by Bill Hardekopf
A long recession, the collapse of the housing market, and loose lending by banks have been blamed for dragging down household finances. However, a new study, Americans' Financial Capability by the National Bureau of Economic Research, says that many Americans lack the skills and knowledge to make good financial decisions for themselves and this is also part of the problem.
The survey of nearly 1,500 Americans in the summer of 2009 shows that many households don't plan for predictable events like retirement or for unpredictable events like emergencies. They poorly manage debt and are stung by higher interest payments and fees. Some don't even know the interest rate they pay on their credit cards or mortgage. Poor planning and financial mistakes make a family even more vulnerable to the shocks of a turbulent economy.
According to the study, many Americans take financial actions and make mistakes that lead to higher interest rates. They overdraw on checking accounts, make a late payment on credit cards, or exceed their credit limit.
Almost half of Americans have trouble paying monthly expenses and bills. 35 percent said it is somewhat difficult to keep up, and 14 percent admitted it is very difficult. One-third of respondents said they had a large and unexpected drop in income during the last year. Only 49 percent had an emergency fund that would cover expenses for three months.
About 15 percent do not have a checking account and 28 percent do not have a savings account, a money market account, or Certificate of Deposit. Considering these two variables together, the proportion of the unbanked is 12 percent of the population. The unbanked are also disproportionately African American and Hispanic; as many as 28 percent of African Americans and 30 percent of Hispanics are unbanked.
Bad Debt Management Leads to Higher Payments
More than 68 percent of respondents had a credit card. Of those, about 27 percent had at least four credit cards. The study found that borrowing habits of 41 percent of credit card users resulted in either substantial interest payments, fees or both. Nearly 33 percent paid the minimum payment, paid a late fee, paid an over-the-limit fee or used the card for cash advances at least twice. 54% always pay their credit card bill in full. Of the 46 percent of credit card holders who don't make their credit card payment in full, 12 percent don't know the interest rate on their credit card with the largest balance.
More than one in five Americans have turned to alternative lenders like payday loans, pawn shops, or advances on payday loans during the past five years.
Tips for Managing Debt
- Learn about the debt you have. Look at the monthly statement for each of your loans, then write down your balance, interest rate, credit limit, and payment due date. The first step in getting out of debt is to understand what you owe and what you are paying.
- The biggest factor in your credit card debt is the APR, the annual percentage rate. Most issuers offer a tier of interest rates. The rate you receive is based on your credit score, but you will not know what your rate is until after you apply. The higher your interest rate, the more you will pay the issuer for the privilege of borrowing money, while less of your money will be used to pay down your balance. A high interest rate can add thousands of dollars in interest penalties and years of payments.
- Your credit card balance consists of all the charges you have made with your credit card. Fees are also rolled into the balance so you do pay interest on all fees such as late payment fees.
- The due date obviously means that you must pay the minimum payment by that date. This is not a soft date for banks and credit card issuers, and there are many consequences for a late payment. The late payment fee can be as high as $35. The late fee is not the steepest consequence of a late payment. Your issuer can increase your interest rate to the default rate, which can be as high as 30%. Before activating the penalty rate, they must give you a 45-day notice. If you have a late payment, quickly catch back up because your issuer should restore your original rate if you make all of your minimum payments on time during the next six months.
- The minimum payment is set by the issuer. Look at the minimum payment box on your credit card bill. You may be shocked to see the number of years it takes to pay off your balance if you make only the minimum payment each month and how much interest you will pay. To pay off your debt in a financially prudent way, you have to pay more than the minimum payment. You pay more money toward your debt, and save money on your interest payments. With any incremental money you receive or save, use it to immediately pay down your credit card debt. Make micropayments to help pay off as much of your debt as soon as possible.
The study showed that many individuals don't know their credit score or information in their credit report; only 36 percent checked their credit score. The majority of people who check their credit score (52 percent) had a score higher than 720.
Credit scores and credit reports determine much more than interest rates and they are too important to be ignored or overlooked. They are used to make judgments and decisions about you, including jobs, insurance, loans and apartment rentals.
Your credit report is a history of how you have handled credit and is a gauge to a bank on the likelihood that you will pay off your debts. FICO is the most widely used score model and a score above 720 will get you a low interest rate. The credit score includes information on where you live, how you pay your bills, and whether you've been sued or arrested, or have filed for bankruptcy. If you have never looked at your credit report, do so at annualcreditreport.com. Once every 12 months, you can request a free credit report from each of the nationwide consumer credit reporting companies: Equifax, Experian, and TransUnion. Check for accurate information and correct any errors.
If your credit score is low today, now is the time to start raising it. Here are ways to improve your credit score.
- Pay your bills on time. A late payment can cause a significant drop in your credit score.
- Pay down your credit cards and keep your debt-equity ratio under 30%. Balances close to the credit limit indicate a risk of default and this is a red flag for issuers.
- Build a long-term relationship with your credit card. Older accounts with good payment history add points to credit scores. If you are just getting started, don't open several new accounts all at once; this looks risky if you don't have an established history.
- Well-managed credit improves credit scores. Managing a variety of loans like a mortgage or car loan helps build your score. Get into the habit of paying all bills before the due date.
Bill Hardekopf is CEO of LowCards.com, a site that simplifies the confusion of shopping for credit cards. It is a free, independent website that helps consumers easily compare credit cards in a variety of categories, such as lowest rates, rewards, rebates, balance transfers, and lowest introductory rates. It also gives an unbiased ranking and review for each card.