Personal Debt

Chapter 4: Personal Debt

Historical Developments
Categories of Debt
Household Debt Service
Interest Rates
Mortgages
Consumer Credit
Consumer Opinions about Debt
Personal Bankruptcies
Preying on Debtors
Identity Theft

Beautiful credit! The foundation of modern society.

Mark Twain and Charles Dudley Warner, The Gilded Age (1873)

He who goes a borrowing, goes a sorrowing.

Benjamin Franklin, Poor Richard's Almanack (1757)

Personal debt has both good and bad effects on the U.S. economy. Americans borrow money to buy houses, cars, and other consumer goods. They also take out loans to pay for vacations, investments, and educational expenses. All of this spending helps businesses and boosts the nation's gross domestic product (the total market value of final goods and services produced within an economy in a given year). As long as debt is handled prudently, it can be a positive economic force. However, some Americans take on too much debt and get into financial difficulties. Debt becomes a problem on a macroeconomic scale when people must devote large amounts of their disposable income (after-tax income or take-home pay) to repaying loans instead of spending or investing their money.

In response to consumer demand, a credit industry has developed in the United States that encompasses a wide variety of businesses. Consumers and regulators complain that some creditors engage in practices that victimize debtors, particularly those who are poor and uneducated. In addition, identity theft has become a major problem in the industry. This is a crime in which personal and financial data are stolen so that criminals can use the good credit histories of others for illegal purposes.

Historical Developments

For centuries religious teachings about making and taking loans affected societal attitudes about the appropriateness of personal debt. The promise to repay a loan was considered a sacred pledge; thus, violating such an agreement was morally reprehensible. The Bible and the Koran (the sacred text of Islam) include scriptures that were interpreted as prohibiting the charging of excessive interest (or even any interest) on loans made to certain groups of people. Granting or assuming debt were actions that aroused disapproval in many circumstances. In William Shakespeare's (15641616) play Hamlet, which was first performed around 1600, one of the characters advises: Neither a borrower, nor a lender be.

English common law allowed for imprisonment of debtors who could not repay their debts. This practice carried over to the fledgling United States. In fact, Robert Morris (17341806), one of the signers of the Declaration of Independence, was later imprisoned in Philadelphia for failing to repay personal debt. The use of debtor's prisons in the United States was gradually phased out during the 1800s because of changing societal attitudes and the enactment of bankruptcy laws.

David A. Skeel Jr. explains in Debt's Dominion: A History of Bankruptcy Law in America (2001) that federal bankruptcy laws were passed in the United States in 1800, 1841, and 1867. However, each law was in force for only a few years before being repealed. Legislators had a difficult time drafting bills considered fair to both creditors and debtors. In 1898 a more workable law was passed that became the foundation for modern bankruptcy law.

As the twentieth century progressed, social taboos about personal debt diminished in the face of growing consumer demand for immediate access to goods. In 1919 the General Motors Acceptance Corporation (the financial arm of the automobile company General Motors) formed to allow Americans to borrow money to acquire new automobiles. The venture proved to be wildly successful and inspired other companies to enter the credit business. During the 1920s middle-class Americans seized on the opportunity to use credit to buy newly available durable (long-lasting) goods, such as appliances. Installment loans became a popular financing method. In the 1950s the first all-purpose credit cards were introduced. Over the next few decades their use became commonplace, representing a major shift in American buying habits and attitudes about the acceptability of debt.

Categories of Debt

Economists divide personal debt into two broad categories: investment debt and consumer debt. Money borrowed to buy houses and real estate is considered investment debt. Because most property appreciates (increases in value) over time, the debt assumed to finance its purchase will likely be a wise investment. Likewise, money borrowed to start a business or pay for a college education can bring financial benefits. All of this assumes that the investment was a wise one and that the short-term costs of the debt can be borne. By contrast, consumer debt is assumed purely for consumption purposes. The money is spent to gain immediate access to goods and services that will not appreciate in value (and may well lose value) over time to help offset the costs of the debt.

Credit falls into two other categories: nonrevolving credit and revolving credit. Nonrevolving loans require regular payments of amounts that will ensure that the original debt (the principal) plus interest will be paid off in a particular amount of time. They are also known as closed-end loans and are commonly used to finance the purchase of real estate, cars, and boats or to pay for educational expenses. Nonrevolving loans feature predictable payment amounts and schedules that are laid out in amortization tables. The term amortize is derived from the Latin term mort, which means to kill or deaden. An amortization schedule details how a loan will be gradually eliminated (killed off) over a set period. Revolving debt is a different kind of arrangement in which the debtor is allowed to borrow against a predetermined total amount of credit and is billed for the outstanding principal plus interest. The loans typically require regularly scheduled minimum payments, but not a set time period for repaying the entire amount due. Credit card loans are the primary example of revolving debt.

Loans can also be secured or unsecured. A secured loan is one in which the borrower puts up an asset called collateral to lessen the financial risk of the loaner. If the borrower defaults (fails to pay back the loan), the loaner can seize the collateral and sell it to recoup some or all the money that was loaned. Mortgages on homes and property and loans on cars, boats, motor homes, and other goods of high value are typically secured loans. In all these cases the collateral can be legally repossessed by the loaners. Unsecured loans are not backed by collateral. They are granted solely on the good financial reputation of the borrower. Credit card debts and debts owed to medical practitioners and hospitals are the major types of unsecured debts.

Household Debt Service

The Federal Reserve Board, the national bank of the United States, compiles an economic indicator called the household debt service ratio (DSR). The DSR is the ratio of household debt payments to disposable personal income. It indicates the estimated fraction of disposable income that is devoted to payments on outstanding mortgage and consumer debt.

The DSR has gradually increased since the 1980s. During the last quarter of 1980 the DSR was 10.6%. (See Figure 4.1.) A decade later it had climbed to 12%. By the end of 2000 the DSR was 12.9%, and it continued to rise to 14.5% in 2006. It decreased slightly to 14.3% by the fourth quarter of 2007. This means that by the end of 2007, Americans as a whole were spending 14.3% of their disposable income on their debt.

Interest Rates

One of the chief factors affecting the amount of debt that people assume is the amount of interest charged on loans. Banks and other financial institutions charge interest to make money on loaning money. The interest rate charged must be low enough to tempt potential borrowers, but high enough to make a profit for lenders. In general, commercial lenders base their interest rates on the rates charged by the Federal Reserve. Lower interest rates encourage consumers to borrow money.

