GRANDMA’S BUDGETING SECRET: LACK OF EASY CREDIT

Almost no one goes into credit card debt deliberately. Just ask Harold.

Harold and Veronica spent most of their twenties and thirties owing money to Visa and MasterCard.

There was the rent bill and the day-care bill and seemingly constant and sometimes staggering repair bills for their clunky Dodge Caravan. There were the trips to visit family members back on the East Coast, many of which came with high price tags. There were the back-and-forth expenses for Veronica, who cared for her father during his final bout of lung cancer. There were the probably too frequent meals at Bob Evans, partly because everyone was too exhausted to cook every night. They had no emergency savings. How could they? They were using the high-interest plastic in their wallets as their go-to rainy day fund. It was a pretty tense time. They quarreled about money, about how to manage their monthly cash flow.

And Harold and Veronica were pretty lucky. Harold had a steady job, earning a respectable middle-class salary. They contributed to a retirement account. They kept up with their minimum credit card payments. They weren’t among the third of households every year with an unpaid bill turned over to a collection agency. They weren’t bouncing checks, juggling payments, trying to decide which payment could be safely ignored while tossing a few extra dollars at a more persistent creditor. Occasionally, Harold would pick up an extra gig and pay off the entire balance, only to soon repeat the cycle.

Many of us spend a lot of our lives in debt. Average credit card debt per U.S. household now exceeds $7,000. But it’s actually worse than that. A little more than half of us manage to pay off our credit card bill in full every month. The rest of us? Take the financial Boy Scouts out of the picture, and the remaining households owe an average of more than $15,000.

We beat ourselves up constantly for getting into debt messes. We’re convinced our grandparents possessed some special financial discipline that we lack.

Not true.

It’s almost certain the secret to our grandparents’ extraordinary financial discipline was a result of the four Ls:

Lack of Access to Credit

Once upon a time, as Elizabeth Warren and Amelia Warren Tyagi pointed out in their personal finance guide All Your Worth, easy credit did not exist. No one needed to exercise much in the way of financial discipline when going into a store. You literally couldn’t fall prey to temptation about that pretty dress or camera lens you didn’t have the money to buy right at that moment. Instead, stores offered layaway plans, allowing customers to pay a small amount toward a purchase week after week until it was completed. Only then could you take it home.

Sometimes the local butcher offered credit to regular customers. But he needed to know you and know you were good for the money on payday. And while in an emergency you could turn to loved ones for help with the rent money, they were unlikely to be sympathetic to a plea for that must-have newfangled television thing. They would tell you to save up for it or put it on layaway. And most people sensibly avoided loan sharks. Remember that scene in The Sopranos when Tony is driving with Christopher, and he spots a guy who owes him a few? Actually, Harold doesn’t remember this, because he’s too cheap to get HBO. But you get the point. Fists were involved.

Things change. Today, the average American who has a credit card has 3.7 of them. You can hardly go shopping without being offered 10 percent off on all your purchases that day if you apply for a store-branded card right this minute. Hospitals and doctors and dentists—not to mention veterinarians—now offer access to fast credit via CareCredit.

And we haven’t even gotten to subprime auto loans, payday loans, pawnshops, rent-to-own, refund loans, loans disguised as convenient payment plans, and other adventures in high-interest lending that capitalize on consumers’ impatience, innumeracy, or simple despair.

How did this happen? Over time, credit loosened up. Usury laws—that is, laws that limited personal credit interest rates—were greatly relaxed beginning in the 1970s. Modern credit scoring allowed credit card issuers to gauge how likely different people were to promptly, or eventually, pay these loans.

This data crunching advanced to the point where financial services companies determined that the best way for them to operate was to not lend money to the most well-heeled borrowers. Come again? you may ask.

Well, the real money for credit card issuers is in making sure people who can’t or don’t pay off their bills in full load up on credit, then charging them for the privilege. As a result, they don’t want you to manage your money responsibly. If you do, they’ll call you a deadbeat. Why? They don’t make any money off you. If you use your card to buy something like an appliance, then pay off your bill at the end of the month, you are costing them money because they can’t charge you any fees.

But use the credit card as an expensive loan, and you are a profit center. But unlike the loan sharks of old, purveyors of these forms of credit can’t break your thumbs if you don’t fully pay. Your creditors will pummel you emotionally instead, hoping to drain a few extra dollars out of you.

