Credit, Debt, and You
Debt is a huge issue for households across America. The average American household has $5,700 in credit card debt, and for households that carry a balance, that number balloons up to $16,000.
In this week's episode of Industry Focus: Financials, Motley Fool analyst Gaby Lapera and personal finance expert Dan Caplinger talk about debt -- how big a problem it is, and the best ways to get out of it. Tune in to find out more about how your credit score is calculated, how having a high credit score can benefit you, why it behooves credit card users to pay more than their minimum monthly payments, why it's so important to pay your loans on time, and much more.
A full transcript follows the video.
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This podcast was recorded on Jan. 30, 2016.
Gaby Lapera: Hello everyone!Welcome to Industry Focus, the podcast that dives into a different sector of the stock market every day. You're listening to the financials edition, recorded today on Monday, January 30th, 2017. My name is Gaby Lapera, andjoining me on Skypeis Dan Caplinger,personal finance guru extraordinaireat The Motley Fool. Hey Dan, how's it going?Dan Caplinger:I'm good, Gaby,how are you doing today?Lapera:I am good. I'm trying to keep upbeatbecause today's topic is very depressing.(laughs) Today, we'regoing to talk about debt and credit. Just so you know, debt plaguesAmericans. We were talking about this earlier, Dan,so I know you know, but our listeners might not,so I'm going to throw out a few statistics here. About15% of Americans think they'regoing to die in debt. About 60% of Americans could not cover anunexpected expense of $500. 34% have$0 in savings, andanother 35% have $1,000 or less butmore than $0. Theaverage amount of student loan debt issomewhere between $31,000 and$37,000depending on your source. The average amount of mortgage debt is about$170,000, whichI guess isn't that much of you think about houses. Buttoday, we're going to talk about credit card debt. The average American household hasabout $5,700 incredit card debt. However, if you are a household thatcarries a balance --which means that you don't pay off everything you owe on the credit card every month --the average amount of debt that you have isabout $16,000. That's a lot of money!Caplinger:It's a lot.Lapera: Yeah,those are a lot of facts and figures I just threw out. It'scrazy, that's a lot of money.Caplinger:$16,000, yeah. When youthink about what the median income for a typical household is --something like $50,000 --you're talking about, even if you took every penny that you brought in and did nothing:didn't eat, didn't pay for your house,didn't drive anywhere,you would still be spending months just getting that debt paid off.Lapera: Yeah. Andwhat's even crazier is that the average interest rate on acredit card is 15.2%. So,a lot of that payment would be going to interest,it wouldn't even be paying down the principal.Caplinger:Absolutely right.Lapera: So,let's talk a little about how we get there. How do you get to$16,000 in debt? Apparently about38% of All American households havesome sort of credit card debt,maybe not $16,000 but some sort of debt. I think,let's start with one that'scommon way, it's a little controversial,which is living paycheck to paycheck, so,spending all of your money every paycheck,as opposed to putting some away for unexpected expenses. Thereason I say this is controversial is because I know that not everyone can afford to live their life differently,other than paycheck to paycheck. Some people just don't make enough money to live any other way. Butthere are plenty of people in America who do makemore than enough money for their needs, and they're stillspending frivolously.Caplinger:Yeah. Andthat's a lot of how you end up in that paycheck to paycheck situation. Andcredit cards actually make it easier, in some ways. When you're reallystretching to make that paycheck last as long as you can,if you still have that credit card and thoselast couple of days are coming up and you spent big early on, right after you got your check, thenit's tempting to cover the difference with that credit card. That's howa lot of people start the ball rolling in terms ofgetting those big credit card balances you're talking about.Lapera: Yeah. One of the things you could doto prevent this is make a budget and stick to it. Make a reasonable budget,I should say, and stick to that. (laughs)I don't think anyone needs to spend $500 a month on pizza unless you have a family of 24 and you're making $1 million a month.