The Federal Reserve makes short-term loans to banks at an interest rate called the discount rate. If the Federal Reserve raises or lowers the discount rate, then banks

TABLE 4.1. Interest payments for particular loans
SOURCE: Created by Kim Masters Evans for Cengage Learning, Gale, 2008
Interest rate Years of loan Amount borrowed Total interest paid Total principal + interest paid
5% 30 $100,000 $93,256 $193,256
10% 30 $100,000 $215,926 $315,926
15% 30 $100,000 $355,200 $455,200
5% 15 $100,000 $42,343 $142,343
10% 15 $100,000 $93,429 $193,429
15% 15 $100,000 $151,926 $251,926
12% 4 $20,000 $5,280 $25,280
12% 5 $20,000 $6,693 $26,693

adjust the federal funds rate, which is the rate they charge each other for loans. This affects the prime rate, the interest rate banks charge their best customers (typically large corporations), which in turn affects the rates on other loans. Figure 1.13 in Chapter 1 shows the bank prime loan rate between 1955 and 2008. The rate has varied widely over time from less than 5% in 1955 to more than 20% in the early to mid-1980s. Since 1990 the prime rate has consistently remained below 10% and temporarily dipped below 5% in the early 2000s.

When a loan is granted, the creditor sets terms that specify whether the interest rate to be paid will be fixed or variable. A fixed interest rate remains constant throughout the life of the loan. A variable rate changes and is typically tied to a publicly published interest rate, such as the prime rate. For example, a loan can be made with the stipulation that the interest rate charged each month will be one percentage point higher than the prime rate. As the prime rate changes, so will the interest rate on the loan and the borrower's monthly payments.

Table 4.1 shows the tremendous difference between loans with differing interest rates and repayment periods. A $100,000 mortgage with a thirty-year fixed interest rate of 5% will result in $193,256 being paid over the lifetime of the loan. The same loan at 10% interest will cost $315,926. Loans for new cars typically have a repayment period of four to five years. A 12% fixed interest car loan for $20,000 paid over four years results in a total payment of $25,280. The same loan spread over five years will end up costing $26,693. However, the trade-off to the borrower for a shorter loan period will be higher monthly payments. Borrowers must consider the financial consequences of monthly payments and interest rates to get a loan they can afford in the short and long term.

Mortgages

For most Americans a mortgage is the largest personal debt they will ever incur. Mortgage debt is a form of investment debt, because real estate usually increases in

TABLE 4.2. Residential mortgage debt outstanding, 19902007
SOURCE: Adapted from Total Mortgages Held or Securitized by Fannie Mae and Freddie Mac as a Percentage of Residential Mortgage Debt Outstanding, 19902007, in Enterprise Share of Residential Mortgage Debt Outstanding, 19902007, U.S. Department of Housing and Urban Development, Office of Federal Housing Enterprise Oversight, March 6, 2008, http://www.ofheo.gov/media/marketdata/ESRMDOutstanding19902007.xls (accessed May 12, 2008)
[Dollars in millions except where noted]
Residential mortgage debt outstanding
1990 $2,909,563
1991 $3,073,707
1992 $3,226,434
1993 $3,382,901
1994 $3,561,122
1995 $3,734,685
1996 $3,970,772
1997 $4,217,362
1998 $4,607,678
1999 $5,074,182
2000 $5,531,095
2001 $6,124,447
2002 $6,922,584
2003 $7,792,665
2004 $8,888,396
2005 $10,061,950
2006 $11,184,546
2007 $11,966,836
Note: Data for mortgage debt outstanding from the Federal Reserve Boards Flow of Funds Accounts of the United States, Annual Flows and Outstandings, March 6, 2008.

value. Thus, assuming mortgage debt is generally considered a sensible economic move, as long as the payments are well matched to the borrower's income and ability to pay.

Mortgage loans have been in use in Europe for centuries, developing along with private ownership of land. In modern times a mortgage represents a lien, or binding charge, against a piece of property for the payment of a debt. In other words, the loan is granted on the condition that the property can be claimed by the loaner (creditor) in the event the borrower defaults. If the loan is satisfactorily paid, full ownership of the property is granted to the borrower. In 2007 the outstanding residential mortgage debt totaled $11.9 trillion. (See Table 4.2.)

There are two types of mortgages in common use: conventional mortgages and government-underwritten mortgages. Conventional mortgages are loans made by nongovernmental businesses, such as banks and finance companies. Government-underwritten mortgages are insured by a federal, state, or local government agency.

The Federal Government's Role in Mortgages

Because high rates of homeownership are considered good for the U.S. economy, the government has taken an active role in the mortgage markets. Mortgage terms have changed dramatically since the early 1930s. At that time home buyers could borrow only up to half of a property's market value. A typical repayment plan included three to five years of regular payments and then one large balloon payment of the remaining balance. According to the Federal Housing Administration (FHA; September 6, 2006, http://www.hud.gov/offices/hsg/fhahistory.cfm), these terms discouraged many potential homeowners. As a result, the homeownership rate stood at around 40%. Most people preferred to rent.

During the 1930s the federal government introduced a variety of initiatives to boost a housing industry devastated by the Great Depression and increase homeownership. These efforts were focused on encouraging the supply side of the mortgage industry. They benefited consumers by enhancing the availability and flexibility of home mortgages. For example, amortization schedules covering fifteen years or more became common, eliminating balloon payments and making it much easier for consumers to afford houses. Following World War II the Veteran's Administration offered mortgages on favorable terms to returning veterans. Postwar economic prosperity and relatively low interest rates led to a housing boom. In the press release Census Bureau Reports on Residential Vacancies and Homeownership (April 28, 2008, http://www.census.gov/hhes/www/housing/hvs/qtr108/q108press.pdf), the U.S. Census Bureau states that the nation's homeownership rate was 64% by the mid-1980s. It was 67.8% in the first quarter of 2008.

There are several agencies and organizations that operate under government control or mandate to increase homeownership among Americans.

