Barbara O’Neill, Ph.D., CFP®
Extension Specialist in Financial Resource Management
Rutgers Cooperative Extension
On a recent webinar sponsored by the New Jersey Coalition for Financial Education, Kim Cole from Navicore Solutions, a New Jersey-based credit counseling agency, discussed consumer credit (a.k.a., consumer debt). This term is used to describe debt excluding a home mortgage including credit cards, car loans, student loans, lines of credit, and other debts. There are two types of consumer credit: revolving credit (where a balance can be carried forward month to month) and installment credit (fixed monthly payments for a specified time period).
The most common form of consumer credit is credit cards. According to government and industry data that were presented on the webinar, average American households with consumer debt owe $16,883 in credit card debt and $29,539 in auto loan debt. One reason for the big increase in consumer debt in recent years is that the cost of living and costs for higher education have far outpaced income growth.
Another interesting trend noted during the webinar was that long-term (6+ years) car loans have increased from 26% of auto loans originated in 2009 to 42% in 2017. Longer-term loans tend to be used to finance larger dollar amounts. In addition, default rates on longer-term loans are higher than those for shorter-term loans and credit scores of borrowers with long-term loans are lower. When car loans exceed five years, borrowers can be “underwater” for years and owe more for a car loan than their car is worth after depreciation.
So what do all these statistics mean? A key take-away is to manage credit wisely and take on no more consumer debt than you can comfortably afford to repay. Another is to pay off consumer debt as quickly as possible and avoid “perma-debt” (i.e., a permanent debt balance that never goes away). Below are five specific action steps:
- Maintain a Low Consumer Debt-to-Income Ratio- Monthly consumer debt payments should not exceed 20% of take-home (net) pay, which is consider a “danger zone.” A ratio of 10% to 15% is even better, especially for people in high-cost states and/or those with high ongoing expenses such as child care. “Do the math” to calculate your current consumer debt-to-income ratio and what it would be if payments for a new consumer debt were added to current debt obligations.
- Buy a Less Expensive Car- When people spend less on a car, say $17,000 instead of $26,000, they can take out shorter loans, make lower monthly payments, and/or be underwater for less time. Purchasing options include a smaller, lower-cost new car or a late model “new used” car in good condition. Services that comparison shop and negotiate prices on a buyer's behalf may also be useful.
- Do a PowerPay Debt Acceleration Calculation- PowerPay is a free web site developed by Utah State University Extension that shows users how much time and interest they can save by accelerating debt repayment. If people have multiple creditors, PowerPay will create a calendar of monthly debt payments. As each debt gets repaid, its monthly payment gets applied to the payment for one of the remaining creditors. Debts can be accelerated in order of highest interest rate, lowest balance, and shortest payoff term.
- Earmark Income for Debt Repayment- Sometimes, it may be possible to apply a large lump sum toward reducing or eliminating an outstanding debt balance. Sources of extra cash can include working overtime, freelance work, reducing household expenses, expenses that end (e.g., child care), completing a savings challenge, and/or receiving a raise or bonus.
- Get Help When Needed- Non-profit credit counseling agencies can assist people whose consumer debt has gotten out of hand. They may be able to negotiate concessions from creditors (e.g., waived late fees and lower interest) but will probably require clients to surrender their credit cards to not run up additional debt.
High consumer debt is a problem for many U.S. families and there is no easy way out. Rather, there are small steps, like those listed above, that can make the situation better over time. It is impossible to borrow your way out of debt because new debt will just make things worse. The solution, instead, is taking positive action.