Lessons of ’08: Pay down debt, don’t panic

For all its complexity, the financial crisis was triggered by one thing: an overabundance of easy money.

For companies, that meant a borrowing binge that is coming home to roost in ugly ways, especially in the financial industry. For individuals, that means most of us have carried far too much debt and probably still have too much of it.

The decline in the housing market has compounded the debt problems. Many folks not only have credit card bills stacked on their dining room table, they also have mortgages higher than the current value of their homes.

This phenomenon of “being underwater” has had a serious impact on consumer confidence. And that has led to changes in consumer behavior.

Credit is no longer cool, and thrift is back in.

Thrift, of course, is a good notion — and one that is certainly overdue. Americans have for some time spent more than they have made, leading to the first so-called negative savings rates since the 1930s.

This overspending, driven largely by borrowed money, occurred in the corporate and financial sectors as well. As individuals rediscover thrift, companies are going through their own process of “deleveraging,” or reducing their credit-bingeing ways.

All this reining in of spending and borrowing has an impact on the broader economic picture, especially as it relates to consumers. Consumer spending makes up 70% of the nation's economic activity, ac-cording to government figures.

In some ways, thrift is paradoxical. If everyone is too thrifty, the economy can grind itself into a nasty slowdown.

Obviously, a nation that borrows and spends like drunken sailors isn't exactly healthy either. The recipe for a robust economy is a mixture of old-fashioned thrift and prudent consumption, with a sprinkling of splurging here and there.

After all, even thrifty people want to get their nails done once in a while.

The rise of thrift is stemming from a sense that people are less rich than before, even if there has been no real change in their employment status, homes or income. Certainly, there has been a reduction in investment portfolios and retirement plans, and this would explain why a person's financial psychology changes even when day-to-day circumstances don't change.

A reduction of spending, of course, is sometimes driven by more than just mind games. A tougher credit environment has contributed to a dramatic drop in car purchases.

Soaring gasoline prices led Americans to drive less for the first time in decades, though gasoline prices dropped dramatically in the last half of 2008, giving the consumer at least one break.

In midyear 2008, some commentators argued that the psychology attached to falling home values and investment portfolios wouldn't have a big impact. Stronger-than-expected second-quarter growth and retail sales seemed to buttress that case.

But as I write this in December 2008, consumer spending has declined markedly during the past several months, and prospects for the Christmas shopping season are bleak. But interestingly, shoppers flooded stores after Thanksgiving, and aggressive discounting has had more people purchasing presents than dour economists initially forecasted.

Still, the financial crisis is widely called the worst since the Great Depression. As the psychology of difficult times sinks in deeper, more people will find small ways to save a buck here or there.

Lenders will remain stingy and may become even more so. All of this can dangerously feed on itself if fears rise.

But when others are panicking, the calm thrive. Those who have prudently prepared for a rainy day are in a position today to acquire deeply discounted homes and cheap stocks.

Let's take a run through all types of debt and discuss strategies for paring back. Reducing debt should be everyone's No. 1 personal-finance goal.

CREDIT CARDS

Credit cards are the most pernicious of debt vehicles. At first, they seem like a wonder, but too many people find themselves lugging big balances and paying large interest payments for years after they innocently sign up for a card with its promises of a 0% interest rate, air miles and bonuses galore.

Sometimes the mismanagement of credit card debt can drive people into personal bankruptcy. Even short of that, maintaining large balances and paying high interest rates eats into more important uses for your money, namely saving and planning for retirement.

But there are some basic strategies to employ to start reducing credit card debt. For starters, pretend that gasoline is still $4 a gallon and use the savings at the pump to pay down debts.

Second, compare credit card interest charges with the interest rates received on a savings or checking account. The odds are that credit card interest rates are far higher.

If so, aggressively pay down credit card debt. If a financial emergency arises, you can always re-up the credit card debt. Meantime, you will have saved money on the interest rate differential between your bank account and your credit card debt.

Also, many credit cards offer a free transfer and lower introductory rates after you transfer your debt. The credit card companies are banking on your maintaining a high level of debt and not bolting when the introductory rate rises.

Although you are paying down your credit cards, you can use the free-transfer strategy to take advantage of various lower-rate offers.

It is important, however, to be diligent about your monthly payments; otherwise, this strategy will backfire.

Another strategy is to borrow money at a cheaper rate to pay off your expensive credit card debt. This has gotten tougher in the credit crunch since lenders have become far stingier.

Also, with home prices falling, the ability to take money out of your home at a lower rate to pay high-rate credit card debt is more doubtful. Still, not all lending has ended, so it is worth exploring this possibility with your local bank.

Another strategy is credit card debt consolidation. Many people have several credit cards, and there is a temptation to consolidate these cards into a single payment.

Many credit card debt consolidators have become expert at appearing soothing and helpful in their pitch to consumers.

Their main pitch: that the monthly payments in a credit card debt consolidation are smaller than the total monthly payments on your cards. But you pay a steep price in two ways: The interest rate doesn't change much, if at all, and the consolidation simply extends your payments so that you end up paying far more in interest than you would have without consolidating.

Sometimes this is the only option for people in tough straits. This technique should be viewed as a last resort, but if it is your only option, it is a step in the right direction.

MORTGAGES AND OTHER DEBT

Most homeowners financed their purchases with a mortgage. For a long time, mortgages had few exotic features.