FEDERAL HOUSING ADMINISTRATION. The FHA was created in 1934 and later placed under the oversight of the U.S. Department of Housing and Urban Development. The FHA provides mortgage insurance on loans made by FHA-approved lenders to buyers of single- and multifamily homes. FHA-insured loans require less cash down payment from the home buyer than most conventional loans. The insurance provides assurances to lenders that the government will cover losses resulting from homeowners defaulting on their loan. In About the Federal Housing Administration (March 12, 2007, http://portal.hud.gov/portal/page?_pageid=33,717454&_dad=portal&_schema=PORTAL), the FHA states that it has insured over thirty-four million home mortgages since 1934.

FEDERAL NATIONAL MORTGAGE ASSOCIATION. The Federal National Mortgage Association (Fannie Mae) was created in 1938. Fannie Mae began buying FHA-insured mortgages from banks and other lenders, bundling the mortgages together and selling the mortgage packages as investments on the stock market. In essence, Fannie Mae created a secondary market for home mortgages. Lenders benefited because they received immediate money that could be loaned to new customers. Home buyers benefited from the increased availability of mortgage loans. The mortgage packages were attractive to investors because the mortgages were backed by FHA insurance. In 1968 Fannie Mae was converted to a private organization and expanded its portfolio beyond FHA-insured mortgages. However, as of 2008 it remained under congressional charter to enhance the availability and affordability of home mortgages for low- to middle-income Americans.

FEDERAL HOME LOAN MORTGAGE CORPORATION. The Federal Home Loan Mortgage Corporation (Freddie Mac) was created by the government in 1970 as a competitor for Fannie Mae, to prevent Fannie Mae's monopolization of the mortgage market. Like Fannie Mae, Freddie Mac sells home mortgages on the secondary market and is a private organization operating under a government charter.

TROUBLE FOR FANNIE MAE AND FREDDIE MAC. The 200506 housing market crash put tremendous financial pressure on Fannie Mae and Freddie Mac. Like many other mortgage providers, the two companies suffered large losses due to defaulted loans. Investors became increasingly nervous that Fannie Mae and Freddie Mac would be unable to raise sufficient money to cover these losses.

Katie Benner reports in The $5 Trillion Mess (CNNMoney.com, July 11, 2008) that shares in Fannie Mae and Freddie Mac had dropped in value by 65% and 75%, respectively, since the beginning of 2008. Benner notes that the two companies held and/or guaranteed approximately $5 trillion in mortgage loans. Some economists and federal regulators had become deeply worried about the financial soundness of the two companies, whereas others expressed confidence in their ability to survive the housing market slump. To calm investor fears, the federal government announced a plan to pump billions of dollars into Fannie Mae and Freddie Mac if the need arises. As of mid-July 2008, it remained to be seen whether this promise of a government bailout would help save the financially troubled companies.

Mortgage Interest Rates: Fixed and Adjustable

A fixed-rate mortgage charges a set interest rate over the entire lifetime of the loan, typically thirty years. Figure 4.2 shows the average annual interest rate charged on a thirty-year fixed mortgage from 1972 through 2007. Comparison to Figure 1.13 in Chapter 1 shows that fixed mortgage rates mirror the ups and downs of the prime rate. One feature of a fixed-rate mortgage is that the monthly payment remains the same throughout the lifetime of the loan.

Creative financing terms introduced by creditors since the late 1990s have led to many alternatives to the conventional thirty-year fixed-rate mortgage. One alternative is a shorter loan period, for example, fifteen years, instead of thirty years. Another popular option has been

the adjustable-rate mortgage (ARM). ARMs feature variable interest rates (and consequently variable monthly payments) over the life of the loan. An ARM rate is typically tied to a published benchmark rate called an index rate. Figure 4.3 displays selected index rates over the period 1996 to 2006. Low index rates during the early 2000s enticed many home buyers to take on ARMs instead of fixed-rate mortgages. Lenders often offer discount (or teaser) rates even lower than the index rate during the early months or years of the ARM repayment period. This translates into extra low monthly payments for an initial period, followed by much higher payments later.

Some creditors offer mortgages that allow homeowners to make interest-only payments for a short initial portion of the loan period. This is followed by a longer period of much higher monthly payments. A similar product is the payment-option mortgage, which allows homeowners to make small minimum payments for an initial short period. Short-term payment schedules requiring one large balloon payment are also offered in some mortgage products.

Mortgage arrangements with changeable monthly payments and balloon payments can pose a financial problem

for homeowners who overestimate their ability to meet the costs of the mortgage. Figure 4.4 illustrates how monthly payments can vary significantly between different types of mortgages on a $200,000 home. The buyer assuming a fixed-rate thirty-year mortgage at 6% interest pays $1,199.10 per month for the entire lifetime of the loan. The 5/1 ARM is a common ARM arrangement in which the initial interest rate remains fixed for five years and then begins to fluctuate with the index rate. In this example, the buyer pays a discounted rate of 4% during the first year of the ARM. This translates to a monthly mortgage payment of $954.83. In year six the monthly payment is tied to a 6% ARM rate, and the monthly payment jumps to $1,165.51. In year seven the ARM rate increases to 7%; consequently, the monthly payment increases to $1,389.51. Two other mortgage types depicted in Figure 4.4a 5/1 ARM with initial interest only payments and a payment-option mortgageboth feature large increases in monthly payments after the initial low-rate period.

Prime and Subprime Loans

Lenders divide mortgage loans into two broad categoriesprime and subprimebased on the creditworthiness of mortgage applicants. Prime loans feature better (lower) interest rates than comparable subprime loans. Subprime loans are for people who do not qualify for prime mortgages for various reasonspoor or short credit history, lack of assets, low income or inability to prove income, and so on. Subprime loan holders are more likely than prime loan holders to default on their loans. As a result, lenders charge higher interest rates on subprime loans because of the greater risk associated with them.

During the early 2000s the United States experienced a subprime mortgage loan boom. In Who Is to Blame for the Subprime Crisis? (2007, http://www.investopedia.com/articles/07/subprime-blame.asp), Eric Petroff indicates that only $35 billion in subprime mortgage loans were initiated in 1994. By 2002 the number had risen to $213 billion. Over the next three years the subprime market skyrocketed. In 2005 subprime lenders originated $665 billion of the risky mortgage loans.

