Unintended Side Effects of Tighter Credit

by | Aug 17, 2009 | Cash Flow, Weekly Column

paper shredderHow many new credit card applications have you received in the mail lately? If you do get one, shredding it is an even better idea than usual. Chances are if you send an application in, it may not be approved anyway.

The economic crisis has already reduced the number of new credit cards. According to data from the Equifax credit bureau as cited in a USA Today article published online on July 7, there was a 38% drop in the number of new credit cards issued in the first four months of this year as compared to the same period last year.

In addition, Congress has recently passed legislation to impose new restrictions on credit cards. These regulations, which will take effect in early 2010, are intended to protect consumers from practices such as arbitrary interest-rate increases and hidden fees.

Unfortunately, the new laws don’t cap interest rates, so an unintended side effect may be an increase in both interest rates and fees. Another result—which is somewhat ironic, since part of the government’s economic stimulus plan is to encourage lending and increase the amount of liquidity in the economy—is that credit cards may become harder to get.

We’re seeing warnings from both the media and credit card companies that warning signaverage Americans will find it harder to obtain credit cards. What these warnings don’t say is this may be the silver lining in the cloud.

If there is one thing Americans need more of, it isn’t more access to credit, it’s less. Returning consumers to more cash-based purchases just might reduce their spending by 18%. This is based on research showing that cash buyers spend an average of 18% less than those who use credit.

While this isn’t good news for the economy over the short run, it is necessary to restore us to financial sobriety in the long term. Americans have been on an overspending/credit binge for a couple of decades. We’ve developed a destructive addiction to easy credit. An abrupt reining in of that credit just may serve as an intervention that will bring us to our senses. Like an intervention for any addiction, it is likely to be painful for a time even though it will ultimately help our lives become better.

We’re already seeing evidence that our savings rate has jumped significantly. In August of 2001 the personal savings rate was a negative 2.7%. By August of 2008 it rose to a whopping 0.8%, and as of May 2009 it was 6.9%. Most of this new savings is being used for debt reduction, building savings, 529 plans, and retirement plans.

While this rate of saving is the highest since December of 1993, between 1959 and 1993 the personal savings rate rarely fell under 7.0%. During those years, Americans averaged saving 8% to 11% of their income. Obviously, a good economy and a good personal savings rate can co-exist.

tighter creditThe big question is whether this new frugality is a temporary reaction to hard times or whether it will last. Once our economy recovers from the current recession, it may be tempting for some of us to go back to the pattern of unrealistic optimism and overspending that helped get us into trouble in the first place. We may be less likely to slip back into that old behavior if credit cards will be harder to get and more expensive to use.

As a friend of mine says, financial planning can be summed up in one simple rule: save more, spend less, and don’t do anything stupid. Tighter credit may help more of us follow that rule.

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