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Monday, December 29, 2008

Using Credit Plays Games with Your Mind

The more I read, learn, and even work with people on budgets who have fallen victim to credit cards and other consumer debt, the more I loathe credit. I made a comment in the last post that credit doesn't slow consumption, it fuels it. And I believe such more and more every day.

Since it is at least tangentially related to my last post, I thought I would point out a back and forth I had with Ezzie on the the use of credit personal credit to make money (note: I am not addressing using credit for legitimate business purposes, which is a different discussion than this one) .

Ezzie advocates the idea of using student loans to build assets in his post Guaranteed Gains. I'm not familiar with all of the ins and outs of student loans, but I know people who do something similar with credit cards, i.e. taking a large cash advance, putting the money is a savings or CD account, and planning to pay back the money before interest on the card kicks in.

Those who recommend these ideas, of course, only recommend them to the "responsible." But something I have learned in life is that few view themselves as irresponsible. And herein lies the problem.

Below is my [slightly edited] response to Ezzie:

I really dislike the idea of building both sides of the balance sheet. It convinces the borrower that they are making money, when they are really setting themselves up for a potentially sticky situation.

Many people I know who are debtors have themselves convinced that they are quite responsible. I would bet the more responsible go by the advice of chazal to never trust oneself until their dying day. While I believe chazal was looking at the issues of the yetzer in terms of keeping hilchot yichud, I think the advice could be extended to taking on debt, experimenting with gambling, etc.

I'm not going to fly into a tirade about credit cards. I do use a credit card, although I pay it off each month in full and I enjoy my cash back. However, like I said in the other comments, if you are going to use a credit card, I would wait until you have some established spending patterns, a budget, and an emergency fund. Too many people think of their credit card as an emergency fund.

Back to the student loan scenario (and you are not the first to promote the idea, nor the last. In fact, not too long ago my husband and I were asked out opinion of a similar "money making" scenario involving a credit card cash advance a 0% APR for 1 year).

I can see the following scenario happening:

An 18 year old hears of this idea and wants to make some cash. In his mind the potential thousand or few thousand is big money. And he thinks he will have no problem putting the money away, being paid interest, and then turning around and returning the principal. And interest free loan sounds great to him.

But let's imagine for a moment:

Sometime towards the end of college, he is introduced to a girl and they are headed to an engagement. He wants to impress her and takes her out for nice dinners, buys her jewelry for the engagement, etc. He feels like he has some cash to spare. After all, it is his senior year and he has been building up his assets. Our chatan even has taken on some work and has made a good amount of pocket money. He believes his investment income is tax free, but knows little about the tax system. As a dependent, he is surprised that his passive income pushed him over the line and now he owes taxes on money he thought was 'gravy.' Setback number one. But he pays up the taxes (state and city too. . .who knew that the state and city can eat money at a lower threshold than the feds?) and is back on track.

Now the wedding comes and, like many other chatanim, he and his kallah decide a one year stint in Israel at Yeshiva would be the best way to spend their shana rishona.

Student loans are deferable, right?

He will have a [small stipend] and she can work as a therapist with special needs kids.

They defer paying back their student loans. And the [loan] money is still in tact and is still growing.

But soon his wife is pregnant. And they need a bunch of stuff. And her job isn't working out quite as planned. His stipend doesn't seem to be stretching as far as they thought it would stretch. So they dip into their "savings."

After a year, they return to America. The student loans are still outstanding, and what is left in "savings" isn't enough to pay off the loans, plus put down a security deposit, 1st months rent, put down a deposit for the daycare, etc.

What seems like a good idea, might not seem like such a a great idea in hindsight. Oh. . . and the young couple returns to a down economy. Finding a job isn't so easy and there is a sizable gap, but the loans can't be deferred any longer, and the loan debt is now growing. It seemed like it would never accrue interest. That wasn't part of the plan. The money was going to be there to pay them off.

I never though I'd have something positive to say about credit card debt. . . . but here it goes: when debt is building on a credit card, it has its own line item and as the interest charges rack up, it can create an urgent situation [for some people].