BE A “DEADBEAT”: PAY OFF YOUR BILLS EVERY MONTH

It feels as if we can never escape.

But we can. We just need to try to surmount the temptation, not to mention the need, to use high-interest credit to get by. High-interest debt can grow so fast it will overwhelm your other savings and investments.

There is no better way to simplify and gain control over your financial life than by eliminating high-interest debt.

So pay off your credit card and other high-interest loans ASAP. For most of us, this is by far the best investment opportunity we’ll ever receive.

Think of it this way: The average interest rate on credit card balances is around 15 percent. On store-branded cards, it is higher, often between 20 and 25 percent. That’s the rate of return you receive, tax-free and risk-free, when you pay that debt down. No other investment reliably earns anything close to that. So there’s nothing more important in your financial life than to pay that down.

PAY MORE THAN THE MINIMUM

When you receive a statement from a credit card company, it will come with a minimum payment requirement.

That minimum payment amount listed on your statement is not a recommendation. Unfortunately, all too many of us take this minimum payment as just that. According to economists Jialan Wang and Benjamin Keys, a third of us will pay the minimum almost every month, with another third sometimes paying the bill in full but also often paying, yes, the minimum. Only one-third of us use credit cards fully in lieu of carrying cash or checks and pay them off regularly at the end of every billing cycle.

Why are so many of us paying only the minimum? Many of us probably can’t afford to pay more. But others are likely falling prey to a concept cognitive psychologists call anchoring. We see the prominently displayed minimum payment, and we believe it’s the right thing to do. The credit card company is saying it’s okay. It wouldn’t mislead us, would it? So we make that payment, or something near to it, and feel okay. We shouldn’t. Paying the minimum when you can afford to pay more takes a lot of money out of your pocket and gives it away to the credit card company. When credit card companies say it could take you more than five years to pay off that restaurant splurge, they aren’t kidding.

RANK YOUR DEBT

Can’t pay all your bills off right away?

Then you need to begin by ranking your debt.

Sit down with all of your bills. That’s right, all of them. Not just credit cards. But car loans and student loans too. You need to work out the following:

1. What you owe each lender

2. What the interest rate and other expenses are for each loan

It shouldn’t be that hard, practically speaking, because if you have followed our advice from the last chapter, you’ll have everything online, contained within your spending and savings plan.

Emotionally, it might be a difficult experience. You’ll likely feel anger, regret, and sadness. It might feel as if every financial, work, or personal mistake were right in front of you. It’s quite possible you’ll recall the vacation taken with an ex-boyfriend or ex-girlfriend to save a relationship that couldn’t be saved or the bills you ran up when you were suddenly downsized with two weeks’ severance. Maybe you should have bought a less expensive car or not fallen for the short-term zero-interest loan offered by a local furniture store. Perhaps you’ll wonder if you could have gotten through college with fewer student loans. It’s okay to acknowledge the mistakes and the roads not taken. But then it is time to take action.

PAY DOWN THE BILL WITH THE HIGHEST INTEREST RATE FIRST

The interest rate you are charged on your credit card is called the annual percentage rate, often shortened to APR. At the beginning of 2015, the annual median rate offered is in the midteens, with those deemed a higher credit risk paying upward of 20 percent.

You have at least twenty-one days from the day the bill is mailed to pay your bill without incurring interest charges. Pay your credit card in full—like one-third of all customers—and you are indeed receiving an interest-free loan. If you don’t, the interest immediately begins to accrue. And once you miss a full payment, you’ll pay a high interest rate on your balance all the time, until the next time you pay your entire bill.

Skip a payment, pay below the minimum amount, pay late, or exceed your monthly credit limit, and get ready for the pain in the form of various immediate penalties. And you are subsequently charged a penalty interest rate, which is typically much higher. How long will you have to pay this higher rate? The language on Harold’s credit card agreement says obliquely that this rate “may apply indefinitely.”

So paying down or—better—paying off your credit card debt is the best financial investment you’ll ever get to make.

But all debt is not created equal. Every form of debt has its own interest rate. How does that work? Well, let’s say you owe $5,000 on one credit card with a 25 percent interest rate and $2,500 on another card that carries a 10 percent interest rate. (We’ve dramatically simplified this example to illustrate a general point.) Let’s also assume you have to make a minimum payment of $25 per month on each card and that you have $150 available right now to pay down the two debts.

