Long ago, when I was in college, there was a long line of credit card companies outside the school bookstore handing out applications. Students would grab as many as possible. The companies knew that first-year students were likely flush with cash from mom and dad and were ready to spend. Each card would come with a $300 or $500 cap, and students would stock up. Friends of mine would carry five or more.
Those were the days, huh? I will tell you how it always ended. The students spent like mad for one or two semesters, maxed out their cards, found themselves in a debt trap that forced them to spend all their liquid funds to cover only the minimum payment on each of several cards, and were saddled with debts in the multiple thousands.
Around the following summer, they would admit all to their parents, who became very angry but paid the balance. With that came a warning: Stop the nonsense. Maybe this scolding worked or maybe not. Either way, the card companies made out like bandits.
Nothing like this happens these days. A combination of tighter regulations and general risk aversion by banks and card companies has made it far harder to get a credit card. The debit card is the norm until the kid can save some money and prepay. Only after demonstrating some responsibility are the cards issued.
I cannot help but think this is a good thing overall. The old system was fun to watch but also slightly edgy, even to the point of being exploitative. It makes sense that credit should only go to the responsible and those who can afford it.
People’s behavior with credit cards still calls forth controversy. Credit card debt has soared in our times, now exceeding $1 trillion, with a rising rate of delinquency. Meanwhile, rates on revolving accounts are running an incredible 21 percent, the highest in the whole industry, if only to cover the risk of default. Half or more of card holders carry balances month-to-month.
This is actually quite bizarre. One would expect credit card debt to fall as a higher interest rate is charged on balances. But it appears that during the lockdown/stimulus period, many Americans got carried away and ginned up their lifestyles. Now, they cannot let go, even when faced with a grim and grueling inflation and absurdly high interest rates.
If you don’t like those rates, I suggest two possible routes: Don’t carry a balance month to month, or tear up the card and use only debit cards. The trouble is that once you get into a debt trap, there is no easy way out. It is simply too tempting to pay the minimum while continuing to throw down the card at the end of a night of boozy socializing.
As a result, millions of Americans are trying to maintain a lifestyle that they cannot afford. Now the candle is burning at both ends. They got in the habit of just paying down a bit, and perhaps many people have not noticed that the interest rates are through the roof. Paying the monthly minimum does not pay anything against the principal.
Let’s go back to fundamentals. Why do interest rates exist? For those paying interest, they are expressing a preference for obtaining now what they are unwilling to wait to obtain later. They make an exchange with some other party that has money to lend, and the lender gets paid rent on their own money. It all works just fine.
The reason for the yield curve is to allocate these time preferences depending on the term. This is why overnight lending typically costs and pays a far lower return than lending over two to 30 years. Because borrowing in longer terms involves more leverage of the future for the present. The price of doing so is higher.
The Federal Reserve can control the rates at which it is loaning to the banks. This is what is at issue when people talk about the Fed’s interest rate. The rates throughout the whole of the yield curve, however, are determined by market forces. The rate on credit cards tends to be very high because the balances can be held indefinitely provided they are serviced month-to-month.
Today, many people are upset about high interest rates on credit cards. The Trump campaign has called for a cap of 10 percent on such revolving loans. That is a very low cap. It means asking borrowers to pay far less for revolving accounts, which sounds nice until you realize that this will only cause people to take out more credit card debt and banks to become even stricter in their lending standards. This will amount to a huge subsidy for the most credit-worthy borrowers and a punishment for those who might need a short-term loan but have sketchy credit histories.
In other words, this is a very bad idea that will make an untenable situation even worse.
Here is a much better idea. Think about what you are doing. When you go into debt, you are necessarily obtaining something before you are in a position really to afford it. Otherwise, you are always better off paying cash. You are even better off saving that money and lending it to someone else by keeping it in money markets or investing it.
In addition, borrowing always means making a bet that in the future, you will be in a better position to pay for the thing you have obtained. That restricts your future options and range of choices, which comes at a cost.
To be sure, many people see the need to do this for college and for a home, which is fine, but it’s good to be aware of the economics behind these choices. It is never ideal. You are better off now just paying cash if you have it.
Every life and every financial decision is different but I’m supposing, and I think it is likely true, that consistently paying servicing charges on a credit card is always a bad idea and probably can always be avoided by making different choices. The ideal credit card rate of interest is zero, and you can obtain that simply by paying off the whole of your balance every month without exception. This is what everyone should aspire to do.
Personally, I’m a fan of high rates for card holders because I’m old-fashioned and believe in thrift. The high rates serve as a kind of punishment for spendthrifts and financial profligacy in general. In this sense, the high rates offer up a kind of moral lesson: You should not be doing this, but if you are going to do it, you are going to pay a very high price. This is a major reason to object to limits on such rates: They only end in removing some of the sting from financial irresponsibility.
It’s probably a good change from when I was in college that stupid kids are no longer given many thousands in seemingly free bucks to spend on drinks and parties. Good. The debit card was and is a wonderful innovation; forcing people to live within their means.
In fact, I would go further and say that governments should also have their credit cards taken away and be forced to live within their means, spending only what they collect in taxes. This alone would make the world a better place. Even better, whatever debt governments issue should always come with a market-based default premium, just like state debts. That means no more promises from the central bank! That alone would clean up the fiscal house of governments in our time.
Cut up those cards! Everyone will be far better off.