Student loans, on the other hand, can be deferred and lack a sense of urgency [everyone has student loan debt, right?]. And, yes, I've seen couples defer them after they marry to spend a year in Israel. The part about ends not meeting in Israel is also something I've seen.

[Just something to think about before trying to beat the system].

Comments welcome, as always. If you have a true story to tell. Please do. The story I imagined above, I should add, isn't completely made up.

33 comments:

lrg said...

Just from a financial point of view this is a bad idea. Unlike credit card debt, student loan debt is almost never discharged in bankruptcy. A majority of bankruptcies are caused by job loss or a medical crisis; i.e. not within your control. This is an extremely dangerous "strategy".

mlevin said...

Look our bank gave us a CC with 0% for one year. DH and I decided to accumulate this money and not payoff until the end of the year. We never considered that money as ours, and when we looked at our balance we automatically subtracted amount owned to CC. The year is out and we are fine. I think it is a responsibility.

One should not get engaged if he can't afford a wife and children, Otherwise he will get into a sticky situation of being in debt. Man should think of himself as a provider and not depend on wive's income, because women get pregnant and have babies and many times there are short term complications where she cannot work.

I heard a story where a newly married couple had triplets. She couldn't go to work, and he was a sole provider. Another story of childbirth complications where a wife had to be in bed for almost three months after the childbirth. Then it took time before she recovered enough to leave their house for prolonged period of time. Another story was where a baby was born with a disability and a mother just couldn't go to work, because she had to go from hospital to hospital with baby problems. In all of these stories, husband ended up a sole provider

tesyaa said...

mlevin, it may be more true that wives have medical complications (due to childbirth) than husbands, but men end up disabled also. You never know what life will throw at you. It's hard to rely on having just one income, especially in today's economy. I was taught that it was best for both spouses to have an income. Yes, there were years I didn't work due to child raising, but I always planned on going back to work, and I was lucky to have qualifications that made it possible to do so. I did not choose to become an actuary because it was such an exciting field, but it helps pay the bills.

mlevin said...

Tesyaa - I am not saying that women shouldn't have a career. They should have skills to earn money because in life one never knows.

My point was that a man should not get engaged until he's sure he can support a wife and children. In the story above, a young man got engaged while still in school, that means he didn't have real income, but he went into debt for that ring anyway. Than they decided to spend their first year in Israel, again no income, and went further into debt. Then they were surprised to have a baby, and went further into debt.

What was that young man thinking off? He was surprised that children are born to married couples? It is not CC's fault, it is immaturity of the man (and wife) involeved. They got themselves into this situation with their eyes open.

tesyaa said...

SL, back to the main post, there's nothing wrong with using the arbitrage if you're comfortable with it and have the time to stay on top of it. I view my credit cards as "convenience cards" (meaning that I don't have to carry a lot of cash), and like you I pay in full every month. I have an almost pathological fear of not paying the credit card bill on time (it happened once in 20 years, when a paper bill got misplaced due to my husband sitting shiva). So I see where you're coming from. I imagine that people like us would have the least to fear, but would probably fear it the most.

ProfK said...

It's not just being responsible SL; it's being knowledgeable. Unless both are there then living on credit and leveraging credit is a risky business. There is also this. Too many people consider the amount of money they may charge on a credit card as already being their money. When considering income available they count in the credit cards. For these people money doesn't just grow on trees; it grows on Visa cards. It all points to a really poor grounding in how finances and budgeting work.

I'm with you and Tesyaa. Credit card balances get paid in full every month, and we only buy what we have the money to pay for. I love the cash back card perks but it's only a perk if you aren't carrying a balance.

anon426 said...

Tesyaa you are coming from the point of view of many years of experience. As are many people on this blog.

I, too, know myself by now well enough to know I should never ever ever use a credit card for anything. And I don't.

I think there are many people out there who get derailed financially by curveballs they didn't expect. My husband and I didn't realize how much day school tuition would set us back. Neither of us went to private schools growing up and hadn't done any research beforehand etc. Moreover, when I was a new working Mom, I was thrown by the amount of work I had to miss because of my kids' schedules, illnesses, etc. And again I was financially unprepared.