(laughs) But,you know what I mean? Some people make budgets, like,I have seen line items on some of my friends' budgets where it's like, "What?Howdo you think you're going to spend so much money every month ongoing to the movies? Andyou also have three movie streaming services,and you pay for cable. Do you really needall of those methods to consume media? Probably not."Caplinger:Yeah,interestingly,a lot of credit cardswill actually help you come up with a budget that will give you a spending history andbreak it down by category, so you can actually seehow much you're spending at restaurants, how much you'respending on movies, utilities,any category that you're using that card for, you canactually use it to your advantage to figure out, "DoI really need to be spending this much on this? Maybe not," andthat could free up money to pay down that balance andget rid of some of that interest and get yourself out of debtthat much faster.Lapera: Yeah,it's really cool, I just got my year-end credit card reportsfrom my banks,and I just spent 20 minutes going over them,looking at all the miscellaneous things that I had spent money on.I spent a lot of money onLyftrides this year.(laughs) Or, I guess,last year now. That's the peril of living in a city withquestionable public transportation. So, another thing: maybeyou're already living paycheck to paycheckand you have money on your credit card, andsome people just don't pay their credit cards off at all, which is a really bad move. Not paying yourcredit card is never going to get you out of debt.Caplinger:Yeah,it's a triple hit. Not only do you not get out of debt, but you pay the interest on what you didn't pay, you'll pay a late fee or non-payment fee to the credit card, and, as we'lltalk about later on, you rip your credit score to shreds, too. So,it's a whole bunch of bad things that come up. It always makes sense,at the very least, to get that minimum payment in toavoid all those excess charges.Lapera: Yeah,absolutely. You would be surprised byhow common this is. Every year, people write stories about credit card debt,and there's always at least one person who is interviewedin these stories who is like, "Ididn't realize I needed to pay the money back.I thought it was just money they were giving me." Which is mind-blowing.I don't know how they got to that point, butI have a feeling it has something to do with somebankers who were not very honest with the termsof the agreement. But,it happens, for sure. But,you mentioned something else, which is only makingthe minimum payment. It's better than doing nothing, but it's not great, either.Caplinger:No. Even when you justmake the minimum payment -- the way thoseminimum payments are set up,it doesn't really pay that much more than what your interest charge is. If you'remaking a $25 minimum payment,you might have$20 of that going just to pay that15.9% you were talking about earlier. That only lets you cut that balance by $5 a month. The way the math works out, it can take years, like 10 years or more, to get to the point where yourminimum balance has actually paid off that amount. Andthat's assuming you don't go out and run up more charges in the interim.Lapera: Yeah,absolutely. Just to back up a little bit,credit card companies or your bank orwhoever it is that owns you debttells you how much you have to pay at a minimumevery month in order not to get a late fee. If you pay less than that, they'llsmack you with some sort of fee. Andthat's what your minimum payment is. So, you'remaking your minimum payments, andhere's another mistake that people make, theyadd on a lot of unnecessary debt. Dan, you were telling me before the show started thathouseholds before the holidays, theircredit card was around $16,000,which is that national figure we were talking about. After holidays, the credit card debt increased by $1,073. That'sa lot of money.Caplinger:On average. When you have theseholiday expenses that come up,whether it's traveling to family orbuying presents or doing shopping,whatever it is, it'stempting. You have those expensesand you have to cover them. A lot of people don't have the income tocover that at that point. Soit's tempting to just add that to the total and figure, "OK,after the holidays are done, I'llresolve to get that paid down." But, yeah,a lot of people get a holiday bump in terms of how much debt they haveon their credit card.Lapera: Yeah. Andas terrible as it isto not really celebrate whatever holiday you have going on, it's not really 100% anecessary expense for you to buy presents for peopleor to travel that year. It's a not-safe-for-work word,it's terrible, it's no fun, but it's a place where you can cut expenses.Caplinger:It is. Theother thing is that you can also pre-plan for it. You know what your holiday plansare going to be. If you set asidea certain amount of money from your checkevery two weeks, or every month,starting in January or February,and you accumulate that over the course of the year, thenyou'll