Get Out of Jail Free Cards for Consumers?

Transcription

1 Debt Consolidation Loans: Get Out of Jail Free Cards for Consumers? Lisa E. Bolton, Ph.D., The Pennsylvania State University Paul N. Bloom, Ph.D., Duke University Joel B. Cohen, Ph.D., University of Florida The full report entitled Helping Consumers Respond Responsibly to the Advertising and Availability of Debt Consolidation Loans is available at National Endowment for Financial Education. All rights reserved.

2 Consumer Debt in the United States Carrying debt is a familiar but often unwanted burden for most Americans. At the end of 2012, consumer debt totaled $11.34 trillion 1 and the per capita share of the total consumer debt balance was approximately $36,000. Certainly many families are able to meet their financial obligations and repay their credit cards, mortgages, student loans, and other debts in a timely manner. Many, however, are not. The magnitude of overdue debt continues to hover near its peak. About 8.6 percent of consumer debt $978 billion was in some stage of delinquency (overdue 30 days or more). 2 Although total household delinquency rates are trending slightly downward from the recent high of 11.9 percent in 2009, they still are far higher than the 4.0 percent rate enjoyed in American households are stressed by large debt loads: 14.7 percent of U.S. families had debt exceeding 40 percent of their income. Among America s poorest families it is even worse: one in four had debt exceeding 40 percent of their income. 3 1 Federal Reserve Bank of New York, Quarterly Report on Household Debt and Credit, February 2013, national_economy/householdcredit/districtreport_q42012.pdf 2 Federal Reserve Bank of New York, Quarterly Report on Household Debt and Credit, February 2013, national_economy/householdcredit/districtreport_q42012.pdf 3 Board of Governors of the Federal Reserve System, 2007 Survey of Consumer Finances, February 2009, oss2/2007/scf2007home.html. Cited in the U.S. Census Bureau s Statistical Abstract of the United States: 2012, p. 735, compendia/statab/2012/tables/12s1174.pdf. These are the most recent statistics available as of this writing. 2

3 What are debt consolidation loans? The Bottom Line: Debt consolidation increases the time you take to pay off your debt, and that dramatically increases your interest! Debt Consolitation Loans (DCLs) are marketed as a financial remedy for consumers faced with mounting debt that they cannot pay each month. With a DCL, a consumer s multiple debts are combined into a single loan. Typically, these loans have a longer loan term, resulting in a lower monthly payment for the consumer. Sometimes these loans also have a lower interest rate. What many borrowers do not realize is that the stretching out of the loan term leaves them with a greater overall debt burden, which must be endured for a longer time. Who Uses DCLs Financial pressures, illness, and overspending contribute to household debt that eventually exceeds the family s ability to make payments. DCLs often are viewed as an easy solution to an immediate crisis or as a way to combat overwhelming feelings of financial stress or hopelessness, particularly in low-income households with few other options. When consumers use them as get out of jail free cards, however, such products can contribute to an undesirable debt/repayment pattern that undermines household financial stability. The way these products typically are marketed also can lead uninformed consumers into unwise and costly dept repayment decisions. Summary of Research Findings Researchers in the financial capability field studied what effects debt consolidation loans (DCLs) and the marketing of such loans had on borrowers. A multi-phase study funded by the National Endowment for Financial Education (NEFE )found: The DCL boomerang : borrowers who have used DCLs are more likely to view them as get out of jail free cards and subsequently incur more debt. DCL marketing messages appear to have widespread effects: consumers who know DCLs are available are more likely to consider higher credit card limits and holding multiple credit cards acceptable rules of thumb. An intervention that is both loan- and lender-focused is more successful than either one alone to improve consumer knowledge and intentions. The dual-focused intervention reduces the likelihood of consumers favoring or trying DCLs. Lisa E. Bolton, Ph.D., The Pennsylvania State University; Paul N. Bloom, Ph.D., Duke University; and Joel B. Cohen, Ph.D., University of Florida, conducted the study, which began in 2008 and was completed in