As Dave Ramsey says "as you soon as you buy that house, murphy takes up residence in the front bedroom." (paraphrasing here)

So many young families simply aren't aware of the pitfalls -- very common pitfalls -- that might befall them. Or they think it can't happen to them. Young people need to be educated, guided by parents or whomever, about the financial realities that inevitably await them.

He also comments frequently that he never met a wealthy individual who got that way by engaging in any complicated schemes, like one which is the subject of the post.

Dave said...

Your credit rating is also affected by what percentage of your available credit is in use.

collegeloanconsultant said...

One good thing about deferred debt. A student can make plans to make their payments by starting a separate income for just that purpose.

In four years they can have a well-established source of income that is not from the job they get when they leave college.

Holiday special- pay for your student loans now

JS said...

Using credit to try to make money is just another stupid get rich quick scheme practiced by people who think they are smarter than everyone else and can "game" the system. Anyone with a good head on their shoulders and a modicum of responsibility will not engage in such risky behavior.

This is the lazy person's approach to wealth building, thinking they can sit back and relax while everyone else schvitzes to make a living. Normally, I would laugh at such ga'avah, but these same people then turn around and ask for scholarships and other help from the community and our collective resources are drained to these people's stupidity.

Before too long, the "brilliant" scheme catches up and all of a sudden you're not using 0% credit to make money, you're using it to stop losing money on out of control interest payments.

There's no substitute to working hard and living responsibly.

mlevin said...

Making money off of CC is not an easy get rich scheme. It takes lots of tedious and careful work. But if one is organized enough, he could meke a lots of it.

Thinking said...

It's hard to start any business without taking on some sort of debt at all. Most people take out a small business loan or some other type of loan to help them get started. I have heard of others who have either used student loans or 0% cc to help them get their initial seed money. The key difference that has to be taken into account in all of these situations is not necessarily the level of responsibility of the borrower, starting a business can be seen as a responsible step, but the flexibility of the terms if "the unexpected happens". If, for whatever reason, you cannot repay the loan in the terms set out at the outset what is your personal liability and how will this affect your future?
Small business loans are typically designed to provide less personal liability to the borrower, the business is in debt and not the individual. Banks are more likely to negotiate terms in lieu of having the business declare bankruptcy.
Student loans, while initially flexible, do have the ability to garnish future wages and will always be paid off at some point. CC's too provide little flexibility in terms of negotiating when things don't turn out the way you hoped.
The bottom line is, use the credit offered to you for the purpose that it was meant to be used to avoid future consequences. Using the credit for other purposes will not always come back to haunt you, but if it does the consequences will be severe. If you like to take risks, the stock market is also a great place to make money.

Anonymous said...

Your credit rating is also affected by what percentage of your available credit is in use.

This is true, but the credit card companies themselves have made a mockery of this measurement by increasing credit limits way beyond anything reasonable. Now, I don't doubt that they've cut way back on this, but until a few months ago, it was standard operating procedure. One of my cards has an obscene credit limit, and the one time I tried to use it (to buy a car), the dealer would only allow me to put a few thousand on the card.

Mark

Ezzie said...

As said there, I don't really disagree with you on much here. Again, I emphasize that it's only for responsible people.

Just a few notes: There's a large difference between similar attempts with CCs and student loans. Student loans aren't going to jump to 29% on the borrower at any point - I'm pretty sure they won't rise at all, but just keep accruing interest, though I'd have to check that. In hard times (say, unemployment), you can defer a student loan for a year automatically; there are other situations where you can defer as well. (Not sure if the interest continues to accrue; I believe it does not in some cases, others it does.) You can also typically consolidate student loans at very low interest rates, which is much more difficult to do with credit cards.

Another important point is the argument brought up by both SL and some commenters about if "something happens", and now you're left with all this debt. Assuming that the "something happening" is something that requires money, because otherwise it doesn't apply: Why would a person be better off NOT having borrowed this lower interest rate money than having it? Where else will the person get the same money from that the borrowing costs would be less?

