A friend who is just starting graduate studies got a note yesterday from Discover Card. Discover is raising her interest rate to prime plus 15 percent for all prior purchases, and prime plus 10 percent for all purchases going forward.
It was a curious notice to read, as the account holder in question pays her card off in full every month, and has no prior purchase balance.
But I have heard so many stories like this — people paid for tuition using their credit cards, then the bank raised their credit card interest rates in a big way — that I have to believe that there is now an unwritten rule among banks against paying for tuition with a credit card. It seems that banks automatically and immediately raise interest rates for any account holder who pays any college tuition, regardless of anything else in the account holder’s history.
The theory, apparently, is that you will be in college for the next four months and won’t be earning much money to pay off your tuition during that time, so the banks may as well soak you for as much interest as they can get during that period.
This may make a few extra bucks for the banks in the short run, but it is a terrible idea. The account holders often feel insulted, cheated, and suspicious, and rightly so, and that can only damage the banks’ chances of future revenue.
My friend in graduate school won’t be paying any interest on her credit card, since she pays the full balance every month, but she is responding to the interest rate hike by cutting back anyway. “I have to stop using my card,” she told me. “When I use my card, I use it too much. I need to save my money — I might really need it someday.” And that’s an approach most of us may have to take.
Even if there is nothing at all wrong with your credit card history, you might suddenly find one day that banks are raising your card interest rates, perhaps even doubling them, or cutting your credit limit, even cutting it below your current balance so that your new purchases are declined, and the bank may do this with no warning and for no reason that you can figure out. Banks are doing this far more often as they try to guess which borrowers are solvent and which are not. There is really no way to guard against this except by not relying on your credit cards.
In a panel discussion last winter, a banker was asked how close to your credit limit you can go before it raises a red flag back at the bank. He may have surprised everyone in the audience when he said that if you want to be safe, you should not spend more than 30 percent of your credit limit. For example, if your credit limit is $13,000, and you don’t want your bank to worry about how much you are spending, keep your balance below $3,899. Years ago, you could spend right up to your credit limit, and often 15 percent more, before the banks would rein you in. Now the credit limit is mostly an illusion. Try spending half your credit limit, and you shouldn’t be surprised if your bank cuts your credit limit by half.
In case it isn’t obvious, this is a part of the “credit freeze” that Federal Reserve chairman Bernanke and Treasury Secretary Paulson have been talking about. It also illustrates why the Wall Street bailout bill that failed yesterday in the House would not have succeeded in addressing the problem. We know it would not have prevented bank failures, but it also would not have made the banks start lending loosely again. If a bank is worried about a consumer borrowing $3,900, it is not because the bank does not have the money to lend. Rather, it is because the bank is worried that the consumer may not pay the money back. That is a worry that will not go away no matter how much money the bank has in its safe.
The current financial crisis has been blamed on a real estate bubble and a derivatives bubble, but the real culprit is the lending bubble. The Wall Street bailout idea can never work because it just feeds a collapsing bubble. A bubble, when it collapses, will continue to collapse no matter how much money you pour into it.
It is a bizarre concept for most of us to imagine an economy that is not primarily built on borrowed money, yet borrowing was not the key to any economy in any century before the 20th century, and we can keep our current economy going even as the lending bubble goes away.
For most of us, this starts with our credit cards. We’ve been hearing for years that paying off credit cards is the surest way to improve financial strength. Now it may be the key to your financial stability too. Now is not the time to lean on any of your credit cards. If you have credit card balances, pay them off quickly, with a sense of urgency about it. Skip dessert or don’t buy any more clothes for a couple of years if that helps you pay off your cards faster.
In the past, many of us have relied on credit cards to get us through tight times financially. That may not be possible in the next few years. If banks learn you are suddenly in a difficult financial position, that is exactly when they would like to cancel your credit cards — something banks are doing far more often these days. In a pinch, you might borrow a little from friends, but for the most part, you are going to have to save money to cover the next little downturn in your personal economy. As bizarre as this sounds, it is the way people did it up until about 1975. Yes, that is a very long time ago, but it still proves it can be done. How much should you save? A good rule of thumb is to save enough to cover most of a year of living expenses.
After you do that, it is important to pay off all your loans — even your home mortgage. Traditionally, we have thought of a home mortgage as a binding contract, which the bank can’t squeeze you out of unless you are ever late with a payment, but banks may be able to find a way out of this too, so a mortgage is not an arrangement you want to entirely rely on either. You may have no choice — you have to live somewhere — but do what you can to get your mortgage balance below what you can earn in one year, and then pay it off completely.
Businesses need to do the same kind of thing. Wall Street lobbyists yesterday morning were going around with a soundbite, probably fictional, of an employer who worried that if the credit freeze continued, he wouldn’t be able to borrow money to meet the payroll. That is a real concern, but the solution is not to encourage banks to lend money to businesses that are living so close to the edge. Those are the loans that go bad. Businesses need to stop depending on loans for their day-to-day operations. I know this must sound bizarre in an age when financiers debate whether a debt-to-equity ratio of 5 or 10 is better. Yet 40 years ago, a banker would laugh you out of the office if you were running a business and asked for a payday loan. If you operated your business that way, bankers wouldn’t even consider it a business. That was a long time ago, but it proves that a business can be operated without relying on multiple lines of credit.
Again, the reason not to lean on credit is for your own financial stability. When the whole credit market is unstable, you cannot add much stability to your own life by employing credit. And as you free yourself from all the entanglements of credit, you also help get the economy going again.
I am not really suggesting that people should never borrow or lend money, just that we may need to bring our use of credit back into balance. In my opinion, that means we should be in debt no more than about half of the time. The way things work now, many of us are in debt from the day we sign up for college until the day we die. That is not a good balance, and the lack of balance is what has caused the credit bubble and the current recession. The faster we can individually stop leaning on credit as a way of life, the sooner the recession can end.