have a nest egg at the end of the yearand you don't have to dip into your credit card,you don't have to add to your credit card debt in order to do it. With an anticipated expenselike holiday stuff, that'smore than a reasonable thing to do,because you can get a sense of it. It's not like there's going to be an emergency where youdidn't know the holidays were going to be coming up. You know exactly whatyour expectations are, and you can plan for them.Lapera: That's a really good point. Also, if you're like me,I really hate buying presents for people, sowhenever I see a present that will work for someone for the holidays,I buy it even if it's the middle of Juneand I stash away. That way,I don't have to worry about it in December. That will also help you pre-plan expenses,hopefully. Plus, it might make your life easier come December. Holiday tips with the Industry Focus gang! So,another way that people can get in trouble with their debtis not understanding the terms of their debt. This issomething I've seen that's common amongpeople my age, weirdly enough --they don't understand what the interest payment is on their credit cards.Caplinger:Yeah. It'ssometimes labeled thefinance charge,sometimes it's labeled something else. It's not always really clear. Plus, the rates tend to change a lot. Differentcredit card companies arebetter or worse in showing you, "This wasyour average balance,this is the current interest rate, do the math,this is how much interest your account accumulated during thisparticular month, this is your minimum payment, so this,after you make your minimum payment, if that's what you do, here'swhat the balance is going to be left." Somecard companies have actually gotten better about doing thisin response to calls from consumer advocates to do somethingto help solve this problem. But not all of the banks are on board with it yet. So sometimesyou have to do your own homework to know what those terms are. In addition, you have a whole span of fees, whether it's late fees, over account limit fees,and a whole host of other things thatyou can end up having to pay for just by making simple mistakes,avoidable mistakes, if you just knew those traps were out there,you could easily avoid them. But a lot of people don't even know that they're out there.Lapera: Yeah, it's all aboutreading the fine print,especially if you get your credit card from a bank, whichI think most people do. A lot of them have all sorts of fees, andthey're not technically hidden, they'rein the fine print, or maybe the agent told you whileyou were applying for the credit card. For example,you have to keep a certain balancein your savings account,and you have to keep a debit card open as wellso that they don't charge you for any of the accounts,or something like that. It's about reading the fine print.Caplinger:It's all there,somewhere. It's just that most people don't go to the trouble of reading that big long book, or thepiece of paper that you need a magnifying glass to readto see all the things you might end up having to pay for.Lapera: I read that, on average, the lengthof the average credit card agreement is about 44 pages.(laughs) That's a lot of pages!Caplinger:A little lite reading for you.Lapera: "Lite"in the fact that they make the print so tiny that it doesn't seem very long. So, we talked alittle bit about credit card debt,how you might get there. Let'stalk about something that'srelated to that, which is credit scores. Dan,why are credit scores important?Caplinger:Credit scores have becomeincreasingly important because,basically, if you ever need to get financing for something,whether at the house, a car, or evenbasic consumer loans,it's important to have a good credit scoreso that you can have any chance of getting that loanin the first place. In addition, evenonce you climb above thebarrier for getting the loan at all --the higher your credit score is,the better your terms are likely to be. If you have a really good credit score,not only would you maybe be able to get offers andtake advantage of offers that other people wouldn't even receive, but yourinterest rate might be lower, youmight be eligible for bigger credit card rewards,the terms of the repayment might be easier for you. You get some rewards,you get some benefits, fromdoing the work to get your credit scoreas strong as it can be.Lapera: Right. Youmight be wondering whocomes up with the credit scores and how are they calculated? There's threecredit bureaus, which is Equifax,TransUnion,and Experian. They all use the samebasic factors to get your credit score. Some of them weight some more or less. But, byworking on those credit factors you can improve your credit score. The one that, in general, holds the most weight ishow on time you are with your payments.
