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Dangerous Borrowing

It's common knowledge to most of us: Credit card debt is dangerous. Too many people are mired in it, having a heck of a time digging themselves out. (We can help you get out of debt.)

In an article at MSN.com, Liz Pulliam Weston offered some eye-opening statistics about credit card debt in America, drawn from the VIP Forum (a research forum) and information specialist Fair Isaac (NYSE: FIC  ) . They found that many Americans owe little to nothing on their cards, which is heartening. Still . check out these tidbits:

  • About 4%-10% of households owe $10,000 or more on their credit cards. That's many millions of people with some hefty debt.

  • As many as 1% of households owe more than $20,000.

  • Some 36% of those owing more than $10,000 have household incomes of less than $50,000, and 13% have incomes below $30,000.

  • Credit card debt has been growing significantly in recent years, with bankruptcies growing briskly as well.

There's smart debt and dumb debt
Credit cards by themselves aren't evil. (Despite our frequent warnings about credit card debt here in Fooldom, we do believe in the utility of credit cards -- enough to have issued our own cards. We negotiated the best deals we could, in an effort to give you real value. Check them out -- they even look spiffy.)

The terrible thing about credit cards is that they often get abused by people charging more than they can afford. Take that and add the fact that many lenders are charging more than 20% annual interest rates (sometimes even more than 30%!), and it's a recipe for disaster. Those charging some customers arms and legs include familiar names such as Citibank (NYSE: C  ) , MBNA (NYSE: KRB  ) , J.P. Morgan Chase (NYSE: JPM  ) , Morgan Stanley's Discover, Capital One (NYSE: COF  ) , Bank of America (NYSE: BAC  ) , and American Express (NYSE: AXP  ) .

While we Foolish investors look to the stock market as a place where we hope to grow our investments by perhaps 8% or 10% or 12% per year, on average, credit card debt reflects the opposite of that -- often growing your debt by 12% or 15% or 25% per year. Ouch.

Risky debt in housing
Credit card debt isn't the only kind of debt we need to be wary of, though. Another big problem in America appears to be mortgages. I'm not speaking here of traditional mortgages, where homebuyers plunk down 10% to 20% or more of a home's worth upon purchase. Instead, I refer to the explosive popularity of newfangled "extreme" loans, which are sometimes referred to as predatory lending.

For example, there are "interest-only" loans available now, for homebuyers. For the first few years, you pay only interest on your mortgage, thus keeping your payments low. The danger here, though, is that if you've got little to no equity in your house and home values fall, then you're in a sticky spot. If you need to sell your home, you'll end up getting less for it than you borrowed and will have to cough up some extra money to pay off the mortgage.

Also, many people are signing up for adjustable-rate mortgages (ARMs). These are not predatory in nature, but they can be used in wrong-headed ways sometimes. They offer significantly lower rates than fixed-rate mortgages, at least for the first year or several years. Then the interest rate begins to rise or fall in relation to interest rates in general. These ARMs are quite popular now, which is fine for those who don't plan to stay in their homes for more than a few years. But those folks with long-term dwelling plans are exposing themselves to some risk with ARMs -- since interest rates are at the low end of history's range, they're more likely to go up than down in the years ahead.

Another risky kind of lending going on involves "low-doc" or "no-doc" mortgages, where the lender requires and receives little to no proof of income or assets from a borrower. You might ask yourself what kind of borrower doesn't want to provide such proof -- odds are, it's someone who perhaps isn't in a position to take out a mortgage.

I'm not the only one shaking my head at this kind of borrowing. Federal regulators are now warning lending institutions to be careful. It's true that banks and other lenders protect themselves by selling off mortgages to investors. But this doesn't protect the borrower.

A recent New York Times article reviewed on this topic, noting some interesting statistics:

  • Some 60% of mortgages last year had adjustable interest rates, many with artificially low teaser rates that expire after the first few years. If a mortgage rate jumps from 4% to 6%, just slightly above current levels, the monthly payment can jump by roughly 30% when the teaser rates come to an end.

  • Roughly a third of homebuyers in the last year and a half bought homes without any down payment, according to a recent survey of home purchasers by the National Association of Realtors.

  • More than 25% of all new mortgages in the last year have been interest-only loans.

  • "The value of home-equity loans shot up 40% in 2004, to $398 billion. Almost all of those loans are at adjustable interest rates, which could rise sharply, and many were extended to people who had just borrowed money to buy a house." Worse, some such loans are for 100% of a home's value.

What's going on?
So why are lenders making these questionable loans? Because they can make money doing so. They can also bring in new customers. This is all good for the lenders and their shareholders. Why aren't regulators coming down harder on lenders? Perhaps because the lenders themselves, and therefore our American financial system, don't seem to be on shaky ground. It's the consumers, and regulators may feel that protecting consumers is less urgent than preventing bank failures.

Your best protection against dangerous borrowing is to educate yourself. Learn more about extreme loans in these articles:

Get great tips on buying and selling homes by visiting our Home Center, which also features some special mortgage rates. Learn more about buying, selling, and maintaining a home by checking out these articles:

SelenaMaranjian's favorite discussion boards include Book Club, Eclectic Library, and Card & Board Games. She owns shares of no company mentioned in this article. For more about Selena, viewher bio and her profile. You might also be interested in these books she has written or co-written:The Motley Fool Money GuideandThe Motley Fool Investment Guide for Teens. The Motley Fool is Fools writing for Fools.


Read/Post Comments (2) | Recommend This Article (3)

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  • Report this Comment On June 02, 2008, at 2:57 AM, ancilanu wrote:

    Credit cards by themselves aren't evil. (Despite our frequent warnings about credit card debt here in Fooldom, we do believe in the utility of credit cards -- enough to have issued our own cards.

    -------------------

    Ancil

    Don't be a victim. Stop credit card debt now. We can help.

    http://www.stop-credit-card-debt.com

  • Report this Comment On June 04, 2008, at 7:31 AM, jessika34 wrote:

    I went through your article and liked it a lot. I would surely like to forward it to ma friends and would like to know more on this article.

    ----------------------

    jessika

    Put The Message Where It Matters! A New Way To Advertise On Social Networks!

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Selena Maranjian
TMFSelena

Selena Maranjian has been writing for the Fool since 1996 and covers basic investing and personal finance topics. She also prepares the Fool's syndicated newspaper column and has written or co-written a number of Fool books. For more financial and non-financial fare (as well as silly things), follow her on Twitter...

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