Let's say for the sake of argument that the person needs $5,000 for an emergency, and there's no family member to borrow from: How are they going to pay that $5,000? Would they be better off using that banked student loan money and paying that off over time at 5% or the like, or would they be better off sticking it on a credit card or trying to convince a bank to lend them the money at a much higher rate?

(Sorry if that wasn't all clear, feel free to ask me to clarify.)

dj said...

In the UK there is a name for making money out of credit and its called stoozing. There is at least one website devoted just to stoozing.

Unfortunately, for those like myself (I've made £2000+) the opportunities are dwindling as banks catch on and charge large fees for balance transfers and cash advances.

Anyway, it all boils down to responsibility and do you trust yourself. I know for myself that for stoozing I do but maybe not for other things.

aml said...

I think it's foolish not to take out a cushion (talking about student loans, not CC). I've see so many fulltime grad students take just enough to cover their tuition (because they are so afraid of debt) and then when something happens- their car needs repairs, their toilet needs a plumber- they end up putting the purchase on a CC that charges 12 or 15 or 22%. A better solution would be to take the extra loan (Stafford, not private) and put the money in a seperate account for the year (or even for the duration of school, if it's subdazided and the government is paying the interest). Then, when you're done pay back the
loan and close out the account.

SephardiLady said...

Thinking-I am not addressing business loans at all. Different ballgame.

Ezzie-All I can tell you is how many overspenders/debtors I know that believe they are living very frugally and can't understand where all the debt came from because they are careful and responsible.

In your last scenario you leave me with two what if options and of course it is better to pay the emergency with the low interest loan than a high interest credit card. But rarely in life are there only two options.

What I am trying to get out is the need to get our community weaned off credit. It isn't helping anything. It doesn't slow consumption, it fuels it and creates false security.

Enough for now.

anon426 said...

Why would a person be better off NOT having borrowed this lower interest rate money than having it? Where else will the person get the same money from that the borrowing costs would be less?

This is an interesting question that reveals a very common and IMHO misguided mindset. (Except in extreme cases such as saving a life and even then you may not really have to use credit to do it.)

The first step on the Dave Ramsey Program for people trying to get out of debt is to build up a $1,000 emergency fund. (It gets beefed up to the proper size later in the program)

One very crucial reason why it is so low so early in the program is he is trying to train people to realize that there are other options to dealing with emergencies than just "putting it on the credit card." Or borrowing a student loan, or on your house, etc. etc. If you only have $1000 to work with AND you can't (or won't) borrow money it forces you to be creative in ways you wouldn't have normally. Or would normally not feel comfortable doing. Like asking for help or selling something you wouldn't normally want to or working an extra job you don't have time for.

He is always saying personal finance is about behavior as much as about cash flow and if you have an emergency for which you don't have money, you must think outside the box and probably 9 times out of 10 it can be handled without credit.

People are so *quick* to use credit to get themselves out of scrapes especially people who don't make a lot of money to begin with. However, it is my opinion that use of credit opens a pandora's box of problems. And probably most of the time, the credit line is not the LAST option people think of, but the first.

Another little Dave Ramsey tidbit regarding how credit messes with your mind: he frequently quotes a statistic that I have not verified that people who use credit cards spend 18% more than those who don't.

Ezzie said...

SL - All I can tell you is how many overspenders/debtors I know that believe they are living very frugally and can't understand where all the debt came from because they are careful and responsible.

I'd assume those people would have the same difficulties regardless. Again, if they're going to get hit with debt, better the lower rate debt. And of course, this is why economic education is so important.

But rarely in life are there only two options.

I have to disagree with that. For many people, there are often two if not only one or none. The situation you gave was one where they suddenly are faced with expenses they did not expect, so they take the student loan money that was supposed to be paid back. If there are other options, they should explore those first; if there are none, we're back to my pair of choices. Your argument seems to be that they will not bother to explore other options; I'd assume that the same lazy approach would result in CC debt instead of student loan debt in your scenario.

What I am trying to get out is the need to get our community weaned off credit. It isn't helping anything. It doesn't slow consumption, it fuels it and creates false security.

Agreed 100%.

Also agree with AML - We have many friends who regret not taking out more in student loans, taking out just enough to cover, and are now picking up much worse debt.

