Why do credit cards cause such big problems? Why do credit cards cause such big problems?
How did we get to this point with credit?
Why have interest rates caused such problems?
Why have bank fees become such a problem?
What is a subprime loan?
What are interest-only mortgage loans?
What is a balloon mortgage?
Is the general economic environment really worse today than it used to be?
As long as you have not gone over your credit limit, credit cards never say no to your request for a loan, and they are always there, ready to play on your dreams, needs, and weaknesses, which is where you can get into trouble if you’re not careful.
Credit cards are fairly new. The first general use credit card did not appear until 1950, but credit cards did not take off until the mid- to late 1960s. After that, credit cards grew and grew. Today it is hard to live in America without using credit cards. But the problem is that credit cards, in addition to making life easier, offer instant loans at high interest rates. The charge for failing to pay off your charge at the end of the month became a standard 1.5% per month (18% per year).
Banks found right away that many, if not most, people did not pay off the charges each month, which meant credit cards were hugely profitable to the issuer and a ticking time bomb to the borrower. If a problem comes up where the minimum monthly payments cannot be made, the individual has a ready-made heavy debt load.
People will take vacations, pay for private schooling for their children, buy luxury cars, or redecorate their homes, and put it all on their credit card. Normally, they have every intention of repaying these charges, but it turns out to be more than they can afford. They never could have gone into a bank and gotten a loan from a bank officer for this spending. The credit card, as long as the limit has not been passed, will happily supply the money.
Another use of credit cards we often see is a source of loans to help people out in hard times. When a person for one reason or another (e.g., sickness, loss of job, layoff, injury) loses his or her income, something must be done to replace these funds. Most families have a little something set aside for such eventualities. However, no matter how many assets you have, if the income is cut off long enough, you will run out of money. At this point there is a temptation to use the credit cards to tide you over until things get better. Soon you have no income and a large debt.
At one time, in the period prior to World War II, the cost of borrowing money was fairly low, in the 3%–6% range per year. This was true for personal loans and for mortgages. Higher rates than this were illegal in many states, and only loan sharks charged more.
When credit cards were developed, they charged higher interest, but no one expected that anyone would carry a balance for several months, let alone several years. But, as it turned out, many people did carry balances for long periods of time, which meant a lot of profit for the credit card companies—so much profit that over the years they kept trying to get cards into the hands of more and more people. In time, cards were given to college students who didn’t have jobs and people with weak credit. To cover possible losses from allowing people who had weak credit to use cards, the credit card companies increased the range of interest rates that could be charged. They also adopted policies of increasing interest rates on individual card holders much faster than for slow pays or other financial sins. Because defaults have stayed rather low over the years, the policy of even higher interest rates on credit cards has resulted in a financial windfall for the issuing banks.
Banks have to answer to shareholders, and shareholders want their stocks to increase in value. Stocks increase in value when companies make more money. At some point, banks can’t increase interest rates on credit cards or find new people to issue high-interest credit cards or mortgages to, so other sources of funds must been found. Enter the bank fee. Banks have charged fees to talk to a live teller or to use an ATM out of their system, among others.
With credit cards and mortgages, banks charge for paying late. Consumer groups have claimed that the grace period in which to pay has been shortened, that the mailing of reminder notices has been delayed, and the clocking in of received payments has been gamed—all in an effort to collect late fees. Thanks to these and other efforts, bank fees are now a major element of bank earnings.
A subprime loan is a loan made to a borrower who has a weak credit history. The borrower’s poor credit history makes loans to him or her riskier, so the borrower is charged a higher interest rate. The term subprime loan is normally used in connection with real estate loans, but financial transactions concerning vehicles and credit cards can also be subprime.
One type of subprime loan calls for paying interest only. It became popular in parts of the country where house prices were higher than most people could afford. In it the borrower paid only the interest on the loan for a period of time and then began making regular, higher mortgage payments or a balloon payment. The borrower who took out this type of loan was normally gambling that he or she could sell or refinance before the higher mortgage payments began. This was a gamble that didn’t always work out.
A balloon mortgage is a mortgage where lower mortgage payments— or even interest-only payments—are made for a period of time. When the time period is up, the entire amount of the loan is due. The monthly payments at times are set at amounts less than what is necessary to fund the loan. As a consequence, every month the debt is growing larger. With a balloon debt, the borrower is clearly gambling on a sale or refinance before the time period expires.
Yes, it is worse than it was in the 1950s and 1960s. One can argue whether globalization and NAFTA have been good or bad for the average person. But one thing is beyond doubt: it has caused a great deal of flux in the economy. The old, large, stable employers—U.S. Steel, GM, United Airlines, etc.—have dropped employees. Smaller companies, which tend to be less stable, have become a larger part of the American economy. Company-supplied health insurance plans are not as common because the old, large companies have downsized. Defined benefit pension plans have gone the way of the dodo to be replaced by the employee managed 401(k). This may be creating the next crisis—people who don’t have enough to live on in retirement.