4 Effects of DCL Marketing The way DCLs are marketed (particularly to low-income households with few other options), can lead uniformed consumers into unwise and costly debt repayment decisions. Whether they have turned to DCLs out of desperation or deliberation, borrowers are attracted to benefits such as: Short-term relief of their cash flow situation Lower monthly payments Convenience of one payment instead of several payments No need to keep track of minimum payment amounts for multiple credit cards Reduction in calls and hounding from creditors The researchers initial qualitative analysis found few advertisements that mentioned higher interest or longer term loans; instead, the majority emphasized lower monthly payments and made hassle-free claims. However, DCLs are not a good choice for most borrowers because of potential pitfalls such as: Encouragement to pull cash out of the transaction, further increasing the overall debt obligation and total interest paid Inclusion of hidden fees and penalties not detailed in the advertisements Converting the debt from unsecured (such as credit card and student loans) to secured, using the home or other assets as collateral Higher interest rates due to borrowers inability to qualify for advertised low rates Damage to borrowers credit rating Subsequent interest rate increases on borrowers credit cards Loans that turn out to be difficult-to-terminate scams or bad deals if not shopped for carefully 2

5 Rules of Thumb by Consumers Exposed to DCL Ads #1 Having more than one credit card is okay When DCLs are available When DCLs are not available 65% say NO 73% say NO #2 Maximum card limits over $1,000 are okay When DCLs are available When DCLs are not available 26% say NO 39% say NO Results: When DCLs are available, more consumers think it is okay to have multiple credit cards and card limits over $1,000. The DCL Boomerang The experimental results suggested that the promotion and availability of DCLs causes consumers to be more likely to treat these loans as potential get out of jail free cards that would allow them to continue their heavy borrowing. They viewed debt consolidation as a future easier way out of their credit dilemma and/or as a way to further increase their borrowing. The net effect is a form of moral hazard or risk compensation: Why avoid risk if a remedy exists to take care of the problem? The DCL messages also appear to have widespread effects on consumer beliefs and intentions. As their current problem credit card status increased 4, consumers exposed to DCL messages were more likely to judge various risks as less severe and were less likely to engage in financial behaviors that reduce risk. The availability of DCLs also increases the number of credit cards and the dollar limit on credit cards that consumers believe are a good rule of thumb, irrespective of education and income. Believing that debt consolidation loans are easy to get and conveniently available can actually lead consumers to avoid taking actions needed to reduce debt, such as cutting back on credit card use and setting up a workable budget. Joel Cohen, researcher 4 As measured by self-report of risky credit card behaviors such as delinquency on current accounts 3

6 Counteracting the Effects of DCL Advertising Next the researchers focused on developing an informationbased intervention to help consumers better understand DCLs, particularly their risks and drawbacks. Results of the preceding experiments provided some evidence that warning messages mitigate the boomerang effect of DCL marketing. The research team also pointed to the importance of creating combined loan literacy and lender literacy (not one without the other), for increasing the intentions of consumers to manage their money wisely. Many people mistakenly believe that lenders are obligated to give consumers the best interest rate for which they qualify, and that lenders approve only loans that the consumer can afford to repay. Lender literacy educates consumers that lenders are sellers who act in the best interest of the organization they represent, and lenders often approve more debt than the consumer can handle Consumers Need Two Types of Literacy Loan literacy: how and why loans work, their advantages and disadvantages (e.g., the relationship between APR, loan lengths, monthly payments, and total interest paid). Provides information helpful for evaluating specific loans. Lender literacy: how and why particular lenders act as they do. Provides information to help increase scrutiny of lenders and their claims. 4

7 Testing Solutions: The Video Intervention The researchers tested a nine-minute video presentation they created that covered both loan and lender literacy, and found positive effects on consumers intentions and risk perceptions. For comparison, they provided basic financial numeracy education to a separate set of consumers and designated a third set as a control group that received no intervention. 5

8 5 years: total interest $5, years: total interest $19,000 Consumers Have More Positive Intentions After Seeing the Video Consumers exposed to the loan-and-lender-focused video showed better intentions of engaging in positive money management, including being more likely to save, avoid debt, and budget finances carefully. They also reported having a better understanding of the importance of the total amount of interest paid when making loan decisions. Self-Reported Intentions to Engage in Positive Behaviors Ranked from 1 (least likely) to 7 (most likely) Consumers Show Less Favor for DCLs After Seeing the Video Consumers exposed to the loanand-lender-focused video also showed a reduced likelihood of favoring or trying DCLs. Self-Reported Likelihood to Favor or Try DCLs Ranked from 1 (negative) to 7 (positive) 6