Editor's note:Credit scores range from 300 to 850. Higher credit scores are better.Caplinger:Yeah. Having a goodpayment history is really important. That's where you get back into those terms. Youneed to understand when those payments are due. You have to make sure that you give enough lead time so that when youmake that payment it's going to credit on time, so you'renot charged with a late payment. That way, you won't have to pay that fee, but you also won't get that dingon the credit report that hurts this amount,because your payment historymakes up about 35% of what your credit score is. So,getting in the habit of being on time with those payments,it can be a really big boost if you've had bad payment history in the past. Getting that fixed will see that score bump up a really large amount.Lapera: Yeah,even if it's just a minimum payment,it's a really important thing to be on time. The next most important thing, probably --because they don't actually releaseexactly how they figure out the formula, but in general, people have figured this is about what it is -- is thepercentage of the utilized credit limit. This is thecombination of every line of creditthat you have, how much you're using it. Sayyou have two credit cards and one has a limit of$1,000 and one has a limit of $2,500,so the total is $3,500. It's how much you use out of that entire amount.Caplinger:Yeah. You hearpeople talking about, "I'malmost maxed out on my credit cards," andusually that's a bad signin terms of this part of the scoring. If you havemost of the credit that you have been extended,if you're using all of that up, andyou already have debt of that amount,it means you really don't have that much left to borrow,and the credit scoring bureaus are going to say, "Boy,that seems risky. That meansyou don't have that much more capacity to borrow, and you owea lot compared to whatcredit card companies and other lenders are willing to give youin the first place." Thatadds up to a more troubling situation thansomebody who has a couple hundred dollars on theircredit cards, but they have thousands of dollars of credit limit. For them,they're not very concerned, because theyhaven't really used up much of their credit at all.Lapera: Yeah. So,there's two ways to attack this. One is to spend less. The other is to get your lines of credit increased, which can betempting fruit for some people,because they're like, "Oh,I have a bigger credit limit, that means I can spend more money." But,the idea is, if you increase yourcredit limit, then the amount that you spend regularly will be a smaller percentage of that. So,one of the ways you can do this is,if you do have a good record with your credit card company -- so,again, if you already have a good credit score,sometimes it gets in a self-perpetuating loop --you can ask your bank to bump up your limit.I know, some banks, you can ask for that online, you don't even have to go into a branch anymore.Caplinger:Yeah. Or,the customer service lines,you can call in on the phone andthey can sometimes be helpful as well.Lapera: Yeah. Andsometimes they just raise your credit limit just because you have beena good customer for a long time. Thathappens on occasion. They'll just send you a letter saying, "Hey, it's more."Caplinger:Butbe careful. A lot of times,when a bank makes that decision,it's based on the expectation that you're the sort of person who isgoing to take advantage of that byspending up toward that higher credit limit. So, really,the most important thing about managing your credit cards is knowing yourself, andknowing what your predilections are. If you'regoing to be tempted, if that temptation is going to be too much to resist, then you have to think about that,and you have to manage things accordingly.Lapera: Yeah, definitely. I've heard multiple people,also my age, say that they don't trustthemselves with a credit card,so they don't have one. It's one of those things that,when I hear that, I'm like, "Ugh,you're shooting yourself in the foot forif you ever want a loan!" But, I mean, that is a deepknowledge of oneself that a lot of people don't have. So,I don't know how to feel about it.Caplinger:It's hard. You'rebetter off having a credit card thannot having it in terms ofbuilding up a healthy credit history. But like you say, if it's apotential addiction, you might be better offstaying totally clear, rather than having it and misusing it.Lapera: Yeah.I want to make a little side note here. Theeasiest way to build credit is via a credit card,because it's easier to get them something like a home loan or an auto loan. You can build credit on those things, butgenerally you're going to have to have someone co-sign on a loan with you. So, it'll go on your credit score, it'll also go on the other person's credit score. So,keep that in mind, if you were thinking about co-signing a loan with someoneto