Refinancing Mortgages

Most home mortgages cover long periodsup to thirty years. However, interest rates can change dramatically in the short term, rising and falling in response to macroeconomic factors. Home buyers who assume mortgages during times of high interest rates can ask creditors to refinance (adjust the mortgage terms) when interest rates go down. Basically, refinancing entails drawing up a new mortgage contract on a property. Because mortgage contracts are complicated legal documents, creditors usually charge fees to refinance mortgages. Thus, homeowners must weigh the long-term benefits of a reduced interest rate against the expense of refinancing fees.

During the 1990s and early 2000s interest rates trended downward, making mortgage refinancing popular. This was particularly true for consumers who had purchased homes during the 1980s, when interest rates were extremely high by historical standards.

Refinancing frequently results in lower monthly payments for the homeowner because of the lower interest rate and because refinancing is commonly performed after at least several years of payments have been made on the original loan. This frees up the borrowers' money for consumer spending, investing, or saving. However, refinances conducted with a long payment period will keep the homeowner in mortgage debt for a longer period than originally anticipated. Some homeowners opt for a shorter loan payback period when they refinance. For example, consider a homeowner who has been paying for five years on a fixed-rate thirty-year mortgage. There are twenty-five years left in the repayment period. Refinancing at a much lower interest rate with a new fifteen-year payback period may not decrease the monthly payment, but it will reduce by ten years the amount of time the homeowner will be in mortgage debt.

Home Equity Loans

Real estate tends to appreciate in value. Thus, a property can increase in value above the amount originally paid for it (i.e., the amount that was borrowed to pay for it). For example, imagine a homeowner who bought a house in 1990 for $100,000 under a thirty-year fixed-rate mortgage. After making mortgage payments for several years, the homeowner discovers that the principal due on the loan has dropped to $90,000, but the property has increased in value to $140,000. The difference between the amount of principal owed (the outstanding loan balance) and the value of the property is $50,000 and is called home equity. Home equity is an asset that can be borrowed against. Basically, homeowners can liquefy (turn into cash) the equity they have built up in their homes.

Since the late 1980s a combination of rising home values and decreasing interest rates has prompted many homeowners to refinance their mortgages and take out home equity loans. Margaret M. McConnell, Richard W. Peach, and Alex Al-Haschimi of the Federal Reserve Bank of New York examine the macroeconomic effects of this phenomenon in After the Refinancing Boom: Will Consumers Scale Back Their Spending? (Current Issues in Economics and Finance, vol. 9, no. 12, December 2003). The researchers note that homeowners liquefied $450 billion of home equity in 2003. In 2001 and early 2002 homeowners used 35% of liquefied home equity funds for home improvements. (See Table 4.3.) Another 26% was used to repay other debts, and 16% went to consumer spending. Smaller shares were devoted to financial investments (11%), real estate or business investments (10%), and tax payments (2%).

TABLE 4.3. Uses of funds liquefied in 2001 and 2002 refinancings
SOURCE: Margaret M. McConnell, Richard W. Peach, and Alex Al-Haschimi, Table 2. Uses of Funds Liquefied in 2001 and 2002 Refinancings, in After the Refinancing Boom: Will Consumers Scale Back Their Spending? Current Issues in Economics and Finance, vol. 9, no. 12, December 2003, http://www.newyorkfed.org/research/current_issues/ci9-12.pdf (accessed June 10, 2008). Data from Glenn Canner, Karen Dynan, and Wayne Passmore, Mortgage Refinancing in 2001 and Early 2002, Federal Reserve Bulletin, vol. 88, no.12, December 2002.
Share of loansa (percent) Share of dollars (percent)
Repayment of other debts 51 26
Home improvements 43 35
Consumer expendituresb 25 16
Stock market or other financial investment 13 11
Real estate or business investment 7 10
Taxes 2 2
aThe percentages sum to more than 100 because multiple uses could be cited for a single loan.
bIncludes vehicle purchases; vacation, education, or medical expenses; living expenses; and other consumer purchases.

Economists are encouraged by the use of home equity money for home improvements. This type of spending is considered an investment, because it adds value to the home. Many homeowners chose to use home equity funds to repay other debt. Because mortgage loans typically have lower interest rates than other loans, this exchange is beneficial. In addition, the interest paid on mortgage loans is tax deductible for most Americans, whereas interest paid on other types of loans is not deductible. Thus, conversion of bad types of debt (such as credit cards) to mortgage debt has favorable consequences. More than half (51%) of the loans obtained from 2001 and 2002 refinancings were taken by homeowners to repay other debts. (See Table 4.3.) However, some economists worry that homeowners who use home equity loans to pay off bad kinds of debt may succumb to temptation and run up bad debt again. This could put them in a dire financial situation. They will no longer have their home equity to fall back on if their new debts become more than they can afford, and they might have to default on their loans. Home equity loans, like all mortgage loans, are secured by property. Thus, default on a home equity loan can result in loss of the home by the owner.

The Housing Market Booms and Bursts

The historically low interest rates of the early 2000s spurred demand in the real estate market. This pushed up prices on new homes and appreciated (increased the value) of existing homes. Many lenders relaxed loan standards and extended subprime mortgages to applicants eager to become homeowners. Subprime ARMs were particularly popular, because they featured low initial monthly payments. Lenders and borrowers of these loans expected interest rates to stay low and homes to keep appreciating in value. That would allow the homeowners to refinance and tap into home equity to offset the financial burden of the coming higher monthly payments. This scenario did not materialize. Instead, interest rates began to rise, and demand dropped dramatically in the housing market. (See Figure 4.5.)

The White House notes in Economic Report of the President (February 2008, http://www.gpoaccess.gov/eop/2008/2008_erp.pdf) that between 2004 and 2006 the default rate among homeowners with subprime ARMs was around 6%. By late 2007 the rate had skyrocketed to more than 15%. The default rate for prime mortgage loans also increased during this period, from around 1% to nearly 4%.

RECORD FORECLOSURE RATE. Foreclosure is a legal process in which a lender takes possession of the collateral (i.e., the home) of a borrower who has defaulted on a mortgage loan. In Foreclosure Rate Hits Record High (Los Angeles Times March 7, 2008), Maura Reynolds reports that the national average foreclosure rate at the end of 2007 was the highest in recorded history. Just over

2% of mortgages were in foreclosure at that time. The foreclosure rate was highest in states that had experienced the greatest housing boom (and hence the greatest housing bust): California, Nevada, Florida, and Arizona.