9 Implications for Consumers and Financial Education Practitioners 4 Tips for Understanding Debt Consolidation Loans 1. Weigh the downsides. Longer loan terms may decrease your monthly payments, but they increase the total amount of interest you will pay over the life of the loan. In addition, you might incur hidden fees and penalties. 2. Know the seller. Lenders are not obligated to give you the best rate for which you qualify, so shop around and look carefully at the terms. Also, just because he or she is willing to sell you a loan doesn t mean you can afford it. 3. Avoid the slippery slope. Don t fall into the trap of increasing the amount of a debt consolidation loan to finance additional purchases. You will unnecessarily increase your monthly payment and boost your overall debt. 4. Establish a plan. The best way to get out of debt is to create a financial plan and stick with it, and to live within your means. Consumers in serious financial difficulty who are considering DCLs may be vulnerable to current promotional practices, especially if they are not very financially knowledgeable. Before making any decision about DCLs, consumers and the counselors and practitioners who may be helping them should first explore other options to relieve financial stress. 4-Step Action Plan 1 Re-examine your current situation. Is there a way you can make your existing debt payments with your current income and expenses? When you know the specific details of your finances you can make decisions based on all the information available to you, rather than reacting to overwhelming feelings of stress or hopelessness. List your monthly income, expenses, and debt. Use paycheck stubs, bills, and statements for accuracy. Keep a diary to track your spending. List 12 months of your income, expenses, and debt. Include sporadic items such as income tax refunds, anticipated holiday expenses, semiannual auto insurance payments, and unexpected costs such as car repairs or medical emergencies. Do you have enough income to cover your expenses and debt payments? Can you increase income, reduce spending, or temporarily defer expenses in order to afford your current debt payments? How much is the difference between what you have and what you need for the year? 7

10 4-Step Action Plan continued 2 Examine lower-risk, more affordable borrowing options first. Traditional bank and credit union loans Home equity loans Loans from family or friends Retirement plan loans Compare loan terms (interest rate, monthly payment, length of loan, collateral requirements) to evaluate which option is best for your particular situation. Use an online loan repayment calculator to test financial scenarios for each potential loan to help make the decision. Consider other consequences related to these options, such as putting your house in jeopardy for a home equity loan, or harming personal relationships by borrowing from family and friends. 3 Research debt consolidation loans and compare them to your other borrowing options. Financially stressed consumers with no other options may find that DCLs are the only way to relieve the immediate crisis. In this situation, consumers can arm themselves with basic facts about debt consolidation loans and lenders in order to fully understand the consequences of choosing this type of loan and a specific lender that is best for them. Watch the Facts About Debt Consolidation Loans video for a straightforward, understandable explanation of loans and lenders. Review 4 Tips for Understanding Debt Consolidation Loans. (previous page) Review 5 Questions to Ask a Debt Consolidation Loan Lender. (above) Collect information on at least three debt consolidation loan offerings available to you. Compare the DCL loan terms to your other borrowing options to determine the best solution for you. Seek advice from a trustworthy professional, advisor, or other source as needed. Paying a small fee for professional advice may prevent you from making a costly mistake with a DCL. 5 Questions to Ask a Debt Consolidation Loan Lender 1. Is there a fee to apply for this loan? 2. What is the interest rate, term, monthly payment, and total amount of interest paid? 3. What collateral is required for this loan? What fees or paperwork is required for the collateral? 4. Is there a pre-payment penalty? 5. How does your firm make money on this loan? View Facts About Debt Conslidation Loans video or download it here: 8

11 Financial educators, particularly those working with adults in community settings (credit counselors, schools, churches, libraries, etc.), can use the successful video intervention and research findings to help their learners understand and navigate their loan options. Include DCLs as a module in your program or guide your counseling clients through the materials on an individual basis. NEFE provides a free workshop and resources on this topic for your use: 4-Step Action Plan continued 4 Plan for financial recovery. Once the immediate crisis has been addressed, consumers can begin to make a plan to restore balance in their household finances. The best recovery from and the best prevention for DCLs is to make a budget or spending plan, use it consistently, and update it as your financial circumstances change. Additional Resources: A good start to learning about DCLs is watching the intervention video developed by this study s researchers at NEFE s Smart About Money website provides a series of articles on credit, debt, DCLs, and other repayment options, as well as numerous other resources to help individuals and families manage their household finances. Resources address financial goal setting, setting up a spending plan, getting out of debt, and using a checking account and credit card at 9

12 National Endowment for Financial Education. All rights reserved.