Do you realise that the average Australian will spend a year of his or her life working just to pay the interest on their credit card? That’s 365 days of their life down the gurgler being a slave of a small piece of plastic.
Way too many Australians don’t understand that the best financial decision they can make is to increase the mortgage on their house, pay off their Visa card and then cut it up never to be used again. Anybody adopting this particular piece of financial engineering needs to clearly understand that the last step is the most important. If they don’t cut up the card and snap the addiction, they will soon be sliding back down the slippery slope of plastic induced financial disaster.
Australians are addicted to credit cards as the record $47 billion in account balances at Christmas shows. What is amazing is that it is only 40 years since the national mail out of bank cards started the consumer credit revolution in Australia. Before that we had no consumer credit industry, you paid with cash or cheques and accounts were settled at the end of the month. Like many a revolution before it, the consequences of the credit revolution were both good and bad. Good because for the prudent few access to consumer credit makes life easier and life has greater choice. Bad for the battling many because consumer credit is financial nicotine and credit cards are financial cigarettes. Choice begets a trial and a trial becomes an addiction.
Think of my friend Shirley who has the average Australian’s account balance of $3,250. How does that trivial sum turn into such a crushing financial burden?
Firstly, credit card balances are a burden Shirley carries for life but a month at a time. Every month the statement comes in and every month Shirley looks at the statement, looks at the fees and interest, and feels like she has put her hand on a hot frying pan. Every month she resolves to pay the balance off next month but this month pays off just the minimum. It is hell for Shirley, she is not trying to prop up a hedonistic lifestyle. It’s about the kids’ excursions, their new clothes and all she spends on herself is getting her hair done for a special dinner once in a blue moon. She cannot escape without real financial pain in a world where advertising says “don’t worry, be happy” and friends and family believe it.
So Shirley carries a life sentence of debt without parole with the added burden that she has to do it silently.
Shirley is subjected to the usurious interest rates the credit card companies charge. They are currently between 16% and 20%. When you deposit with the bank you get between 3.5% and 4.5%. So the increase from the borrowing rate and the lending rate is between 444% and 457%. Even the difference with mortgage interest rates is more than 100%.
Not only is the interest rate so high but there is one last catch — the interest payments on credit card debt are not tax deductible so the amount you pay has to come out of after tax income and, as it is your last discretionary dollar, it is almost always at a very high marginal tax rate. It is not like a loan you take out to fund an investment where you get tax deductibility through negative gearing. And it is not like a housing loan where you invest in something you get to sell and, quite often, make a tax-free gain. With plastic it is all hard work down the plug hole.
Shirley takes home $65,000 on her $85,000 salary after tax. At the 38% marginal tax rate, an 18% interest rate and, assuming she has the average balance from 18 till her death at 84, she will have paid $62,000 in interest on a pretax basis. Close enough to $65,000 or one year’s income. What a waste of a year for her.
There is just no way anyone can survive paying 20% interest rates. Smoke that stuff for long enough and you get financial lung cancer. What is one of the world’s great investments for credit card providers is the world’s worst financial decision for you.
What financial planning experts try to teach those who are addicted to credit cards is that the addiction is the financial equivalent of a death sentence if you are a serious user. What they have also found is that it takes an average of about four years to get clean and kick the habit and recover.
The first two years are just spent getting people to admit they have a problem and that they need to change. That is two years just to hear the message that consumerism at 20% interest will destroy you.
The next two years are there to implement the get clean plan which comes in three versions from easy to hard.
The first is to use bonus money to pay off the credit card and follow this with cutting up your credit card. People just don’t understand the maths of having credit card debt despite being able to pay it off within a year. They make a terrible financial decision without any reason except the siren song of ‘spend now pay later’ despite having the financial resources to escape today.
The second plan is that described at the beginning of the article. Remortgage the house and cut up the credit card. A person can then make a budget and live within his or her income with a limited belt tightening. Finally the person needs to agree a set of rules for paying off the additional mortgage so as to reduce their debt. As explained this is a strategy that many employ but fail to follow through on by cutting up the cards. Shirley employed this strategy four times and four times went back on the credit cards. By the time she was finished she was a huge amount more in debt because she did not stop charging things to her credit card despite knowing the risk. She finally had to sell her house to pay back her, now far larger, mortgage which left her with no equity in her home.
With no home equity or discretionary income you are left with plan three. This plan is to allocate a fixed amount per month out of your salary to pay off the credit card. This sounds so simple to people without the problem but is just horrendous to implement for those who are in this money-less trap. Some people can find $100 per month and some $200 but it is a slow and painful process. Some people just can’t find the money to even make a tiny step to freedom.
This is where Shirley is; she sold the house, her bonuses were a thing of the good times and so she hasn’t had one for two years. Finally she just doesn’t have any fixed amount per month to spare. Interest payments and just getting by take all the money. She is in a poverty trap that is driving more and more Australians into the category of working poor because of their financial obligations. They have perfectly good incomes but the payments on their debt mean they can only just make ends meet. As a society we thought consumer credit was about giving people choice and instead we have made many slaves in the service of the banks. A cardholder who owes $1,000 at the start of the year and pays only the minimum payment of $25 (based on 2.5% of the debt) will take 13 years and three months to pay it off based on an interest rate of 18.5% and assuming they never spend an extra cent. Over that time the card holder will pay total interest of $1,196.
In reality, of course, the situation is even worse because cardholders so often keep spending to keep the card constantly maxed out and ask for, and get, bigger and bigger limits.
In my view, it’s time something was done about this nonsense. It’s time for legislators to act. I’m as strong an advocate of choice and free markets as anyone but sometimes society faces the fact that occasionally people have to be protected from themselves. For instance, we don’t let people drive when drunk and we all have to wear seatbelts. We even insist on people saving for retirement by investing in superannuation. And now I think it’s time to think about what we can do to protect credit card addicts from themselves. My first proposal is that the minimum monthly payment could be raised from 2.5% to 10%. A small first step but a very important one.
And, if that’s not part of the right answer, maybe we demand that banks come up with a better one.
*Mark Carnegie is head of the Lazard Australian Private Equity business and a Business Spectator writer.