help them out,to help them start building credit, that debt also goes in your name. So, it can impact your credit score as well. So,in general, credit cards are the easiest way to build up. But I think, Dan,you were saying that student loans also go toward credit scores, right?Caplinger:Yeah. A lot of people, their firstexposure to debt is when they go to collegeand they need to borrow money in order to pay their tuition and their room and board and that kind of thing. With most student loans, they'rein the student's name, versus the ones that are in the parent's names. Student loans for the student use that student's social security number, goes on the student's credit history. Some of those loans, like you said, even if they're co-signed by parents, if it's in a student's name,it's the student that's on the hook for it. Ifyou're in that situation, take those student loan payments seriously,because they might be the foundation on which you're building up a healthy credit score,if you manage your debt well.Lapera: Yeah,which brings us back to our nextmetric, which is how many lines of credit you have. That includes auto loans,mortgages, student loans, and credit cards. The more different types you have,and the greater in number they are,the better your credit score.Caplinger:That's right. That'sgenerally right.What lenders want to seeit's like you're able to handle different kinds of debt. Whether that's a fixed-paymentkind of debtlike a car loan,where you have a set amount that you pay every month,or a home mortgage, a fixed mortgagewhere you pay that set amount every month,as well as the variable amounts you would pay on credit cards,that gives a more complete picture of how credit-worthy you are.Lapera: Yeah. Again, this is kind of thedouble edged sword. Because you could take out a bunch of differentkinds of credit. But of course, that means you'll havea bunch of different ways to get into debt. And that'spart of the thing they're measuring -- yourcapacity to be in debt,because that makes you a good customer,because they know you will be paying at least the principaland probably interest payments,if you're the average American, as well, andthat's how banks and credit card companies make money. Number four is the length of yourcredit history. There is no way to game the system on this one. You just have to have a line of creditfor as long as possible. The longer you have credit,the better your credit score. The only way,if you really want to try and to help someone else, ifyou have kids, you can open a credit cardin their name and your name and pay moneyto pay off the bill every month,and that will help them. That's actually what my parents did for me. Thanks Mom and Dad!Caplinger:Yeah,the one strategy you can use here,it comes up when people are thinking aboutclosing out a credit card. A lot of time, you might have acredit card and you don't really use it that much anymore, and you think, "I have a better card,"maybe the old card is just a plain old vanilla credit cardwhere is the new credit card you havegives you mileage, air miles, orpoints or cash back or something like that. Before you cancel that old card,consider what effect it's going to haveon the length of your credit history. If it's your oldest card,if you've had it forever, thensometimes it makes sense to hang on to it and to use it every once in a while in order tomake sure that youmaintain that length of credit history and boost up your score a little bit.Lapera: Yeah. You can do that. Other than that, like I said, it's pretty much parentsputting the kid's name on their debt,which is a double-edged sword, because if the parents don't pay off the debt, then the kid's credit score gets trashedbefore they even have a chance to start. Then, the last metric that the credit unions check is hard checks. It's a hard pull on your credit score. This is, forexample, if you go to a car dealership and you're going to buy a car, theyalways check your credit before they offer you the loans, so they know what terms to give you. If you have a lot of those hard pulls on your credit, you're going to be dinged at least a few points,because that means, for whatever reason, you'reopening up a lot of debt at the same time.Caplinger:That's reallywhat they're looking for. If you're going out and trying to openthree or four new credit card accounts all at the same time,most of the credit card bureaus are going to assume that the reason you're doing that is, you got yourself in trouble and you need a big inflow of credit right now. That's the kind of risk that thosebureauwant to take a look at closely and flag theircustomers on so that whoever the last person isto give that new credit cardunderstands, when they're doing it, that this person already just opened up a whole bunch of other things,and to take that into account inmaking the decision about whether or