then the news comes. The husband’s company is downsizing, and he has two months to find a new job. After three months of looking, with very little luck, he takes another job, one which pays about two-thirds of his old salary. This is when the problems really start to emerge.
First, due to the stress of the lost job, the bills have started to pile up, and our couple has had to pay a couple of late fees to their credit card companies. Second, on more than one occasion, they’ve had to deal with over-draft fees at the bank. Third, that new car, which just a few months ago was their pride and joy, has suddenly become a financial burden. Unfortunately, they now owe more on the car than it is worth, and if they sold it, their friends and neighbors might know that something is up. Afraid to death, they begin to argue more and more about money, and our happy couple isn’t so happy anymore.
For credit to be useful and have its proper place in the economy, borrowers must have the ability to repay their obligations. Our young couple, who together brought home $60,000, now have over $25,000 in debt, he’s lost his job, and they have no money in savings. They have nice, bright, shiny new things… but they have no money!
The scenario I have described to you above isn’t imaginary. This is the reality that thousands, no millions, of Americans are facing, right now. Overwhelmed with debts they cannot repay, people are worried, frustrated, angry, and depressed. Who is to blame? Sure, our couple should have known better than to buy such an expensive car, and maybe they should have waited a year or two before purchasing that new couch, but the money – or rather the credit disguising itself as money – was right there. They believed, as most people believe, that their future income would pay for their past purchases. Unfortunately for our young couple, and millions of other people just like them, the future isn’t always bright. Life can throw some tremendous curve balls, and the pressure of being overextended can really slow down our swing.
Credit Justifies Impulsive And Irresponsible Spending
I can make the payments. How many times have we heard this statement from someone who is trying to justify a particular purchase? Is there anything wrong with purchasing a new television set? No. In fact, I have a nice, two year old HDTV sitting in my den right now, and I love it. Is there anything wrong with buying a newer car? No. In fact, I just washed my wife’s van, which we purchased, slightly used, several months ago. There’s absolutely nothing wrong with owning stuff, even new, nice stuff. Problems arise when we purchase things that we cannot afford, based solely on the fact that we can make payments.
Several of my favorite personal finance bloggers use credit cards, but they use them primarily for convenience. They never spend more than they can afford to spend, and they always pay their credit card balances off, in full, at the end of each month. I cannot think of one writer who’s opinion I respect who would tell you to go out and finance a new car unless you had an adequate emergency fund in the bank and you were adequately prepared for a job loss or similar emergency. I would suspect that even the biggest fan of credit card rewards points and credit card frequent flyer bonuses would suggest that credit can be dangerous when viewed as a solution instead of as a tool.
Our young couple would have been better suited to fully-fund an emergency fund, begin to live on a budget, and plan for their major purchases. A year or two down the road, they could have paid cash for the new television, and really shopped around for the new sofa. Perhaps, instead of financing a new car, they could have saved up a nice down-payment (or payment-in-full) and purchased a decent, used automobile, letting someone else take that depreciation hit. When our husband lost his job, instead of arguing and worrying about money, they could really tighten their belts, use some of the money in their emergency fund, and given him an extra few months to find a job that he really enjoys doing.
Credit Can Be Beneficial
I almost ended this article with the previous point, but had I done so, I’m pretty sure that I can guess the types of responses it would have received. There are those who would agree with all of the points above, but there are others who would point out a pretty obvious reality – credit can be beneficial. So, instead of waiting for readers or detractors to point this out, let me be the first to agree – credit can be beneficial.
In certain circumstances, the availability of credit can makes things easier. It’s easy to reserve a hotel room with a credit card. It’s much more convenient to swipe a credit card than it is to walk around with a big wad of cash in one’s pocket. Online, credit card transactions are processed instantaneously, facilitating the rapid purchase of goods and services. There are those who are only comfortable when maintaining a rather large cash reserve in the bank, and these people would rather make payments on a car loan than be cash poor. Without credit, millions of Americans might be shut out of the housing market, forced to be life-long renters.
I understand the role that credit plays. I’m just saying, I think that role is too large. We have become beholden to credit, and to the agencies that pedal it. I think we have borrowed ourselves into a gigantic mess, and, unfortunately and unwisely, we are tying to borrow our way out of it. It’s one thing to use a credit card to buy groceries, come home and pay your credit card off, and collect your rewards points. It’s another thing entirely to max out that same credit card, overwhelm yourself with loan payments, and live without cash reserves.
The bottom line is, whether you use credit or not, you need a long-term financial plan. This plan should be based on actual, real income and should take in to consideration that life doesn’t always move forward in a straight line. You will face ups and downs, and abusing credit can lead to financial ruin. If you must borrow, never borrow more than you can repay in a timely manner, and never extend yourself to the point that you are using credit simply to survive.
I’d love to hear your thoughts. Have we overstated (or understated) the dangers associated with credit? Does credit cause problems, or just reveal them? Would we better off without credit? Worse? Leave your comments below.