There are, of course, several ways to divide up this $150. You can pay $75 to each card. You can make the minimum payment on the big debt while you concentrate on paying off the smaller debt. Or you can choose the opposite strategy of paying down the higher-interest-rate card first, making the minimum payment on the other. (You could of course skip payments or pay less than the minimum. Just don’t do that.)

At the end of three years, these strategies yield very different results. Without paying a penny more, you save almost $1,000 by prioritizing your most costly debt.

This is why interest rates matter. The fastest way of ending your debt drama and getting off the debt treadmill is to devote your resources to paying down the bill with the highest interest rate while paying the required minimum on the rest. When you’ve retired that bill, you move on to the debt with the next-highest interest rate.

Some argue for a different strategy: Make a list of all the debts, and pay them down in order from the smallest to the largest. You can think of this as the momentum method. Does this approach work better? For some people, maybe. A study published in 2012 by two professors at Northwestern University’s Kellogg School of Management found that the more bills people were able to put to bed—no matter what the amount—the more likely they were to work their way out of debt.

You have to know yourself. If you need the psychic boost that comes with putting to bed your small debts, consider that approach. But know it will cost you. And the higher the interest rates on your loans, the more you will pay over time.

DON’T GO IT ALONE: FIND AN ACCOUNTABILITY PAL

So how can you surmount your initial urge to pay off the smallest amounts over the highest interest rates? How do you slowly chip away at your mountain of debt, a process that can sometimes take years of hard work and financial trade-offs? How do you stop using your credit card to purchase everything from pick-me-ups to groceries?

Get an accountability pal. That’s a friend or relative you can check in with every so often, to make sure you are on track. Don’t underestimate how much outside cheerleading can help. Take Ellie, Meredith, and Joan. The three women met when they signed up for a six-week personal finance class offered by their city’s college alumni organization. Over the course of the sessions, they became friendly and realized they were all there to knock out debt and get a grip on their savings. So after the class ended, they made a pact to meet once a month, talk over their progress, share their successful (and occasionally unsuccessful) strategies. Ultimately, another three women from the class joined them. After two years, the group of now six women had collectively knocked out tens of thousands of dollars in debt. And that wasn’t all. Meredith, who dreamed of going out on her own, left her job and opened her own graphic design business. “We needed the strength of the group,” Ellie said. “When I started, I had no savings and carried a huge amount of debt. It’s just what everyone I knew did, so I did it too.”

If you don’t want to turn to your personal circle, there are also online groups that can perform this function, such as Frugal Village. Support gives an added boost, bucking you up when you feel as if you can’t do it and making you feel less alone in your battle.

IT NEVER HURTS TO ASK: TRY TO NEGOTIATE YOUR CREDIT CARD BILL

One way to pay off your bills faster is to negotiate lower interest rates. After all, the lower the rate, the slower the bill will grow. How do you do this? Call each and every one of your creditors, and see if you can lower the interest rate on the debt you currently owe.

Will it work? It depends. The credit card companies don’t want to see you transfer your balance to a lower-interest credit card offer or, even worse in their view, turn to the bankruptcy courts. Don’t be shy, and don’t be embarrassed about your financial position. The worse that can happen is that your credit card company says no. But we can guarantee you won’t get anywhere if you don’t try at all.

Another common strategy is to move the debt from one credit card to another, chasing introductory interest transfer offers, not to mention a permanent lower interest rate. This is called a balance transfer. It’s not a bad strategy—provided, that is, you don’t rack up more debt on your new credit card. Why? Many of these deals come with a significant gotcha—that all the new debt will be issued at a higher interest rate than the one offered for your balance transfer.

Another catch to watch out for: Don’t mindlessly follow the advice of online credit card comparison websites for the best low-interest or balance-transfer deal out there. According to the Wall Street Journal, many either highlight the cards of their advertisers over better offers or bow to pressure from banks and credit card companies to show their fees and interest rates in the best possible light.

REDUCE YOUR CREDIT CARD SPENDING—AND GIVE YOURSELF A REWARD

If you are tempted to over-rely on your credit card or borrow more money, you are going to make it even harder to pay off your revolving balances. When you commit to paying down your credit card bills, you should avoid running up more debt on them. If at all possible, use cash, a debit card, or a prepaid card to make purchases.