not to give you that card.Lapera: Yes. So,now you might be asking yourself,how do I get this information? Do I have to pay for it? The answer is no, it's free. There'sa couple of different ways to go about getting your credit history, which is also a very vital thing --you should check it periodicallyto make sure there's no one expected loans or charges that are under your name thatshouldn't be there. But,the other thing is to check your credit score. Dan, I think you do the free report every year with the three bureaus, right?Caplinger:I do. You can go to annualcreditreport.com. It is a government-sponsored site, and it let's you pick,you get your credit report from each of the three reporting bureaus once every year. You can get all three reports at the same time, you can get one now and wait a few months and get the second then wait a few months and get the third,however you want to do it. It will not give you credit scores,it only gives you the credit report. Butthat will tell you all the sources of credit that you have. It will, like you said, flag up if you see something that you didn't borrow, it will tell you that. It's federally mandated that you have accessto that website on an annual basis.Lapera: Yeah. And thenthere's some other credit reporting sites that,you have to put in your credit card number,and they offered to send you your credit report every month. But sinceyou're entitled to that one free credit report,if you put in your credit card number andcancel it after you get your free credit report -- they'refederally mandated to give you at least one free one -- you can also do that.I am going to sound like a corporate shill here for a second,but I promise I'm not getting paid,creditkarma.com. They show you your credit score forTransUnion and Equifax,and you can check it whenever you want. They also give you your credit reports. That's free. You can check itmultiple times a month, however many times you want. The way that they make money is through ads. They're like, "We see you havethis credit score, have you thought about this credit card, or this type of loan for yourself?" Butit's great, because you can monitor your credit scorepretty constantly. That's really important for me,because all of my data has been stolen multiple timesthrough the OPM hack. If you're from DC,I'm sure you've heard of it. Even my fingerprints are gone. Someone in China probably has them. I don't know what they're doing with them. It's pretty sad that they have them.(laughs) But,that's why I monitor my credit reports so hawkishly, becauseI know that it's out there. Most people's are,but I definitely know that mine is.(laughs)So, yeah,do you have anything else you want to say, Dan?Caplinger:It's easy to think thatcredit is something you take advantage of when you need it,and you're not really thinking about it most of the time. But in order to have that credit available to you when you need it,it actually makes sense to think about these things beforehand, and to think, "IfI'm thinking about buying a house a year or two from now,what's my credit score now?" Andonce I know that, how can I get it higher,so that when the time comes and I actually need the loan,I'm going to be in the best position to get it? Doing that homework canput you in a better position than trying toscramble at the last minute rightwhen you need to get that loan, and you need it right now.Lapera: Definitely. And also,please be careful about getting into debt. Dan,I really love the way that you summarize our episodes at the end. There's a little perfect send-offevery time. I also want our listeners to remember thatthis is not personalized advice,this is general advice. Please don't write to us and ask forpersonalized advice, because I'm going to send you anemail back telling you that I cannot give you personalized advice, the SEC will not let me and I'll get into a lot of trouble. If you do haveany questions that are general,please contact us at industryfocus@fool.com, or by tweeting us @MFIndustryFocus. Also, ourinternship applications close some time today or tomorrow. If you'rereally interested in working atThe Motley Fool in the summer, the internships are awesome,that's how I got my job, you should scurry to our site, careers.fool.com or jobs.fool.com, both of them redirect to the same site, andapply right away,because I'm pretty sure those close tomorrow. Thank you so much for joining, us, Dan. You're always wise.Caplinger:Thanks for having me, Gaby.Lapera: And Austin,have you ever check your credit score?Austin Morgan:I have checked my credit score.Lapera: Excellent!I am really glad to hear that. Way to be responsible. Thank you to Austin,today's totally awesome producer,and thank you to you all for joining us. Everyone, have a great week,and go out there and check your credit score!
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