Purchasers had to “put down” 20% of the home's sale price, and then the bank would finance the remainder of the purchase with a long-term mortgage, the standard length being 30 years. The structure of the traditional mortgage has several benefits.

By putting 20% down, the owner acquires an immediate equity stake in the home. If the value of the home declines, odds are that the down payment will mean you still have some equity in the home.

The 30-year term helps stretch payments out, allowing investors to more easily become homeowners. These positive notions became radically twisted during the housing bubble.

Although many people took the traditional route, a great many did not. People with lousy credit — or no credit — took out subprime mortgages.

Banks offered mortgages with no down payment, payments [that could be skipped] and interest-only payments. Many of these mortgages went bad when people couldn't afford them.

On top of these mortgages, a lot of people also took out home-equity loans or home-equity lines of credit. When home values were high or rising, these worked beautifully.

As home values dropped, these versions of debt became anchors.

All around the country, foreclosure rates have skyrocketed. A lot of homeowners, owing more on their homes than they are worth, have simply walked away from their mortgages.

Others are scrambling to hold on to their homes in tough circumstances. Traditionally, home values weaken when the unemployment picture worsens.

This time, home values declined ahead of rising unemployment. With job losses mounting, the home market could face more tough times ahead.

Homeowners, however, should not get too worried about the value of their homes. Perspective, not panic, is always the first step in assessing the situation.

Despite the scary headlines, the vast majority of homeowners are still sitting on decent gains, even if the value of their homes has declined over the past couple of years.

It is important to understand that home values rocketed in the early part of the century in a flukish way. Those kinds of gains won't be seen again anytime soon.

Home prices, after the shakeout ends, are most likely to resume their steady, nearly humdrum appreciation of value.

Also, interest rates remain low and you may be eligible for a refinancing, which is something a shrewd homeowner should always consider. If you are carrying expensive debt, such as credit card debt, refinancing will enable you to substitute cheaper debt for more expensive debt.

In such a strategy, you refinance your home and take “cash” out of the house in the form of a new, slightly larger mortgage.

The mortgage associated with this cash almost always carries a lower interest rate than credit card and other high-interest-rate debt, making such a debt “swap” rewarding for individuals. The perfect cash-out refinance takes advantage of lower mortgage rates, uses cash to pay down credit card debt and doesn't result in higher monthly payments, because of the lower mortgage rates.

But never take a large risk with your home. Approach any home-related debt with prudence.

In times such as these, simply holding on to your house and riding out the downturn is important. It is a buyer's market, and homes take some time to sell.

If you are forced to sell quickly, you may get a really lousy price — and if you haven't had your home very long, there is a good chance that you will sell at a loss.

If you are struggling with the mortgage and refinancing isn't an option, talk to your bank. Although bankers are in a stingy mood, many will talk with you about reworking your mortgage if you are under particular stress.

There are many negotiating options, such as paying only interest for a period of time or making partial payments.

After all, most banks would prefer to work something out, if possible, and keep you in your home rather than foreclose. They have plenty of empty homes on their books already.

In addition, get creative about extracting more cash from your home. An obvious way is to rent out the basement or a room.

Defer putting in that new kitchen and instead put that money into your investments to build a larger cash cushion to weather the hard times.

Ultimately, if you need to sell, it is important to know that the housing downturn cuts both ways. You may not get the price you once could have, but buying a new place will be cheaper than in the past.

AUTO DEBT

It is smartest to acquire a car with cash or with as little debt as possible. As we have learned in the past two years, the mounting piles of debt consumers have accrued can lead to terrible problems.

Many people borrowed too much to buy more home than they needed. They often did similar things when acquiring cars.

If you have a heavy car debt, there are some basic strategies to reduce your debt. The simplest is to sell your car, pay down the debt and get something cheaper.

As you will see if you do the research, a used car is most times a better value than a brand-new car. Most brand-new cars lose a chunk of value the moment you drive them off the lot.

The new-car smell really isn't worth all that. So-called certified pre-owned cars are usually the best option.

These cars have been inspected and come with a manufacturer's warranty that a used-car lot doesn't usually offer.

At a minimum, your car costs shouldn't be more than 20% of your disposable income. This figure should include your loan payment, insurance, fuel and other vehicle-related expenses.

If you are paying more than that, you should take action to reduce your car debt burden.

STUDENT DEBT

Many younger folks coming out of college or graduate school face a large student loan burden. Higher education is widely considered a good investment, as it equips people to perform better in our fast-moving, constantly changing economy.

Still, it is one more form of debt that needs to be dealt with.

Since folks usually face student loan debt while young, cash flow is often a more important consideration than paying down the debt outright. Also, student loan debt generally has a more favorable interest rate than other debt, making it less burdensome.

For instance, it isn't a shrewd move to pay off student loan debt with a high-interest-rate credit card.

Still, as with all debt, it is smart to pay it off as quickly as you reasonably can. One strategy for dealing with student loan debt is consolidating it. Most students emerge from college with several loans, each with its own payment. Student loans come in two flavors: private loans from banks and government-backed student loans.

Consolidation usually requires you to keep these loans separate to retain your lower-interest rates. Also, you can usually consolidate your loans only once.

Dave Kansas is editor at large of FiLife.com, a personal finance website.

The “Wall Street Journal Guide to the End of Wall Street as We Know It” by Dave Kansas (HarperCollins Publishers, 2009) and courtesy of The Wall Street Journal.

For archived columns, go to investmentnews.com/advisersbookshelf.

Related Topics: Adviser's Bookshelf, Mortgages