Consumer Credit

The Federal Reserve defines the term consumer credit as credit extended to individuals that does not include loans secured by real estate. In other words, mortgages are excluded from consumer credit. The Federal Reserve states in Federal Reserve Statistical Release G.19: Consumer Credit, March 2008 (May 7, 2008, http://www.federalreserve.gov/releases/G19/Current/g19.pdf) that consumer credit topped $2.5 trillion during the first quarter of 2008. (See Figure 4.6.) The amount had risen since 2003, when nearly $2.1 trillion in credit was outstanding. The breakdown for the first quarter of 2008 was $1.6 trillion in nonrevolving loans and $956 million in revolving loans. Nonrevolving debt includes loans for vehicles, boats, vacations, and student loans. Revolving debt is almost entirely comprised of credit card debt.

Figure 4.7 shows the breakdown of outstanding consumer debt by creditor as of March 2008. Nearly one-third (31%) of the total was owed to commercial banks. Pools of securitized assets (bundled debts sold as securities on the stock markets) accounted for 27% of the total. Finance companies held another 23% of the debt and credit unions held 9%. The remaining creditors each accounted for 4% or less of the total.

Interest Rates on Consumer Loans

Consumer loans are not secured by real estate. Because they have a higher risk of default, consumer loans generally have a higher interest rate than mortgage loans. Table 4.4 lists the average interest rates charged on various kinds of consumer loans from 2003 through 2007 and for the first quarter of 2008. It should be noted that borrowers with good credit histories would have likely received lower interest rates than these averages and that borrowers with poor credit histories would have been charged higher rates.

New Car Loans

Loans for the purchase of new cars (and other types of vehicles) are secured by the vehicle being purchased. In other words, the creditor can repossess the vehicle if the loan is in default. As a result of this collateral, the interest rates on new vehicle loans tend to be lower than on other types of consumer loans.

As of the first quarter of 2008, the average interest rate on a four-year loan from a commercial bank for the purchase of a new car was 7.27%. (See Table 4.4.) The interest rate charged by auto finance companies for a new car loan was lower, at 4.85%. According to the Federal Reserve, the latter rate is based on the rates charged by the finance companies of the big three automakers: General Motors Corp., Ford Motor Co., and Daimler-Chrysler AG.

The typical loan period reported by the auto finance companies was 62.6 months (just over five years). (See Table 4.4.) This is much longer than the three-year loan period that was common for new car loans in the mid-1970s. Longer loan periods reflect longer car lifetimes. The average loan-to-value ratio reported by the auto finance companies for the first quarter of 2006 was 94%. This means that the average new car buyer borrowed 94% of the value of the new car being purchased. The remaining 6% was a down payment paid by the buyer in cash or via trade-in of another vehicle. The

TABLE 4.4. Terms of credit at commercial banks and finance companies, 2003first quarter 2008
SOURCE: Adapted from Terms of Credit at Commercial Banks and Finance Companies, in Federal Reserve Statistical Release G.19: Consumer Credit, March 2008, The Federal Reserve, May 7, 2008, http://www.federalreserve.gov/releases/G19/Current/g19.pdf (accessed May 8, 2008)
[Percent except as noted, not seasonally adjusted]
Institution, terms, and type of loan 2003 2004 2005 2006 2007 2008
Q1*
Commercial banks
Interest rates
48-mo. new car 6.93 6.6 7.08 7.72 7.77 7.27
24-mo. personal 11.95 11.89 12.05 12.41 12.39 11.4
Credit card plan
All accounts 12.3 12.72 12.51 13.21 13.38 12.48
Accounts assessed interest 12.73 13.22 14.55 14.73 14.67 13.71
New car loans at auto finance companies
Interest rates 3.81 4.92 6.02 4.99 4.87 4.85
Maturity (months) 61.3 60.7 60 63 62 62.6
Loan-to-value ratio 95 89 88 94 95 94
Amount financed (dollars) 26,295 24,888 24,133 26,620 28,287 27,586
*Preliminary.
Notes: Interest rates are annual percentage rates (APR) as specified by the Federal Reserve's Regulation Z. Interest rates for new-car loans and personal loans at commercial banks are simple unweighted averages of each bank's most common rate charged during the first calendar week of the middle month of each quarter. For credit card accounts, the rate for all accounts is the stated APR averaged across all credit card accounts at all reporting banks. The rate for accounts assessed interest is the annualized ratio of total finance charges at all reporting banks to the total average daily balances against which the finance charges were assessed (excludes accounts for which no finance charges were assessed). Finance company data are from the subsidiaries of the three major U.S. automobile manufacturers and are volume-weighted averages covering all loans of each type purchased during the month.

average amount financed during the first quarter of 2008 for a new car purchase was $28,174.

Personal Loans

Personal loans are generally unsecured loans based on the creditworthiness of the borrower. A lack of collateral makes personal loans more risky from the loaners' view-point; thus, interest rates are higher for personal loans than for car loans. (See Table 4.4.) In the first quarter of 2008 the average interest rate charged by commercial banks for a twenty-four-month personal loan was 11.4%. The rate varied from 11.89% to 12.41% between 2003 and 2007.

Credit Cards

Credit cards have the highest average interest rates of all types of consumer loans. Most credit card loans are unsecured and are granted based on the creditworthiness of the borrower. The higher risk factor for the creditor and the huge demand for credit cards contribute to the high interest rates that are charged.

The average interest rate charged by commercial banks on credit card loans was 13.71% during the first quarter of 2008. (See Table 4.4.) The rate varied from 12.73% to 14.73% between 2003 and 2007. However, Lucy Lazarony of Bankrate.com explains in Store Credit Cards: Flashy Perks, High Rates (2008, http://moneycentral.msn.com/content/Banking/creditcardsmarts/P55860.asp) that rates charged on credit cards issued by department and specialty stores can be much higher. Lazarony notes that even though these stores sometimes offer discounts and rewards for items charged on their cards, their interest rates can be more than 20%.

REVOLVING CREDIT AND MINIMUM PAYMENTS. Credit card debt is an example of revolving debt, a type of debt that is not amortized. There is no preset schedule of payments that will eliminate the debt within a particular time frame. The creditor grants the borrower a total amount of credit at a particular interest rate. Even though the interest rate may be fixed for a short introductory period, in general, credit card interest rates are variable.