Anon426 - I agree with SL that using credit is generally bad; you can see the thread over there or any other posts of mine on the subject. I am merely noting that SL's argument of a scenario where people suddenly hit an emergency expense is a poor argument against the suggestion, because we're assuming that the person is taking the rational approach. This means that they would explore any non-credit options before relying on credit - and if none are available, they'd rather be stuck with the lower interest. (In the same vein, if they're not listening to Ramsey and merely taking the lazy way out and using credit immediately, they'd also be better off with the lower rate debt.)

Al said...

Most businesses are NOT started with business loans... they are financed from savings and credit cards... it is nearly impossible to get a business loan that isn't buying an existing business that your assets would theoretically let you buy from liquidating until you have two years operating history.

Now inventory credit lines are another matter, but those normally come from vendors, not a third party bank, for new businesses, because nobody trusts them.

Until you hit a substantial size, good luck with getting a loan without a personal guarantee. Some are implicit, Amex gives out business cards and lines of credit left and right, and the personal guarantee is hidden (it says in the signature line "and personally"), some are explicit, the SBA backed loans generally want a personal guarantee from anyone holding 20% or more of the business... stopped me from refinancing some payables that had to get moved to a credit card to get paid from 30% to 13%, because a minority shareholder wasn't involved anymore... ended up moving it to a personal credit card at 8%.

People need financial education, but all things being equal, cheaper debt is better, but if you are borrowing money instead of investing it, you're on the wrong side of the compounding interest equation.

SephardiLady said...

I'd assume those people would have the same difficulties regardless. Again, if they're going to get hit with debt, better the lower rate debt.

Ezzie-Unfortunately this is another myth. Plenty of debtors are debtors because they don't plan ahead, don't put away a cash cushion, overextend themselves with obligations, and aren't willing to cut the small expenses.. . .. and then the emergency happens.

I really enjoy reading "Get(ting) out of Debt" stories. But they are also so sad because more often than not, the people working themselves out of debt, with different decision making, could have some assets and would have some real choices.

Child Ish Behavior said...

Your right it is extremely irresponsible thing for a person to do. What is even more unfortunate is that the government in it's infinite wisdom has the right to do exactly this scheme and get away with it. They call it Keynesian Economics, spend spend spend, and the country is spent rich. People only learn from their example. They think that they are making themselves rich by spending money that they will possibly earn in the future. And why not? This is what the American dream is all about. borrow from one, and float a bond to pay it back; borrow from a student loan and pay it back with some cd interest, after all not only do you get rich and have extra spending power, you help the economy too. Idiots.

Dave said...

To be fair, Keynesian Economics is a lot more about priming the pump than anything else.

And to work, it requires government to be frugal when the economy is going well, so as to be able to take on temporary debt in times of crisis to be able to smooth out the downturn.

Child Ish Behavior said...

"it requires government to be frugal when the economy is going well, so as to be able to take on temporary debt in times of crisis to be able to smooth out the downturn"

You don't need me to tell you that in this is all nice in theory but in reality government just spends and spends like there is no tomorrow. When was the last time you heard about balancing any budget?

Our own government is the greatest at the credit games.

Anonymous said...

You don't need me to tell you that in this is all nice in theory but in reality government just spends and spends like there is no tomorrow. When was the last time you heard about balancing any budget?

Our own government is the greatest at the credit games.


Eventually that will cease. And not due to choice, it will happen because others will simply stop lending our government the money.

Mark

Dave said...

When was the last time you heard about balancing any budget?

Federal budget? When Clinton was President.

State budget? Required to be balanced.

Ezzie said...

Aside regarding the last few comments: There's talk that the states which are more stable economically will stop paying into the federal government when they decide that the money is all going one way. Don't know how realistic that is, but it's interesting that it's even being mentioned.

SL - I'm not sure I understood your comment; which part is another myth?

Plenty of debtors are debtors because they don't plan ahead, don't put away a cash cushion, overextend themselves with obligations, and aren't willing to cut the small expenses.. . .. and then the emergency happens.

Agreed; but again, why would that be more likely in this example? If anything, this is someone who is showing an ability to understand how debt works and shows the ability to plan ahead. No?