Finally, don’t fall for credit card rewards programs. Of course it’s nice to have a free airline ticket or statement credit. It’s so nice that the lure of these rewards likely leads you to be less vigilant about spending. A study of one such program showed that consumers received an average monthly cash-back reward of $25. People’s monthly spending on these cards increased by $76, and their debt on these cards increased by $197. That’s a bad deal.

Our suggestion: Reduce your own credit card spending, and then buy yourself a prize.

BEWARE OF DEBT CONSOLIDATORS

Proceed with caution if you are thinking about debt consolidation or debt counseling. Debt consolidation is when an organization such as a bank, credit union, or company specializing in debt management pays off all your debts. In return, you pay the organization back. That means one monthly bill, not a dozen or dozens. It might well be for a smaller amount than you were paying multiple creditors on your own.

Well, first, it’s not free. Debt consolidation is still debt. It might be at a lower interest rate than the other debt but maybe not. If the monthly bill seems lower than what you were paying on your own, it might be because of lower interest rates, or it might be because you lengthened the payment period, actually increasing your total tab.

But all that pales in the face of another downside: Debt consolidation loans need to be secured by a possession; that’s usually a car or a home. Fall behind on this loan, and you are putting your car or your house at risk of repossession.

Then there is debt settlement. Consumers confuse it with consolidation. They shouldn’t. Debt settlement is when you turn to a debt counselor, who will attempt to negotiate partial forgiveness for the debt on your behalf.

Unfortunately, more than a few debt settlement counselors and consolidators are poor business citizens. Many jack up the fees, leaving the desperate consumers who turned to them in worse shape than when they began the process. Others don’t even contact creditors on your behalf at all. It can be very hard for the typical consumer to tell the difference between the good guys and the goons. The standard advice for dealing with debt counselors is to tell consumers to use a nonprofit service such as the National Foundation for Credit Counseling. However, it’s important to remember even the most honest players can have conflicts of interest. Some of the nonprofits funded with bank and credit card money, for instance, will rarely recommend bankruptcy, no matter how dire your situation.

Many people are now turning to peer-to-peer lending sites as a sort of do-it-yourself debt consolidation. Companies like the Lending Club use sophisticated algorithms to determine who is most likely to pay the money back versus who is in danger of defaulting. It’s a great deal—if you can get it. Unfortunately, many are not able to utilize this method. The people who need help the least are the most likely to get it, thanks to those algorithms.

All in all, if you are so desperate you are turning to debt consolidators and debt counselors to get out from under, you might be better off chatting with a bankruptcy attorney instead.

On that note . . .

DO NOT BE ASHAMED TO DECLARE BANKRUPTCY

There were about 900,000 personal bankruptcy filings in the United States in 2014. While there is this pervasive myth out there that all too many of us fecklessly charge up consumer goods and then turn to the courts to get out from under when the debt blows up in our faces, the truth is much more depressing. Most of us end up in financial trouble because of the economic plagues of the twenty-first century—health-care bills, unemployment, and family collapse. Moreover, the evidence suggests that most of us wait too long to declare bankruptcy, draining retirement accounts that would otherwise be safe from creditors once we seek the protections of the courts, in an increasingly hopeless effort to keep up with our bills.

So repeat after us:

There is no shame in admitting we can’t keep up.

There is no shame in declaring bankruptcy.

Now take a deep breath. Bankruptcy is not an easy process, but it just might be easier than dedicating years of your life to paying off bills that the courts would agree are too much for you to handle on your income and assets.

There are two types of bankruptcy. If you have lots of debts and little in the way of assets, you can file for Chapter 7. After a review of the situation, your debts will be wiped out, and you can start your financial life anew. If, however, you own a home or other assets you would like to protect from creditors, you file for Chapter 13. You’ll work out a three- to five-year repayment plan that won’t leave you destitute. At the end of that period, any debts you still cannot pay off will be discharged.

Are there downsides? Of course. Access to credit is likely to be difficult for several years. Some future employers are likely to look down on it, but then again, those same employers may not hire you because of a low credit score, which you will almost certainly have if you can’t keep up with your bills. On the other hand, you can no longer be hassled by debt collectors or others seeking to collect the money you owe them. The law prohibits them from contacting you once you file for bankruptcy.