Each month the borrower is billed for the outstanding balance on the credit card, which includes principal plus interest. The borrower can pay off the entire balance or a lesser amount down to the minimum payment required by the credit card issuer. Payment of any amount less than the minimum required will result in additional finance charges on the remaining balance. This is an example of compound interest (interest charged on an amount that already includes built-up interest charges).

When credit cards were first introduced, it was common for creditors to require 5% or more of the balance as a minimum monthly payment. Minimum payment requirements were gradually reduced to 2% by most credit card

TABLE 4.5. Effects of different minimum monthly payments on credit card debt
SOURCE: Created by Kim Masters Evans for Cengage Learning, Gale, 2008
Interest rate Amount borrowed Minimum monthly payment required Months to pay off loan Total interest paid Total principal + interest paid
13% $1,000 2% 148 $815 $1,815
18% $1,000 2% 232 $1,931 $2,931
21% $1,000 2% 397 $4,198 $5,198
13% $1,000 4% 77 $322 $1,322
18% $1,000 4% 87 $516 $1,516
21% $1,000 4% 95 $665 $1,665

issuers. Low required minimum payments, high interest rates, and the effect of compounding interest make it difficult for many consumers to pay off credit card debt. The Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 requires creditors to tell borrowers how long it will take to pay off their credit card debt if only minimum payments are made.

Table 4.5 illustrates the tremendous difference to the borrower between credit card debts paid off by differing minimum monthly payments. A $1,000 loan at 13% interest takes 148 months to pay off with 2% minimum monthly payments. The same loan takes only seventy-seven months to discharge if 4% of the balance is paid each month. The higher monthly payment also results in far less interest being paid over the life of the debt ($322 compared to $815). Even greater savings are achieved when a minimum monthly sum of 4% is paid on credit card loans that charge 18% or 21% interest.

Student Loans

Student loans are loans obtained to pay for educational expenses, primarily at the college level. Even though they are technically consumer loans, student loans are not for consumption purposes. They fund the advancement of skill and knowledge in individuals, likely increasing the potential for higher future income. Thus, student loans are considered a type of human investment.

Because the federal government encourages secondary education, it plays a major role in ensuring that student loans are available. There are three major types of student loans:

  • Low-interest loans provided by the government through the financial aid departments of participating schools; these loans are available to needy students through the Perkins Loan Program
  • Loans provided directly to students by the government through the William D. Ford Federal Direct Loan Program
  • Loans guaranteed by the federal government but provided to students by private lenders
TABLE 4.6. Public opinion poll responses regarding credit card payments, April 2008
SOURCE: Question qn21. Thinking about All Credit Cards including Department Stores, Retail Chain Stores, as well as General Bank Credit
Cards Such As Visa and MasterCard, How Many Credit Cards Do You Have?) [IF ONE OR MORE CREDIT CARD, ASK:] How Do You
Generally Pay Your Credit Card(s) Each MonthDo You Always Pay the Full Amount, Do You Usually Pay the Full Amount, but Not Always, or Do You Always Pay As Much As You Can, but Usually Leave A Balance, Do You Usually Pay the Minimum Amount Due, but Not Much More, or Do You Sometimes Pay Less Than the Minimum Amount Due? in Gallup Poll Social Series: Economy & Personal Finance, The Gallup Organization, April 2008, http://brain.gallup.com/documents/questionnaire.aspx?STUDY=P0804015 (accessed May 13, 2008). Copyright © 2008 by The Gallup Organization. Reproduced by permission of The Gallup Organization.
THINKING ABOUT ALL CREDIT CARDS INCLUDING DEPARTMENT STORES, RETAIL CHAIN STORES, AS WELL AS GENERAL BANK CREDIT CARDS SUCH AS VISA AND MASTERCARD, HOW MANY CREDIT CARDS DO YOU HAVE? [IF ONE OR MORE CREDIT CARD, ASK:] HOW DO YOU GENERALLY PAY YOUR CREDIT CARD(S) EACH MONTH DO YOU ALWAYS PAY THE FULL AMOUNT, DO YOU USUALLY PAY THE FULL AMOUNT, BUT NOT ALWAYS, OR DO YOU ALWAYS PAY AS MUCH AS YOU CAN, BUT USUALLY LEAVE A BALANCE, DO YOU USUALLY PAY THE MINIMUM AMOUNT DUE, BUT NOT MUCH MORE, OR DO YOU SOMETIMES PAY LESS THAN THE MINIMUM AMOUNT DUE?
Mean: N/A Total N: 785
% N
Do you always pay the full amount 42.87 336
Do you usually pay the full amount, but not always 16.58 130
Do you always pay as much as you can, but usually leave a balance 25.41 199
Do you usually pay the minimum amount due, but not much more 11.95 94
Do you sometimes pay less than the minimum amount due 0.75 6
Other (vol.) 0.89 7
Don't know 0.76 6
Refused 0.79 6
N = Population.

According to the U.S. Department of Education, in Performance and Accountability Report Fiscal Year 2007: Highlights (February 1, 2008, http://www.ed.gov/about/reports/annual/2007report/report-highlights.pdf), the loan portfolio of the William D. Ford Federal Direct Loan Program totaled $99 billion as of September 30, 2007. The total outstanding balance of federally guaranteed student loans held by lenders at that time was $363 billion.

Consumer Opinions about Debt

In March 2005 the Gallup Organization, in conjunction with the credit marketing company Experian, began compiling a Personal Credit Index (PCI; http://www.personalcreditindex.com)an index gauging consumer perceptions and intentions regarding personal credit. The first index value was arbitrarily set to one hundred. Periodic polls have been conducted to calculate a PCI for comparison to the original value. In December 2007 pollsters found that the PCI had declined to a value of seventy-six, indicating a more negative viewpoint about personal credit.

