Maxed Out

Frank and Naomi Cooper have a secret for sound sleep: debt-free living. Frank, 86, remembers baling hay for 50 cents a day during the Depression, so he refuses to take financial risks. He paid cash for his house. He once burned a credit-card offer that came in the mail. "If you don't have the cash, you just don't buy," he says. Their daughter Linda Rinkes, 53, has liberalized that maxim only slightly. She has a car loan and carries a credit-card balance when she must, paying it off quickly. For the family's third generation, though, Grandpa's philosophy is completely obsolete. "Just because I don't have the cash for something doesn't mean I shouldn't buy it," says Jen Rinkes, 29, who carries $8,000 on credit cards and a $438-a-month Saab on her $40,000 income. "I don't think debt is a sin," she says. "I'm living in a style I want to become accustomed to."

That sentiment became a national battle cry during the country's long economic boom. Now, as the expansion slows to a crawl, many Americans carry a dubious legacy: too much debt. Together consumers owe $7.3 trillion, according to the Federal Reserve--double the amount they carried into the last recession. And as layoffs increase (as they did last week at Ford, which will eliminate 5,000 jobs) and stock winnings dwindle, many are piling on even more. Homeowners are borrowing against their houses' rising value to fuel discretionary spending. Banks are peddling risky loans to people with poor credit history (page 40). As the economy slows, mortgage delinquencies and credit-card write-offs are already rising. Forecasters say a record 1.4 million people may file for bankruptcy this year. The phrase debt crisis used to refer to Mexico's or Argentina's defaulting on bonds. In the months ahead, some economists warn, a growing number of families may experience one firsthand.

Of course, the disaster scenarios may be premature. Most economists still say families can afford all this debt thanks to the income gains they enjoyed during the long boom. Even with debt at record levels, more than four out of 10 credit-card holders pay their bill in full each month. Among those who fall behind on mortgage payments, most catch up; even in tough times, actual foreclosures remain rare. "I'm not convinced you can make a case for impending disaster," says Richard Berner, chief U.S. economist at Morgan Stanley. Indeed, the present danger to everyone--debt-ridden and debt-free--isn't that millions of Americans suddenly become deadbeats. It's more subtle: that their big debts act like a giant headwind, limiting the consumer spending that's helped fend off a recession. "We're basically in a race," says Brian Nottage of Economy.com. "Does consumer spending stay strong long enough for the economy to rebound?" If big debts crimp spending, a recession could well follow.

And loan payments are only part of the weight consumers are carrying. Stuart Feldstein, president of SMR Research, says government statistics don't count auto-lease payments, rent, overdue utility or medical bills, alimony or child-support payments as debts, even though these monthly obligations place similar constraints on households. Yes, unemployment remains low, but huge numbers of employed people are seeing income fall as commissions, overtime pay, tips, bonuses, or self-employment income decline. As debt payments consume more of their shrinking incomes, they'll have no choice but to cut other expenditures.

Some consumers are squeezing in a last dose of spending before they cut back. Rock Gibbens and Linda Gossett of Dallas recently charged a $7,000 diving trip to the French West Indies. "It was like our last hurrah," says Gossett. Back at home, they've refinanced their house--purchased for $42,000 six years ago and worth $123,000 today--adding $77,000 to their mortgage to pay off credit-card debt and car loans and make home improvements. Others see no reason to slow down. Marilyn Sullivan, a Wall Street market-maker, admits that she's maxed out two of her credit cards (balance: $9,000) but still uses the third for restaurants and weekends away. "I've spoiled myself and I can't change my habits," she says, ticking off unused shoes, a flat-screen computer and a $500 telescope she's bought recently.

Looking askance at such wantonness is a long, proud tradition. Humans have wrestled with the morality of debt since Biblical times, and they usually succumb to what historian Lendol Calder, author of "Financing the American Dream: A Cultural History of Consumer Credit," calls "The Myth of Lost Economic Virtue." While it's tempting to see our fall into debt as a New Economy phenomenon, he writes, that is hardly accurate. George Washington and Thomas Jefferson shouldered heavy personal debts. Americans binged on debt after the Civil War, took on car loans and margin debt in the 1920s and went deep into hock in the 1950s. Indeed, the wider availability of mortgage, car and revolving credit loans have helped raise living standards for most Americans--and fueled the postwar booms that have made our economy the envy of the world. Nor is the debt hangover that follows an expansion a uniquely millennial phenomenon. "This is nothing new," says economist John Kenneth Galbraith, who at 92 has seen his share of business cycles. "Consumer debt tends to rise--and in some cases get out of hand--in the good times, and the pressure of that accentuates recessions."

