Paying off Debt in a Recovering Economy
Debt in this country is extraordinarily high. In 2012, household debt from sources like student loans, credit cards and auto loans accounted for about $11.3 trillion dollars, according to the Federal Reserve Bank of New York. In comparison, the national debt was $16.748 trillion as of May 17, 2013. The United States has become the national equivalent of Wimpy from the old Popeye comic strip: we'll gladly pay you on Tuesday for goods and services today.
How Do You Score on Credit?
Credit is the convenient shovel we use to dig ourselves into debt. Building up a good credit standing is important, as many things cannot be purchased without a high score. When someone applies for a line of credit, whether in the form of a mortgage, a credit card, or a loan, their individual score lets lenders know what type of risk they are entering. This risk is contained in a credit report, which calculates the score based on a system created by Fair Isaac and Company.
Fair Isaac, now called FICO, was founded in 1956 by Bill Fair, an engineer, and Earl Isaac, a mathematician. In 1958 the company released its first credit scoring system, which it calls the most widely used system in the world. Some of FICO's clients include nine of the top ten Fortune 500 companies, a third of the top 50 U.S. retail companies, and over 150 healthcare companies. About 65 percent of credit cards used worldwide are managed with FICO systems, and 12 different countries purchase the credit scores that FICO calculates.
FICO scores fall in a range of 300 to 850, and are calculated using five different factors, weighed with varying rates of importance:
- Payment history (35 percent)
- Amounts owed (30 percent)
- Length of credit history (15 percent)
- New credit (10 percent)
- Types of credit in use (10 percent)
Lenders request this score from one of three different agencies (Equifax, Experian and TransUnion) that use FICO's software to calculate scores in order to evaluate the future credit risk of a potential borrower. These scores may vary, as each credit agency collects different information in addition to what FICO provides them. High amounts of debt, any defaults on outstanding loans or missed payments can adversely affect the score reported by these agencies, and therefore keep people from buying a house, enrolling in school or opening a new credit card account.
Paying Down America's Debt
Even with the high amount of debt that Americans hold, there has been positive progress in recent years. According to the Federal Reserve Bank of New York, household debt was $12.7 trillion in 2008. That number decreased to $11.3 trillion in 2012, an 11 percent drop over four years. Between 2008 and 2010, households moved from borrowing to repaying, which reduced annual consumer cash flows by almost $500 billion.
The report stresses that this huge paying down of debt may have a few different reasons behind it. Not considering defaults, "from 2007 through 2011, consumers reduced their debt at a pace not seen over the last 10 years." The cause is unclear -- it could be that borrowers were forced to pay down debt due to tighter credit standards, or they may have made a voluntary change in saving behavior.
The paying down of debt is a double-edged sword. When households change their habits in order to lower the amount of debt they owe to lenders, credit card companies, and other agencies, it means they have less disposable income to spend on consumer goods, slowing economic growth. While paying down debt can have a deleterious effect on the overall economy, it can benefit individuals and families. Once households have a better grasp on their finances they can resume spending, but in a more responsible way.
Climbing out of a Money Pit
For those in financial trouble, what's the path to get back to a responsible level of debt? There are a few options available, some of them drastic. One of these is enrolling in a debt management plan (DMP), as described by Deanna Templeton. A DMP is negotiated with a consumer credit counseling service or debt management company. The plan could take 4-5 years to pay off, depending on the size of the debt and how much is paid each month. The counseling service asks lenders to lower interest rates and monthly payments to an amount digestible for each individual, and a single payment is made to the counseling service that handles the DMP. They may charge a fee for handling the DMP and payments, so proper research to find competitive rates is recommended.
DMPs aren't without rules and risk. While enrolled in a DMP, people agree not to open new lines of credit or apply for any loans. This may be a personal risk in the event something drastic happens, but it is the price that has to be paid. Another risk is that an individual's credit score could take a hit once they are done with the DMP when creditors close that account. All the credit information could be lost once that line disappears from a credit report, and this may damage a credit score temporarily. Responsibly opening a new line of credit in order to re-establish a credit score could reverse this detrimental occurrence.
Another option for individuals is to take ownership of their finances by speaking to a financial advisor on how they can allocate their funds better, or by taking a few classes in personal finance. Even if you're working full-time, you might be able to fit in an online finance course. Learning how to budget correctly, and properly manage finances, can help people avoid sinking too deep into debt, or help them avoid falling into debt again.
About the Author:
Jamar Ramos has been writing poetry and fiction for many years, and earned his bachelor’s degree in Creative Writing from San Francisco State University. For the last three years, Mr. Ramos switched to producing blog posts for CBSSports.com and writing professionally as an independent contributor for a number of Internet sites. His creative works have been featured in The Bohemian and The San Matean. He now contributes articles for OnlineDegrees.com, OnlineColleges.com, and AlliedHealthWorld.com.