In Gallup Poll Social Series: Economy & Personal Finance (April 2008, http://brain.gallup.com/documents/questionnaire.aspx?STUDY=P0804015), Gallup notes that

TABLE 4.7. Public opinion poll responses regarding ability to make minimum payments on credit cards, April 2008
SOURCE: Question qn19e. Next, Please Tell Me How Concerned You Are Right Now about Each of the Following Financial Matters, Based on Your Current Financial SituationAre You Very Worried, Moderately Worried, Not Too Worried, or Not Worried at All? If a Particular Item Does Not Apply to You, Please Say So. First, How Worried Are You aboutNot Being Able To Make the Minimum Payments on Your Credit Cards? in Gallup Poll Social Series: Economy & Personal Finance, The Gallup Organization, April 2008, http://brain.gallup.com/documents/questionnaire.aspx?STUDY=P0804015 (accessed May 13, 2008). Copyright © 2008 by The Gallup Organization. Reproduced by permission of The Gallup Organization.
NEXT, PLEASE TELL ME HOW CONCERNED YOU ARE RIGHT NOW ABOUT EACH OF THE FOLLOWING FINANCIAL MATTERS, BASED ON YOUR CURRENT FINANCIAL SITUATIONARE YOU VERY WORRIED, MODERATELY WORRIED, NOT TOO WORRIED, OR NOT WORRIED AT ALL? IF A PARTICULAR ITEM DOES NOT APPLY TO YOU, PLEASE SAY SO. FIRST, HOW WORRIED ARE YOU ABOUTNOT BEING ABLE TO MAKE THE MINIMUM PAYMENTS ON YOUR CREDIT CARDS?
Mean: 1.92 Total N: 1021
% N
Very worried 11.22 115
Moderately worried 12.3 126
Not too worried 18.71 191
Not worried at all 41.57 424
Doesn't apply (vol) 15.73 161
Don't know 0.07 1
Refused 0.4 4
N = Population.

nearly 22% of respondents had no credit cards at all. Another 17% had one credit card. Seventeen percent reported having two credit cards, and nearly 14% had three credit cards. These are credit cards issued by banks, department stores, or retail chains. When asked about their payment habits, nearly 43% of people said they pay off their credit card bills each month. (See Table 4.6.) The remainder usually carry over a balance from month to month. Twelve percent of those asked usually pay only the minimum amount due each month. A small percentage (0.75%) reported they sometimes pay less than the minimum amount required. Nearly a quarter of respondents reported they were very worried (11.2%) or moderately worried (12.3%) about not being able to make the required minimum payments on their cards. (See Table 4.7.)

Personal Bankruptcies

The word bankrupt is derived from the Italian phrase banca rotta which means bench broken, referring to the benches or tables used by merchants in outdoor markets in sixteenth-century Italy. Bankruptcy is a state of financial ruin. Under U.S. law people with more debts than they can reasonably hope to repay can file for personal bankruptcy. This results in a legally binding agreement between debtors and the federal government worked out in a federal bankruptcy court. The agreement calls for the debtors to pay as much as they can with

whatever assets they have, and after a predetermined amount of timeusually a number of yearsthe debtors begin again with new credit. Depending on state law, certain belongings may be kept through the bankruptcy.

The American Bankruptcy Institute explains in General Concepts (2008, http://consumer.abiworld.org/?q=node/21#5) that an official declaration of bankruptcy benefits individuals in the short term, because it puts a stop to all collection efforts by creditors. An automatic stay goes into effect that prevents creditors from calling, writing, or suing debtors covered by a bankruptcy plan.

Figure 4.8 shows the number of personal bankruptcy cases filed per fiscal year between 2001 and 2007. A fiscal year ends September 30. In fiscal year 2007 over 775,000 individuals filed for bankruptcy, down from nearly 1.1 million cases in fiscal year 2006. After climbing through the early 2000s, the number of personal bankruptcy filings decreased dramatically in 2006 and 2007.

There are three types (or chapters) of personal bankruptcy under which individuals may file:

  • Chapter 7a liquidation plan is developed in which the debtor turns over certain assets that are sold and used to pay creditors.
  • Chapter 13a payment plan is developed under which debtors receiving regular income repay their creditors. Liquidation of assets is not required in most cases.
  • Chapter 11while similar to Chapter 13, Chapter 11 is reserved for individuals with substantial debts and assets.

According to the U.S. Courts (September 2007, http://www.uscourts.gov/bnkrpctystats/sept2007/f2table.xls), in fiscal year 2007, 467,248 (60.3%) of personal bankruptcy cases were filed under Chapter 7. Another 307,521 (39.7%) of filings were under Chapter 13, and the remaining 571 (0.1%) were under Chapter 11.

Evolving Bankruptcy Law

The first federal bankruptcy laws were written in the early 1800s but were considered emergency measures to remain in effect for only short periods of time. The first comprehensive federal legislation was the National Bankruptcy Act of 1898, which was extensively amended during the 1930s and later replaced by the Bankruptcy Reform Act of 1978. This law was substantially amended by the Bankruptcy Reform Act of 1994. Major reforms in the law were enacted when the Bankruptcy Abuse Prevention and Consumer Protection Act of 2005 went into effect.

Because of different state laws regulating which assets and belongings a person could keep after a Chapter 7 filing, regulators and creditors believed that some people were using bankruptcy as a way to keep possessions without having to pay for them. The new federal law instituted measures intended to eliminate abuses and loopholes and increased the amount of paperwork and fees required for most filers.

Opponents of the new bill argued that it was designed to make more money for credit card companies and lenders and that it would be detrimental to ordinary people who chose bankruptcy as a last resort.

Bankruptcy Filers

In The Two-Income Trap: Why Middle-Class Mothers and Fathers Are Going Broke (2003), Elizabeth Warren and Amelia Warren Tyagi note that women and families with children at home are two of the fastest-growing groups filing for personal bankruptcy. For example, between 1981 and 1999 the number of women who filed for bankruptcy went from about sixty-nine thousand to about five hundred thousanda 625% increase.

Warren addresses the phenomenon of bankruptcy among middle-class American families in Financial Collapse and Class Status: Who Goes Bankrupt? (Osgoode Hall Law Review, vol. 41, no. 1, spring 2003). Writing of the importance of documenting who files for bankruptcy, she states, Knowing who files for bankruptcy can signal information about successes and failures throughout the population, informing research, for example, on the economic progress of different social and racial sub-groups, the heightened vulnerability of the elderly, or the economic risks facing divorced women or mothers of small children. Warren finds that an overwhelming majority of the people she interviewed who had filed for bankruptcy had at least some college education, worked in occupations that are typically rated high in status surveys, and were homeownersthe three factors that Warren used to identify membership in the American middle class. This finding contradicts the idea that people who declare bankruptcy tend to be poorly educated and economically disadvantaged from the outset. Additionally, the most common reasons people give for declaring bankruptcy are sudden financial setbacks, such as job loss, illness or injury, medical debt, or divorce, rather than long-term problems involving chronic overspending (although these cases do exist).

