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.

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, and joining me on Skype is Dan Caplinger, personal finance guru extraordinaire at 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 upbeat because today's topic is very depressing. (laughs) Today, we're going to talk about debt and credit. Just so you know, debt plagues Americans. 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. About 15% of Americans think they're going to die in debt. About 60% of Americans could not cover an unexpected expense of $500. 34% have $0 in savings, and another 35% have $1,000 or less but more than $0. The average amount of student loan debt is somewhere between $31,000 and $37,000 depending on your source. The average amount of mortgage debt is about $170,000, which I guess isn't that much of you think about houses. But today, we're going to talk about credit card debt. The average American household has about $5,700 in credit card debt. However, if you are a household that carries 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 is about $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's crazy, that's a lot of money.

Caplinger: $16,000, yeah. When you think 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. And what's even crazier is that the average interest rate on a credit 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 about 38% of All American households have some sort of credit card debt, maybe not $16,000 but some sort of debt. I think, let's start with one that's common 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. The reason 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. But there are plenty of people in America who do make more than enough money for their needs, and they're still spending frivolously.

Caplinger: Yeah. And that's a lot of how you end up in that paycheck to paycheck situation. And credit cards actually make it easier, in some ways. When you're really stretching to make that paycheck last as long as you can, if you still have that credit card and those last couple of days are coming up and you spent big early on, right after you got your check, then it's tempting to cover the difference with that credit card. That's how a lot of people start the ball rolling in terms of getting those big credit card balances you're talking about.

Lapera: Yeah. One of the things you could do to 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? How do you think you're going to spend so much money every month on going to the movies? And you also have three movie streaming services, and you pay for cable. Do you really need all of those methods to consume media? Probably not."

Caplinger: Yeah, interestingly, a lot of credit cards will actually help you come up with a budget that will give you a spending history and break it down by category, so you can actually see how much you're spending at restaurants, how much you're spending on movies, utilities, any category that you're using that card for, you can actually use it to your advantage to figure out, "Do I really need to be spending this much on this? Maybe not," and that could free up money to pay down that balance and get rid of some of that interest and get yourself out of debt that much faster.

Lapera: Yeah, it's really cool, I just got my year-end credit card reports from 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 on Lyft rides this year. (laughs) Or, I guess, last year now. That's the peril of living in a city with questionable public transportation. So, another thing: maybe you're already living paycheck to paycheck and you have money on your credit card, and some people just don't pay their credit cards off at all, which is a really bad move. Not paying your credit 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'll talk 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 to avoid all those excess charges.

Lapera: Yeah, absolutely. You would be surprised by how common this is. Every year, people write stories about credit card debt, and there's always at least one person who is interviewed in these stories who is like, "I didn'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, but I have a feeling it has something to do with some bankers who were not very honest with the terms of the agreement. But, it happens, for sure. But, you mentioned something else, which is only making the minimum payment. It's better than doing nothing, but it's not great, either.

Caplinger: No. Even when you just make the minimum payment -- the way those minimum payments are set up, it doesn't really pay that much more than what your interest charge is. If you're making a $25 minimum payment, you might have $20 of that going just to pay that 15.9% 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 your minimum balance has actually paid off that amount. And that'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 or whoever it is that owns you debt tells you how much you have to pay at a minimum every month in order not to get a late fee. If you pay less than that, they'll smack you with some sort of fee. And that's what your minimum payment is. So, you're making your minimum payments, and here's another mistake that people make, they add on a lot of unnecessary debt. Dan, you were telling me before the show started that households before the holidays, their credit 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's a lot of money.

Caplinger: On average. When you have these holiday expenses that come up, whether it's traveling to family or buying presents or doing shopping, whatever it is, it's tempting. You have those expenses and you have to cover them. A lot of people don't have the income to cover that at that point. So it's tempting to just add that to the total and figure, "OK, after the holidays are done, I'll resolve to get that paid down." But, yeah, a lot of people get a holiday bump in terms of how much debt they have on their credit card.

Lapera: Yeah. And as terrible as it is to not really celebrate whatever holiday you have going on, it's not really 100% a necessary expense for you to buy presents for people or 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. The other thing is that you can also pre-plan for it. You know what your holiday plans are going to be. If you set aside a certain amount of money from your check every two weeks, or every month, starting in January or February, and you accumulate that over the course of the year, then you'll have a nest egg at the end of the year and 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 expense like holiday stuff, that's more 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 you didn't know the holidays were going to be coming up. You know exactly what your 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, so whenever I see a present that will work for someone for the holidays, I buy it even if it's the middle of June and 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 debt is not understanding the terms of their debt. This is something I've seen that's common among people my age, weirdly enough -- they don't understand what the interest payment is on their credit cards.

Caplinger: Yeah. It's sometimes labeled the finance charge, sometimes it's labeled something else. It's not always really clear. Plus, the rates tend to change a lot. Different credit card companies are better or worse in showing you, "This was your average balance, this is the current interest rate, do the math, this is how much interest your account accumulated during this particular month, this is your minimum payment, so this, after you make your minimum payment, if that's what you do, here's what the balance is going to be left." Some card companies have actually gotten better about doing this in response to calls from consumer advocates to do something to help solve this problem. But not all of the banks are on board with it yet. So sometimes you 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 that you 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 about reading the fine print, especially if you get your credit card from a bank, which I think most people do. A lot of them have all sorts of fees, and they're not technically hidden, they're in the fine print, or maybe the agent told you while you were applying for the credit card. For example, you have to keep a certain balance in your savings account, and you have to keep a debit card open as well so 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 the piece of paper that you need a magnifying glass to read to see all the things you might end up having to pay for.