What's new is just how many ways today's consumers have to buy now and pay later. Much of the change comes from credit cards. As recently as the 1980s, says Robert McKinley of CardWeb.com, most cardholders had just a single Visa or MasterCard and didn't pay much attention to fees or rates. But as debt loads increased during the 1991 recession, customers began comparing cards. Lenders reacted by dropping annual fees, encouraging more people to carry multiple cards. Banks also began using teaser rates to entice people to transfer existing debts to new cards. Incentive cards became popular, rewarding heavy chargers with free airline tickets and cash rebates. Grocery stores, doctors' offices and other new venues became card-friendly. That's driven up the number of "convenience users," but it's also increased the balances of "revolvers," who don't. By the end of 2000, the average cardholder had $8,123 in credit-card debt.

The consequences of stepping on this treadmill are sobering. A University of Michigan study found that more than half of low-income families with high consumer debts and low net worth in 1994 were still broke in 1999; in fact, their average indebtedness grew from $2,900 to $18,500. Before Beth Tull got off welfare and took a $19,000-a-year job in 1997, she never had a credit card. Now she has seven (combined balance: $12,000). "I am not stupid, but credit can get away from you," she says. Even people whose debts are manageable admit their cards enable bad habits. Scott Leonard and his partner, Scott Spragg, don't stress about their $7,000 balance because they see their income holding steady at about $100,000. But it's clear their cards take the place of budgeting or balancing their checkbook. "We run out of money, wait until we get paid and start spending again," Leonard says. "I can't be bothered... keeping track of how much is coming in and going out."

Freud could have a field day analyzing the denial and rationalization that underlie our relationship with credit cards. Frivolous shopping is part of the problem: many debtors blame their woes squarely on Tommy, Ralph, Gucci and Prada. But it goes beyond conspicuous consumption. Cornell economist Robert Frank, author of "Luxury Fever," sees lots of "defensive spending" rooted in families' refusal to afford less than other people have. Parents often shoulder a big mortgage to get their kids into a good school district. Other spending comes from refusing to forgo items "normal" people have. If everyone has a mobile phone, why shouldn't you? Add in Internet service and digital cable, and you may spend $150 a month on services that feel like necessities--and didn't exist during the last recession.

Beyond buying an expanding list of must-haves, many debtors behave in curiously irrational ways. Wharton professor Nicholas S. Souleles studied how borrowers react when lenders increase the amount people are allowed to charge on their credit cards. Not surprisingly, folks who are nearly maxed out quickly use a lot of their new credit. But within six months of the credit increase, he found, even cardholders with credit to spare carry bigger balances. "People figure 'If the bank thinks I can afford this $10,000, they know better than me'," says Bob Manning, author of "Credit Card Nation." Ruth Valdez, 29, had 13 cards, but she recently held a "clipping party," consolidating her $10,000 debt into just four. A few weeks later she celebrated by applying for another. "I apply for them thinking they won't give them to me, but they almost always do," she says.

That lack of discipline is fueling growing ambivalence about debt. In a 1977 survey, 27 percent of people said using credit cards was "bad" for consumers. By 2000, that number jumped to 51 percent, according to Fed research, and 41 percent agreed we'd all be better off if credit cards didn't exist. Those views seem hypocritical--most cardholders are still charging faster than ever. But the disdain may grow as the economy falters. In the second quarter, according to Moody's, the percentage of delinquent credit-card payments rose to 5 percent from 4.3 percent. Card write-offs increased to 6.4 percent from 5.6 percent. Until this year, both numbers were declining.