Moreover, several types of debt are not eligible to be discharged in bankruptcy. These include IRS liens and child support payments. As for student loan debt, you need to prove “undue hardship”—a very tough standard to meet.

However, declaring bankruptcy might well give you peace of mind. Many people who have been through the process say their only regret is that they wish shame had not kept them from turning to the courts for relief sooner. There are no points to be gained from attempting to pay bills you cannot keep up with. After all, no one wakes up in the morning and thinks, “What a great day to go into debt.”

HANDLE STUDENT LOANS LIKE A PRO

The Federal Reserve estimates Americans owe $1.3 trillion in student debt. While people under forty are responsible for two-thirds of that debt, the amount owed by older people, even senior citizens, is soaring too. Studies have shown student loan debt affects everything from home ownership to marriage, even retirement. These loans that we assume to help train us for adulthood often end up determining it instead.

What’s more, many people sign up for student loans without paying attention to the actual loan, let alone the fine print. A recent study published by the Brookings Institution found half of college freshmen thought they had borrowed less money than they had. Among all first-year students with federal loans, 28 percent reported having no federal debt and 14 percent said they didn’t have any student debt at all.

Unfortunately, thanks to the fact that the cost of higher education has increased at a rate significantly more than the rate of inflation—not to mention our salaries—since the 1980s, many of us are not in a position to avoid taking out loans to pay for college. But there are things you can do to make the situation a bit easier.

First, know what kinds of loans you have. We can borrow money to attend college from either the federal government or private banks. It’s quite possible you have both types of loans.

You should always borrow from the federal government first. Why? Federal loans offer much more flexibility than privately issued loans. There are different monthly payment plans based on income. In some cases you can defer payment if you return to school or are underwater financially. More generous options are available if you work in selected public service occupations too. The Department of Education provides an informative website, StudentAid .ed.gov, that runs through the options and fine print on student loans and where to go for help. Visit it.

The issuers of private student loans are much less forgiving and flexible than the federal government. Unlike with federal loans, the interest rate does not need to be fixed. That leaves your financial life more than a bit uncertain. And if your income isn’t high enough to meet your private monthly student loan payments? Well, too bad. Sometimes the bank will help, and sometimes it won’t, and you won’t have much in the way of recourse.

As a result, this is a rare case where even if the amount owed on the federal loan is at a higher interest rate than your other bills, we’d strongly suggest you pay down almost every other bill you have before you take this one on.

Quick note about consolidating student loans: This can be very tempting. For starters, it allows you to pay one or two bills a month instead of making payments to what could be several different lenders. It also reduces the overall monthly payment, freeing up cash for other uses.

No-brainer, right?

Not quite. As with other consolidated loans, the lower monthly payment might well come at the cost of lengthening the term of the loan and increasing the amount of money you are going to pay over time. What’s more, consolidating federal student loans is, in the vast majority of cases, a onetime offer. There are no do-overs, unless you return to school and acquire more federal student debt. The best place to begin the process of figuring out if consolidation is right for you is to check out the Department of Education’s website.

At no point should you turn to private counselors or services offering to help you reduce the load of your student debt repayments. According to a report issued by the National Consumer Law Center, these are almost always high-priced and fee-ridden consolidation services interested in padding their own bottom lines and less concerned about protecting yours.

One other potential pitfall: Do not combine federal and private student loans. Why? Once again, federal loans provide more flexibility in the event of financial hardship, and you will lose those benefits if you consolidate those loans with a private lender.

Finally, if you can’t keep up, don’t be an ostrich! Don’t go into default; that is, don’t simply stop paying your monthly bill. The penalty fees will pile up fast. Instead, look for help. A good place to start is the website of the Consumer Financial Protection Bureau, ConsumerFinance.gov, or the Department of Education. These sites offer unbiased guidance and tell you how to ask for help and what you need to do to receive it.

YOU’RE OUT OF DEBT, NOW WHAT?

Now that you are out of debt, remember to pay off your credit card bill in full every month if you can. If you can’t do it, take it as a sign to immediately retire the card until the debt is gone.

Debt all too often happens to us when we are working to improve our lives but meanwhile need to just get through the day. Don’t let it steal your future. It won’t be easy to pay off or otherwise eliminate consumer debt from your life, but the results will be worth it. Just ask Harold. As we wrote this chapter, his wife and daughter went off to Paris on vacation. No debt required.