I really enjoy reading "Get(ting) out of Debt" stories. But they are also so sad because more often than not, the people working themselves out of debt, with different decision making, could have some assets and would have some real choices.

VERY much agreed. Always bothers me as well. On a similar note, these shows and books which talk about helping people get out of debt or bad situations and as part of it, they give them complete non-necessities... it kills me. The people end up getting used to living a lifestyle that is beyond their means, and reverts back completely to how they were before if not worse. Ugh.

Al said...

Ezzie, "There's talk that the states which are more stable economically will stop paying into the federal government when they decide that the money is all going one way."

Uh, that happened twice before... after the revolutionary war, the southern states were debt free, the northern states heavily in debt... the Federal government absorbed those northern debts... which was part of the compromise that led to the Federal District being put between two southern states (Maryland and Virginia, then both southern slave states).

A second time, the northern industrial states were in financial trouble, and demanded the government place tariffs that would bring money in to bail them out. The agrarian southern states were stronger fiscally, and when the northern states voted for a regional candidate for president, raised taxes to push the burden on the southern states, AND agitated about undermining the southern states economic model... 13 southern states left the union, and the country fought the war between the states for many years.

I'm sure this side isn't covered in a NYC US History text book, that makes it ALL about the evil southern slave states (where slavery was on the decline for economic reasons) and good natured northern yankees liberating them, but the reality is more complex.

Notice in the current crisis, the economic problems were in the heavily Democratic states... the formerly industrial midwest made uncompetitive with union contracts, the west coast that has gotten rich with the investment of pension funds into VC funds, and the northeastern that got a 700 billion dollar bailout of the NYC based financial firms.

Urban areas appear to create wealth, but they are less stable economically and more prone to swings, and they lord it over the rest of the country in good times, and demand help in bad times.

SephardiLady said...

The myth I'm referring to is that many debtors would have problems regardless. I believe that much of debt is caused by overconsuming and is exasperated by certain disasters.

Ezzie said...

Al - The first one makes sense; the second, as you noted, is rarely presented as such (in my Ohio textbook either). This time would be interesting because it would be harder for the debt states to justify a reason for the other states to continually pay in for them, particularly in light of the bailouts, etc. The liberal "elite" may think it's coming to them, but we'll see how much longer everyone else puts up with it, in light of the clear fiscal irresponsibility on the part of those states.

SL - Agreed with that.

Dave said...

Here are the numbers from 2005 on Federal Tax Burden and Federal Spending per state.

http://www.nemw.org/taxburd.htm

They don't back up the assertion that the liberal and urban states are a net "drain" being supported by the conservative and rural states.

In fact, in as much of a trend as I can see, the opposite seems to be true.

Al said...

Dave, your numbers agree with my point... Urban areas tend to produce more income... but they are more prone to wild swings... booms and busts... goes with the growth.

In 2005, a boom time, they were net contributers. In 2008, it came crashing down, and the housing collapse was centered in California, southern Florida, and a few wealthy urban areas in the sun belt... The financialcollapse was in NY.

The last major collapse that needed a Federal bailout was the S&L crisis, again in urban liberal areas.

The most recent one, a union bailout of the midwest, same thing.

I never claimed net, I claimed that when the progressive areas collapse, they tend to shift the burnen. The net burden on the liberal states in good times is a result of policies pushed by those same area's legislative representatives.

Also, a lot of the southern US's net benefit from the federal government is military spending, which swings southern because southerners are more likely to serve... it's hard to call their willingness risk their life for their country a leaching on the system, but that's what these sorts of numbers demonstrate.

Dave said...

I would toss out Maryland and Virginia, simply because Federal spending around DC is going to skew things. But military bases are spread around the nation.

Urban areas tend to be more liberal. They also tend to be more affluent.

Even in the current economic state, the urban areas are generating more tax revenue for the federal government than the rural areas; I don't see this changing. Nor do I see the rural areas deciding they need less money than their political heft can get them.

I would be very surprised if the per-capita numbers were remarkably different when we get the 2008 and 2009 information. Of course, by then, we'll have completely forgotten this discussion.