Preying on Debtors

Consumer demand for credit has led to enormous growth in businesses engaged in making loans, counseling debtors, and arranging debt management plans. Even though these are legitimate enterprises, some businesses have aroused consumer ire and even run afoul of the law with practices considered abusive toward debtors.

Predatory Lending?

Most large creditors, such as banks and finance companies, only make consumer loans to applicants who meet stringent requirements for creditworthiness, excluding people with low incomes and poor credit histories. This has led to the growth of subprime lendersbusinesses that make consumer loans to customers considered undesirable by traditional lenders. Because they are assuming higher risk, subprime lenders charge their customers higher interest rates and fees to loan money to them. Some consumers and legislators have accused these businesses of charging excessive fees and interest rates on consumer loansa practice called predatory lending. Predatory lenders allegedly victimize poor people by imposing loan terms designed to maximize creditor profits and make it difficult for debtors to pay off their debt.

Usury is a word that centuries ago meant interest or the charging of interest. In modern terminology it has come to mean the charging of excessive interest. Even though there are state usury laws against the charging of excessive interest, this issue has not been addressed at the federal level. In fact, most banks are allowed to ignore state usury laws. Other lenders can avoid usury laws through a variety of means, such as charging large loan fees and forcing borrowers to take out expensive insurance policies.

Two particular types of consumer loans are often called predatory: payday loans and refund anticipation loans (RALs). Borrowers obtain payday loans from establishments that agree to accept and hold personal checks until the borrower receives a paycheck. RALs are also short-term loans that must be paid back within two weeks. Creditors offer RALs to people expecting refunds when their income taxes are filed. The Consumer Federation of America claims in Refund Anticipation Loans: Updated Facts and Figures (January 17, 2006, http://www.consumerfed.org/pdfs/RAL_2006_Early_info.pdf) that RALs are targeted at uneducated minority populations that are vulnerable to quick cash loan offers.

Credit Counseling and Debt Management Services

The explosive growth in consumer debt has resulted in many organizations offering credit counseling and debt management services to debtors in financial difficulties. Consumer activists maintain that many of these organizations charge debtors large fees in return for little to no aid. In September 2003 the Permanent Subcommittee on Investigations began investigating alleged abuses in the credit counseling industry and published its findings in Profiteering in a Non-profit Industry: Abusive Practices in Credit Counseling (April 13, 2005, http://frwebgate.access.gpo.gov/cgi-bin/getdoc.cgi?dbname=109_cong_reports&docid=f:sr055.109.pdf).

The committee explains that credit counseling as an industry began in the 1960s with the help of large creditors, such as banks, concerned about rising bankruptcy rates. The early credit counseling agencies (CCAs) were locally based nonprofit organizations with trained counselors who met in person with debtors and provided advice on budgeting and paying off debt. CCAs could also arrange debt management plans for debtors in which creditors agreed to charge lower monthly minimum payments, lower interest rates, and waive outstanding late fees. The CCAs collected the new monthly payments from the debtor and paid the creditors. Creditors supported the CCAs with contributions and participated in debt management plans in hopes that the debtors would avoid filing for bankruptcy. Some CCAs also charged small fees to the debtor for administrative costs. These reputable CCAs were members of the National Foundation for Credit Counseling, an organization known for its focus on standards and ethics.

The committee finds that several of the new CCAs that have entered the industry since the 1990s operate in a much different way. Most are Internet-based, communicate with consumers solely by phone, and focus exclusively on enrolling debtors in debt management plans for large fees. Although officially nonprofit organizations, many of these new CCAs have ties to for-profit businesses. The committee concludes that these CCAs engage in deceptive practices and provide no actual counseling services to debtors.

The committee's investigation coincided with a federal crackdown on CCAs. The Internal Revenue Service began revoking the tax-exempt status of CCAs found to be funneling money to for-profit businesses. The Federal Trade Commission (FTC) filed charges against some of the CCAs accused of wrongdoing. Stephen Manning reports in AmeriDebt Founder Settles with FTC over Alleged Hidden Fees (Associated Press, January 11, 2006) that in January 2006 Andris Pukke, the founder of AmeriDebt, agreed to pay the FTC a $35-million fine to avoid a trial. AmeriDebt had allegedly collected more than $172 million in fees from an estimated three hundred thousand customers who never received any credit counseling. In Debt Management Telemarketers Settle FTC Charges (June 15, 2006, http://www.consumeraffairs.com/news04/2006/06/ftc_debt_management.html), ConsumerAffairs.com notes that in June 2006 the CCA Credit Foundation of America agreed to pay over $926,000 in fines to the FTC for making false claims about its debt management program and operating as part of a for-profit company.

Identity Theft

Modern technology and compilation of personal and financial information in computer databases has made obtaining loans faster and easier than in the past. No longer are face-to-face meetings required between creditors and borrowers. Loans can be secured through the mail, over the phone, and via the Internet. However, this convenience has a price. It allows unscrupulous people to pretend to be someone else by stealing the identity of people with good credit histories and using it for criminal purposes.

The number of identity theft complaints reported to the FTC has skyrocketed from around 86,000 in 2001 to more than 250,000 complaints in 2007. (See Figure 4.9.) According to the FTC, in Consumer Fraud and Identity Theft Complaint Data, JanuaryDecember 2007 (February 2008, http://www.consumer.gov/sentinel/pubs/top10fraud2007.pdf), the most common outcome of identity theft cases in 2007 was credit card fraud. Nearly one-fourth (23%) of the complaints filed were associated with credit card fraud. More than half of these cases occurred when consumers were opening new accounts with credit card issuers.

The FTC notes that the ten metropolitan areas (in descending order of number of complaints per one hundred thousand population) associated with the most reported cases of identity theft in 2007 were:

  1. Albany-Lebanon, Oregon
  2. Greeley, Colorado
  3. Napa, California
  4. Punta Gorda, Florida
  5. Allegan, Michigan
  6. Roseburg, Oregon
  7. Dunn, North Carolina
  8. Willimantic, Connecticut
  9. Concord, New Hampshire
  10. Gainesville, Georgia

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