Big credit-card balances are troubling, but some experts are more alarmed by consumers' new willingness to pile debt onto what was once the bedrock asset of Americans' balance sheets: their homes. Part of this explosion in mortgage debt stems from the skyrocketing real-estate prices of the late '90s, which required buyers to stretch. Some already show the strain. Home buyers who took out new mortgages last year are twice as likely to be three months behind in payments as borrowers from the previous year. The bigger change in home finance, though, is the rise in "cash-out refinancing," which allows existing homeowners to take out a new, bigger loan, letting them cash in some of the value their home has gained since they bought it. In 2001 $670 billion of the nation's $5.1 trillion in mortgage debt will be refinanced, according to Mortgage Bankers Association estimates. Fannie Mae economist Orawin T. Velz figures that nearly half of borrowers will add to their loan balances. All told, homeowners could walk away with $55 billion in cash this year from refis. Spending from that windfall could exceed the impact of the $38 billion tax rebate.

This illustrates a big shift: many homeowners no longer look forward to mortgage-burning parties and instead treat their homes like piggy banks. Kevin Mysliwiec, a Chicago software developer, reaped $30,000 when he refinanced his $200,000 condo in February. His rate dropped to 6.5 percent, but his payment jumped from $1,500 to $1,700 a month on the bigger balance. He used the cash to buy a Mercury Mountaineer and pay off credit cards. "I don't think the economy is really going to tank," he says, so the bigger payment is no worry. Troy Morris inherited his Indialantic, Fla., home mortgage-free in 1994; since then he's borrowed against it three times, most recently in May to add a second floor for his two kids. His payments are now $1,640 a month, but he sees his job as a police chief and his wife's teaching position--and their $80,000-a-year income--as secure.

Most economists are similarly sanguine about the rising mortgage balances. They say it's smart to use lower-cost, tax-deductible home loans to pay down consumer debt. It's the kind of savvy maneuver corporations have done for years. As long as house prices stay steady and unemployment doesn't soar, steeper home loans aren't a huge risk. "When people refinance their homes, they take it seriously--they don't go out and splurge on fancy cars and designer clothes," says Sung Won Sohn, chief economist at Wells Fargo & Co. Indeed, Fed research shows most cash-outs go toward paying down debt or home improvements.

But some experts do see danger in the offing. Forecasts call for home prices to continue rising, though much more slowly. But "if we get a very rough landing or a real recession, house prices will fall," says Wellesley College real-estate expert Karl Case. That could leave some homeowners with mortgages that exceed their homes' value, increasing anxiety and reducing their ability to sell their homes. Other observers warn that it's never smart to trade credit card or auto debt for mortgage debt, which carries the risk of foreclosure. "They're making the bet that nothing will go wrong, and if it does, they lose their home," says Elizabeth Warren, a Harvard Law bankruptcy expert. The biggest problem is that too many people are using home equity to pay down credit-card debt without changing their spending behavior. "Unfortunately they don't cut up their credit cards," says Southfield, Mich., bankruptcy lawyer Stuart Gold. "They cut down their debt and build it back up." Spend time among debtors, and the future can look grim. Warns Tom Coates, a Des Moines, Iowa, credit counselor: "As this economy slows down, a lot of people are going to lose their homes."

Even if that prediction proves false, watching so many households reshuffle their I.O.U.s is a sobering reminder of how complex financial life has become. Since November, Dallas photographer Nancy Newberry, 33, has seen her credit-card balance rise from $8,000 to $15,000, "the most debt I've ever had," she says. But she justifies most of it as business expenses. "It's OK to have debt because I'm a growing business," she says. Judy Land, a nurse who lives in a $412,000 home in San Rafael, Calif., earns 29 percent of her $70,000 income through overtime pay; her regular salary barely pays the mortgage. So she's using a home-equity line to pay off credit cards and to finance a European vacation. "But I finally paid off my credit cards, and that felt good," she says. Others live more perilously. Chet and Cheryl Mielniczek went bankrupt during the 1991 recession, losing their Naugatuck, Conn., condominium. Today they pay only the minimum balances on five cards, have no savings and feel stressed. Says Chet: "We're giving them money and the bill is not going down."

Keeping ahead in a world where every family could use its own chief financial officer requires more savvy and self-discipline than ever before. The Amone family of Patchogue, N.Y., is lucky: Mark Amone is, in fact, a financial analyst. After watching their $285,000 waterfront Victorian rise sharply in value, he recently cashed out $40,000 to pay off credit cards, build a driveway and shop for a car. "I'm trying to take a conservative approach," he says. As so many other families rebuild their balance sheets amid this teetering economy, we'll all have a stake in their decisions.

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