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3 Ways to Protect Yourself in a Credit Crunch
Rising debt, delinquencies, tapped-out equity: ominous signs of a credit system that is seriously out of whack. Here's your best insurance against the day when dollars are scarce and credit is tight.
First it was the stock market bubble. Then the housing bubble. Now concern is growing about what may, in fact, be the ultimate bubble: consumer debt.
Americans have piled on so much debt in the last decade that some economists are worrying about the possible fallout if consumers, already living on the edge, are pushed over by rising unemployment.
If a growing number of layoffs leads to widespread loan defaults, consumer bankruptcies and deflation, you've got a grim scenario indeed. Not only does credit become much harder to obtain, but it's more expensive, because the dollars you use to pay back your debt would be worth more in the future than they are today.
A Hard-Earned Dollar
This concept is a little hard for those of us raised after the Depression to grasp. After all, we've always paid back debt with cheaper money. Thanks to inflation, dollars repaid in the future are worth less than dollars borrowed today.
Here's how it works: Let's say the annual rate of inflation is 2% and you take out a loan at 7%. Your loan's real interest rate, adjusted for inflation, is just 5%. If instead you have deflation of 2%, the cost of a 7% loan in real terms jumps to 9%.
On the macroeconomic level, more costly and less available credit reduces the funds consumers have available to spend, undercutting one of the economy's major pillars of strength over the past few years. Jim Jubak describes the potential impact on investors in “Get ready for the consumer credit crunch.”
A Credit Flood
So how real is the consumer debt bubble? It's hard to appreciate how much credit inundated the economy in the 1990s until you look at the numbers. Here's just a sample:
- The amount of outstanding credit card debt rose from $173 billion in 1990 to $608 billion in 2001, according to Cardweb.com. Adjusted for inflation, that's a rise of 160%.
- During the same period, average credit card debt rose from $2,985 per card-carrying household to $8,367.
- Home equity lending rose sharply from $461 billion of outstanding debt in 1990 to more than $1 trillion last year. Adjusted for inflation, that's a 60% increase.
- Household debt burdens have risen to near record highs. Ten years ago, 12.47% of the average household's disposable income went to pay consumer and mortgage debt, according to the Federal Reserve. This year, the figure is up to 14.05%.
Bigger debt loads aren't necessarily a concern if they're accompanied by growing assets and rising incomes, as they were for most of the 1990s. But now we're seeing signs that easy credit is taking its toll:
- Foreclosures have reached the highest level in at least 30 years, according to the Mortgage Bankers Association of America. The latest figures, showing 0.4% of homes in foreclosure, are especially disturbing because foreclosures don't usually rise in a hot real estate market, when most homeowners can sell their homes quickly. This indicates that a rising number of homeowners may owe more on their homes than the houses are worth.
- Bankruptcies keep hitting record highs, with 1.5 million filings in the 12 months ending March 30, 2002.
- Credit card delinquency rates have risen 30% in the past year, with 3.88% of credit card accounts past due.
- The average homeowner's equity represents just 55% of the home's value -- down significantly from the 67% level typical of the 1960s, 1970s and 1980s. Again, this is as home prices are rising -- indicating that people are draining the equity out of their homes at an alarming rate, leaving less as a cushion in case of emergency or declining home values.
In some cases, lenders seem to be responding by gradually tightening, being slightly less willing to extend new credit. Those zero-percent balance transfer offers are getting a little harder to find, and their terms are generally shorter -- two to three months instead of six months to a year, for example.
Some credit card lenders are raising rates on people who make only minimum payments each month or who max out their credit cards. Both behaviors are seen as a sign the consumer may be headed toward bankruptcy.
Federal regulators are also cracking down on banks that loan money to less-creditworthy borrowers, known in lending circles as the subprime market. That means those customers may be facing higher interest rates, lower credit limits and more trouble getting loans.
3 Ways to Protect Yourself
In the worst-case scenario, a rising number of defaults and delinquencies could cause lenders or regulators to slam the brakes on credit. As the cost of credit rises and its availability diminishes, bankruptcies, defaults and delinquencies could rise still further -- thereby fueling higher costs and perhaps even tighter credit.
No one really knows the chances of a real credit crunch occurring. As a consumer, though, you can protect yourself from the potential fall-out in the following ways:
- Build and maintain a good credit. People with good credit histories and high credit scores (typically FICO scores over 720) will generally get the best deals, regardless of the overall credit environment. People with poor credit may see much of the easy lending terms of the last few years disappear.
- Don't overextend. Maxing out your credit cards and borrowing every nickel a mortgage lender will give you are rarely good strategies. They're particularly bad ideas in rough economic times.
- Pay down your debt. Again, this is always good advice, but especially so when the cost of credit could be on the rise. Start with nondeductible consumer debt, like your credit cards, and then move on to auto and personal loans (assuming you won't face onerous prepayment penalties). Mortgage debt is generally cheap, and tax deductible besides, but it still makes sense to at least pay down your home equity loans. The more home equity you leave untouched, the more of a cushion you have in case of emergency.
