a. It is important to establish a positive credit history because it will help you save money.
b. It does not matter what your credit history is.
c. If you have a negative credit history, there is nothing you can do about it.
d. Your credit score never changes.
As this new school year begins, this question from my 7th grader's math homework last spring still bothers me. Her mom & I knew "c" & "d" were out. These days, I knew "b" wasn't the answer, but that left me conflicted. I resigned to telling her that whomever came up with the question was probably going for "a", but I was disappointed about it.
A good chunk of an individual's credit history is built upon his/her ability to make regular loan repayments. The type of debt, whether it's revolving (credit card) or installment (car loan), makes up most of the rest. Such a history culminates in a person's credit score, which ranges from around 300 to somewhere north of 800. The higher the better. The fewer late payments made, the lower the interest rate will be on any future loans. This is beneficial ... as long as we're talking in terms of borrowing for purchases rather than saving for them.
This is where I had a problem with the 'correct' answer to her homework problem. A credit score is built on borrowing for the purposes of borrowing again, determining the future interest rates you pay. But if you're paying interest, you're not earning it, which is what happens when you save.
If, for example, you wanted to send your son off to college next year with an Apple MacBook, but didn't have $1,200 for it, you'd have two options. You could wait until next year & charge it to a credit card. According to indexcreditcards.com, the average consumer credit card rate as of July 31st was 17.55%. Assume that drops to 15% by then. If you repay $100/month, it would take 14 months to pay off, and you'd end up paying $108.31 in interest, for a total payout of $1,308.31.
However, if you chose to start saving now by socking away $100/month in a savings account that earned 5% interest, at the end of a year they'd have $1,333 saved. That's an almost $250 swing in two less months! By carving out some room in his budget ahead of time, he comes out ahead.
Why then do we borrow so much?? It started with interrelated events in the late 1970s-early 1980s: the decline of both the personal savings rate & the Federal Funds rate, and the increase in the usage of credit cards & the consumer portion of our Gross Domestic Product (the GDP, the most widely accepted measure of economic health & prosperity).
Personal savings as a percentage of disposable income fluctuated between 10-13% from the early 1950s to the mid-1980s. At that point, it started sliding toward 5%, even as real median income held steady or increased slightly. Additionally, while it accounted for 60% in the decades after World War II, the consumer portion of the GDP started climbing in the 1980s to reach nearly 70% today. At that same time began the proliferation of the all-purpose credit card.
Perhaps I overdo it a tad when I tell my 8 year-old that I use a debit card "because credit cards are evil". I mean, it's not like they're exactly like a syringe that gives a shot of instant gratification just below where you tied off the rubber string above your elbow, but ... It shouldn't be a hard sell that, with patience, comes rewards. But part of our problem is cultural. A 'keeping up with the Joneses' attitude pervades our society: "I have to have whatever my neighbor has. I can't hang out with my friends unless I have the newest gadget." And credit card companies have been only too happy to market their 'solutions' to fill any such gaps: "It's everywhere you want to be." "Don't leave home without it." "What's in your wallet?" " Earn points every time you use."
Such peer pressure is not new. Ben Franklin observed in 1758 "But what madness must it be to run in debt for (the artificial wants of mankind ... extravagancies)! We are offered ... six months of credit ... because we cannot spare the ready money. But, ah, think what you do when you run in debt; you give to another power over your liberty."
Seems like a more favorable trade-off would be to earn interest rather than be beholden to pay it to another. Moreover, aside from a brief period of time to right the ship & improve our habits, we might not have to scale back all that much the portion of consumption that comprises GDP. Alas, that's where institutional policies hinder us.
After Paul Volcker hiked it to 20% to extinguish the excessive inflation of the late 1970s, the effective federal funds rate, which determines what rate banks offer on savings accounts, started on its own downward trend. The last time someone could so finance saving for an item such as a MacBook was the late 1990s (unless you could time the 15-month 2006-2007window).
The Federal Reserve lowers interest rates to stem the severity of a recession. By itself, that's partially a lesson learned from the Fed's handling of what would become the Great Depression. The problem is that rates have recovered successively less & less after each of the last three downturns, finally reaching the nadir that has been near-0% for the last few years. But what has it gotten us? Fake 'bubble' growth (housing, the stock market) further impeded by wet-blanket fiscal policy.
Perhaps a better way to 'help' Main Street would be to increase the interest rate earned on savings. Since the last recession, the savings rate has pushed back to 5-7%. Maybe Uncle Sam should take a cue from the people. It might also help ease another bubble that has formed; student loan debt. Prospective college students would have an incentive to save more, thereby avoiding excessive amounts of debt that lawmakers purport to be concerned about.
The recent stock market correction already knocked down the primary beneficiary of the Fed's loose monetary policy. Maybe it's time for the Fed to correct itself.
I contacted my daughter's teacher that evening last spring to confirm the answer to her homework question. Sure enough, the 'correct' answer was "a". I thanked her & relayed my concern. I asked her what happened when they went over it in class the next day, and she told me that her teacher changed it to a bonus question.
Change has to start somewhere.