CREDIT CENTER: Industry Secrets

Our Credit Crunch

We're deeper in debt than we've ever been before. And that's just what the lending industry ordered. So how did we get into this mess in the first place?

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By Dayana Yochim

What's in your wallet?

Scratch that. Let's rephrase the question: Who's in your wallet? Or even more to the point -- how much of what's in your wallet is yours?

Don't know? Try this quick calculation:

Add up the following to come up with your total monthly debt obligations (do not include mortgage or rent and utilities):

  • Your minimum monthly credit card payments
  • Other loan obligations (e.g., car, student loan, doctor's bills)

Next, add the following to calculate your total monthly income:

  • Your annual gross salary, divided by 12
  • Other regular monthly income that you can count on (babysitting bucks, eBay profits, bonuses, etc.)

Now, divide your monthly debt obligations by your total monthly income. That number is a rough debt-to-income ratio -- the lending industry's oft-used measure of fiscal health. Since this brief calculation does not take into account long-term loans, like a mortgage, and savings, like retirement or your short-term stash, don't rely on this as the end-all be-all assessment of your overall financial stability.

According to Gerri Detweiler, author of the Ultimate Credit Handbook, a debt-to-income ratio of 10% or less is considered great. And that's not a bad rule of thumb for Fools, either. If your debt-to-income ratio is hovering in the 20% or higher range, there could be trouble ahead. One fender bender, leaky roof, or embarrassing happy-hour catastrophe that ends in a visit to the emergency room, and you could be facing a mountain of debt that could take years to eliminate.

Still, far be it for the credit card industry to poo-poo your request for a line of credit. Even if your debt-to-income ratio is 50% or more, you'll probably have little trouble qualifying for a credit card. Never mind that mortgage lenders preach that your debt level -- including mortgage and all revolving unsecured debts -- should not exceed 36% of your gross monthly income. In their eyes, that leaves just 8% of your income for non-mortgage debts.

Going for broke

A long time ago, we were a nation of cash-rich, house-poor people. Then, we became house rich and cash poor. Today, we're a nation that's credit dependent and cash broke.

That's right: Broke. Completely bust. According to a BusinessWeek report, total household debt -- including car loans, mortgage, and student loans -- topped 100% of disposable annual income last year for the first time ever. Contrast that to 20 years ago when the nation's debt stood at just two-thirds of our disposable income.

On average, we carry eight cards per person and have a balance of $8,400 in credit card debt. Twenty percent of our cards are maxed out, reports CardWeb.com, which tracks the lending industry's machinations. And just 40% of Americans pay off their accounts in full at the end of the month. The average line of credit is around $3,500. (A decade ago it was just $1,800.) The average household pays their lender $1,000 a year in finance charges. That might not sound like much, but consider that the amount of interest we paid as a nation last year alone could have purchased the entire inventory of 5,000 Jaguar dealerships. Or a 2,000-year endorsement deal with Tiger Woods. Or IBM, the entire company, with $55 billion to spare.

It's not just that we're borrowing more money and paying it back more slowly; it's that we're spending money we used to consider off-limits. Home equity loans are more popular than ever as people borrow against their home to feed their spending binge. Today, average homeowners owe nearly 50% of their home's value. Twenty years ago that figure stood at 30%. Can't you just picture the modern-day needlepoint plaque? "Home, Sweet Credit Line."

Perhaps it's time to heed the words of Dickens, who wrote in David Copperfield: "Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."

The cash crash

Then again, in Dickens's time a line of credit was not nearly as easy to come by. It wasn't until the 1830s that someone could buy a home without having to plunk down one lump sum on closing day. A little more than a century later, The Diners Club introduced the first charge card that could be used at more than one merchant.

Bankers had a hit. Here was a product that paid dividends on two fronts -- from the merchants who paid a fee on every charge to participate in the service, and the card-carrying customers who provided a healthy line of profits through fees and interest payments.

Lenders were raring to get a credit card into every consumer's hand, whether they wanted it or not. (In 1970, President Nixon (!) banned lenders from sending unsolicited, activated credit cards to customers.)

And by god, they're almost there. Today, 80% of all households have at least one credit card. Eighteen percent of all U.S. consumer spending is currently made with a bank credit card. Throw retail credit cards and debit cards into the mix, and the figure rises to 24%. Industry watchers estimate that by 2006, about 30% of all spending will be on credit and debit cards combined.

Fees, glorious fees

It's no wonder that credit card issuers started rooting for cash to crash. The credit card business continues to be the most profitable segment of banking. Author Robert Manning writes in Credit Card Nation that bank credit card interest and fee income tripled in the 1990s -- from a combined $28.6 billion in 1990 to nearly $80 billion in 1998.

Despite an economy with a case of the shakes and growing card competition, last year was one of the most profitable ever for lenders. Fees are rising and lenders are getting more creative about what they slap them on. In addition to annual fees and interest, there are fees for balance transfers, fees for paying late, fees for going over your credit limit, fees for account inactivity, foreign currency transaction fees, commissions for cash advances, fees to pay your bill by phone. The list goes on, and the fees keep going up.

There's no stopping 'em, either. According to the American Bankers Association, 26 states have no limit on what bank credit card issuers can charge for interest rates. And 27 states are free to charge whatever they can get for annual fees.

There's a tidy profit to be had, and a lot of issuers want a piece of the action, including yours truly. According to CardWeb.com, among the five major payment networks -- Visa, MasterCard, Discover, American Express, and Diners Club -- there are more than 30,000 different programs. For help wending your way through the labyrinth of offers, read our guidelines for finding The One -- or at least the one for right now.

Together, credit card issuers mail out more than 3 billion solicitations a year and spend millions marketing to you during the Super Bowl and Survivor XVIIIM: Fear Factor Contestants v. Big Brother Housemates. They will spend anywhere from $50 to $150 per account to get your business. There's little doubt they'll make up the acquisition costs with the fees the new customer will rack up.

Today, Visa (and its brethren) are certainly everywhere you want it to be. And in some places they don't belong.

Crossing the credit line

Not surprisingly, lenders' promiscuity is catching up with them. Subprime lenders -- who built their businesses by pursuing the un-creditworthy -- are getting squeezed by their customers. Job loss and other consumer hardships are affecting these bankers' bottom lines. Subprime lenders are writing off losses in the 15% to 17% range, versus the average industry loss rate of 6.5%. Delinquency rates now average about 10% while those for the rest of the lending industry average just 5%. In the past year, some big-name banks have been dealt pink slips of their own.

It's not just the bottom-feeders feeling the pinch. Response rates to direct-mail solicitations are shrinking. Charge-offs are on the rise. Bank credit card issuers lose about $1 billion each year in fraud, reports CardWeb.com. They lose another $3 billion annually in fraudulent bankruptcy filings. And we're not even talking about the number of Americans who legitimately filed for bankruptcy.

Your credit crunch

So what does any of this have to do with you? Great question. The more you know about your creditors, their competition, and your borrowing peers, the better off you'll be. After all, if you're going to use credit cards -- and who isn't -- you might as well make sure the cards you've been dealt are good ones.

You'll find everything you need to assess your credit situation, improve it, or simply find fodder to gloat about at parties ("Hey, baby, guess what my FICO score is.") in our comprehensive Credit Center. We'll show you how to manage your credit Foolishly, teach you how lenders officially keep score, and walk you through every step it takes to get out of the credit crunch, if you're currently struggling.

It all boils down to knowing what's in your wallet -- how much, at what interest rate, to whom it is owed, and how it affects the rest of your financial life.