March 15, 2011
Diana Burkart-Waco, 26, applied for her first-ever credit card last month, but she rarely uses it, paying off each purchase immediately. She has a stable job in academic research and invests some of her savings in index funds, stocks and green technology. She dreams of buying her first home, and has saved up more than enough for the standard FHA first-time homebuyer loan of a 3.5 percent down payment on a $200,000 property (the price limit to be eligible is $580,000 in the California county where she’s looking). But she’s not going to. Instead, she’s working to save 25 percent and plans to wait until she’s confident she can make monthly payments well above the minimum required by a mortgage. Burkart-Waco is part of a growing crowd of debt phobics, scared to take the plunge into the land of red ink.
After seeing so many indebted Americans get pummeled by the recession — not to mention the $14 trillion mess the federal government finds itself in — a newfound fear of borrowing has crept into the minds of Americans, especially for those who came of age during the crisis and are new to the job market. Young people are graduating with the highest levels of student debt in history — $24,000 on average. The last thing they want to do is take on even more debt, especially for something as large as a mortgage, causing their finances to resemble a homespun Pay-Go plan; a lesson obviously not learned from Uncle Sam. But young people are not the only debt phobics. On Thursday, the Federal Reserve reported that total U.S. household debt, which includes mortgages and credit cards, fell to its lowest level since 2004.
“Many young people equate debt with bad consequences. They saw their parents suffer and the whole economy suffer because of too much debt,” says Kimberly Palmer, author of Generation Earn: The Young Professional’s Guide to Spending, Investing, and Giving Back.
After an era of glutinous spending and borrowing, a move to frugality is a welcome shift for some. Spending sprees may be good for the economy in the short term, but saving can build wealth and stability for long-term economic health. Yet debt phobia can have troubling consequences on the next generation of investors. “Young people have become more conservative with their money, to the extent that they’re afraid to take on debt even when it’s good for them financially, and that applies to mortgages. Housing, student loans and starting up a small business can all be good forms of debt,” says Palmer.
Crippled by Fear
Although a shift towards saving over spending can be positive for American pocketbooks, and foster steady economic growth instead of volatile booms and busts, an exaggerated fear of debt can deter young people from important investments in their future.
“Not taking on debt is sinking the futures of many young adults,” write authors Richard Settersten and Barbara E. Ray of Not Quite Adults: Why 20-Somethings Are Choosing a Slower Path to Adulthood, and Why It’s Good for Everyone, who conducted 500 interviews with 20-somethings. “Fearful of the burden of college loans, they are underinvesting in themselves at this critical time, letting their immediate worries compromise their long-term security.” The late Nobel laureate Milton Friedman advised people to borrow the most early in life, save a lot during their midlife years when their earnings are highest, and spend their savings after retirement.
Not buying real estate, especially at a time when prices are low, could cause them to miss out on an investment opportunity, and stunt the housing market recovery. Saving up too much for a down payment can actually hurt you financially. Due to inflation, the money would be better off invested in something that accrues value. “It’s good to save, but putting it under the mattress is not a good idea because you’re just losing money to inflation,” says Louis Hyman, author of Debtor Nation: The History of America in Red Ink. “It might feel safe, but you’re actually destroying your own value.”
Palmer says that it’s important to find a balance between good debt and bad debt. “There’s a huge upside to this. Hopefully 20-somethings will not overspend, live within their means more, and not buy a bigger house than they can afford. It’s just all about finding that balance.”
The Long Tail of the Housing Crisis
The number of first-time home buyers has been falling since the housing tax credit ended. Housing newbies made up 35 percent of the market in January, down from 48 percent in March 2010. The size of the average down payment for first-time homebuyers has also increased slightly to 4 percent, from 2 percent in 2006 — a promising sign since in 2006 a whopping 43 percent of first-time homebuyers put no money down.
For the first time on record, more debit cards are being swiped than credit cards. Credit card use fell for nearly all of 2009 and 2010, ticking up only slightly during the holiday shopping season at the end of 2010, but falling again in January of 2011, according to the Federal Reserve, which monitors consumer credit. A report by Javelin Strategy and Research found that the drop in credit card use is most pronounced among 18- to 24-year-olds. Layaways, which originated during the Great Depression and let the consumer pay in increments, are also coming back, with Kmart and Toys “R” Us, pushing their new layaway programs.
“Even more so than with mortgages and student loans, people treat credit card debt now like it’s the plague, they just want to get away from it. They have really embraced that you should pay off your credit card debt, and from a personal finance perspective that’s definitely a good idea,” says Palmer.
Back to Frugality
This anti-debt mindset might seem familiar to the generation that lived through the Great Depression, with images of people stashing money under the mattress or burying it in the backyard. It was a time when adages like “a penny saved is a penny earned” entered American vernacular, and consumers took heartfelt pride in saving.
According to the authors Settersten and Ray, this happened in the 1930s because “the fear [of debt] is, in part, a hangover from our puritanical upbringing. To be in debt in America was a curse worse than death. Debt was a sign of weakness, a stain on one’s character. Like a fat man giving in to the éclair, a man in debt lacked the willpower to control his baser urges,” they write. “Defective, delinquent and dependent were words of scorn in 18th and 19th century America, and debtors were all three. Thrift, on the other hand, was a virtue.”
But as the boom times raged, so did the deficits of American families. Debt crept up as department stores began offering credit cards in the 1940s, and companies realized they could make a huge profit off the interest of consumer debt. Long-term mortgages became more common, as families moved to the suburbs and claimed their stake in the housing boom. But the jobs were plentiful and stable and few families defaulted on their loans — though the age of saving was over. In 2005, the savings rate fell into negative territory at minus 0.5 percent, something that hadn’t happened since the Great Depression.
But as so many Americans found out during the recession, debt can cause financial ruin when things don’t go according to plan. Millions of homeowners have defaulted on their mortgage loans since the recession began, with 3.4 million of them losing their homes to foreclosure. In 2007, the average American had four credit cards, with 14 percent holding more than 10 cards, causing many Americans, particularly students and young people, to rack up bills with a mountain of finance charges — debts impossible to pay off unless someone wins the lottery. The idea of a never-ending stream of virtual money on a piece of plastic entered the American mindset, and caused people to spend freely and recklessly at times. One recent study by Visa found that people who pay with a credit card spend 30 percent more than people who pay with cash.
When 33-year-old and now-debt phobic Travis Robertson of Franklin, Tenn., was 23, he and his wife took out a loan of $270,000 to purchase a house, upgraded to a $550,000 house two and a half years later, then sold it right before the market tanked at a loss of $5,000. He says he lived a life of grandeur during these years, but they were also filled with stress and anxiety, and he doesn’t feel like his family is any better off now. “If I could do it all again, I would have saved up to buy a house in cash. I think anything you want to do can be done without debt, it’s just harder and takes more time and discipline. We just had a bunch of payments, and we never really owned anything. We were just renting a lifestyle. Had we done things differently, in all honestly, we’d probably be millionaires by now.”