Lapera: I read that, on average, the length of 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 a little bit about credit card debt, how you might get there. Let's talk about something that's related to that, which is credit scores. Dan, why are credit scores important?

Caplinger: Credit scores have become increasingly important because, basically, if you ever need to get financing for something, whether at the house, a car, or even basic consumer loans, it's important to have a good credit score so that you can have any chance of getting that loan in the first place. In addition, even once you climb above the barrier 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 and take advantage of offers that other people wouldn't even receive, but your interest rate might be lower, you might 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, from doing the work to get your credit score as strong as it can be.

Lapera: Right. You might be wondering who comes up with the credit scores and how are they calculated? There's three credit bureaus, which is Equifax, TransUnion, and Experian. They all use the same basic factors to get your credit score. Some of them weight some more or less. But, by working on those credit factors you can improve your credit score. The one that, in general, holds the most weight is how 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 good payment history is really important. That's where you get back into those terms. You need to understand when those payments are due. You have to make sure that you give enough lead time so that when you make that payment it's going to credit on time, so you're not charged with a late payment. That way, you won't have to pay that fee, but you also won't get that ding on the credit report that hurts this amount, because your payment history makes 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 release exactly how they figure out the formula, but in general, people have figured this is about what it is -- is the percentage of the utilized credit limit. This is the combination of every line of credit that you have, how much you're using it. Say you 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 hear people talking about, "I'm almost maxed out on my credit cards," and usually that's a bad sign in terms of this part of the scoring. If you have most of the credit that you have been extended, if you're using all of that up, and you 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 means you don't have that much more capacity to borrow, and you owe a lot compared to what credit card companies and other lenders are willing to give you in the first place." That adds up to a more troubling situation than somebody who has a couple hundred dollars on their credit cards, but they have thousands of dollars of credit limit. For them, they're not very concerned, because they haven'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 be tempting 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 your credit 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 and they can sometimes be helpful as well.

Lapera: Yeah. And sometimes they just raise your credit limit just because you have been a good customer for a long time. That happens on occasion. They'll just send you a letter saying, "Hey, it's more."

Caplinger: But be 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 is going to take advantage of that by spending up toward that higher credit limit. So, really, the most important thing about managing your credit cards is knowing yourself, and knowing what your predilections are. If you're going 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 trust themselves 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 for if you ever want a loan!" But, I mean, that is a deep knowledge 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're better off having a credit card than not having it in terms of building up a healthy credit history. But like you say, if it's a potential addiction, you might be better off staying totally clear, rather than having it and misusing it.

Lapera: Yeah. I want to make a little side note here. The easiest 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, but generally 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 someone to 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 first exposure to debt is when they go to college and 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're in 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. If you'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 next metric, 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's generally right. What lenders want to see it's like you're able to handle different kinds of debt. Whether that's a fixed-payment kind of debt like a car loan, where you have a set amount that you pay every month, or a home mortgage, a fixed mortgage where 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 the double edged sword. Because you could take out a bunch of different kinds of credit. But of course, that means you'll have a bunch of different ways to get into debt. And that's part of the thing they're measuring -- your capacity to be in debt, because that makes you a good customer, because they know you will be paying at least the principal and probably interest payments, if you're the average American, as well, and that's how banks and credit card companies make money. Number four is the length of your credit history. There is no way to game the system on this one. You just have to have a line of credit for 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, if you have kids, you can open a credit card in their name and your name and pay money to 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 about closing out a credit card. A lot of time, you might have a credit 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 card where is the new credit card you have gives you mileage, air miles, or points or cash back or something like that. Before you cancel that old card, consider what effect it's going to have on the length of your credit history. If it's your oldest card, if you've had it forever, then sometimes it makes sense to hang on to it and to use it every once in a while in order to make sure that you maintain 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 parents putting 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 trashed before 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, for example, if you go to a car dealership and you're going to buy a car, they always 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're opening up a lot of debt at the same time.

Caplinger: That's really what they're looking for. If you're going out and trying to open three 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 those bureau want to take a look at closely and flag their customers on so that whoever the last person is to give that new credit card understands, when they're doing it, that this person already just opened up a whole bunch of other things, and to take that into account in making 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's a couple of different ways to go about getting your credit history, which is also a very vital thing -- you should check it periodically to make sure there's no one expected loans or charges that are under your name that shouldn'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. But that 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 access to that website on an annual basis.

Lapera: Yeah. And then there'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 since you're entitled to that one free credit report, if you put in your credit card number and cancel it after you get your free credit report -- they're federally 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 for TransUnion and Equifax, and you can check it whenever you want. They also give you your credit reports. That's free. You can check it multiple times a month, however many times you want. The way that they make money is through ads. They're like, "We see you have this credit score, have you thought about this credit card, or this type of loan for yourself?" But it's great, because you can monitor your credit score pretty constantly. That's really important for me, because all of my data has been stolen multiple times through 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, because I 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 that credit 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, "If I'm thinking about buying a house a year or two from now, what's my credit score now?" And once 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 can put you in a better position than trying to scramble at the last minute right when 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-off every time. I also want our listeners to remember that this is not personalized advice, this is general advice. Please don't write to us and ask for personalized advice, because I'm going to send you an email 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 have any questions that are general, please contact us at [email protected], or by tweeting us @MFIndustryFocus. Also, our internship applications close some time today or tomorrow. If you're really interested in working at The 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, and apply 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!