How credit card debt makes income inequality worse

Debt financing is commonly called leverage for a good reason:

Debt leverage

Source: YouTube

The lever is one of the classic “six simple machines” we learned about in school. Using a long stick and a fulcrum, a lever trades distance moved for force, enabling the lifting of a heavy object, or, in a financial example, the purchase of a new car with little money down. But as the see-saw example above demonstrates, sometimes the heavy object fights back. With credit card debt, the “heavy object” usually wins. [1]

Less discussed is how trends in credit card debt since the mid-1980s have exacerbated income inequality in the U.S. In short, most Americans who use credit cards are on the left side of that see-saw. We have established a financial system in which most credit card users are pretty much destined to keep falling behind the income growth curve.

Where your credit card interest rate came from

In 1981 South Dakota’s Governor Bill Janklow single-handedly made laws against usury (“loan sharking”) in fifty states unenforceable by enticing New York’s Citibank to move their credit card operations to his state in exchange for lifting the cap on allowable consumer debt interest rates. All other states had to change their usury laws in order to keep banking businesses from fleeing to looser territory.

As recently as the 1970s, credit cards were largely limited in the interest rates they could charge by those state usury laws, and as a result, they were harder for the average consumer to get. “Store cards” from major chains like Sears were the most common cards, or the Diner’s Club card and its competitors were available if your credit was really good. The average interest rate paid on those cards in 1974, net of inflation, was only about 6%.

The rise in consumer debt availability after 1981 was a godsend for consumers who knew how to manage it and clearly spurred consumer spending. But the “innumerate” among consumers failed to understand the Rule of 72, which tells you how long it takes for a debt to double at a specified interest rate. According to a recent article in the Los Angeles Times, the average interest rate paid on credit cards at the end of July, 2019, was 17.8%. At this rate, your unpaid balance is doubling every four years (72 divided by 17.8). [2]

In other words, if you let an unpaid balance linger on your card, that $25 lunch you charged long ago could cost you $100 or more over time. Since you are charged interest on any unpaid balance at the beginning of each month, you are effectively still paying interest on the oldest charges that carried over. A credit card debt with a 24% annual interest rate (not uncommon) will double in just three years unless paid off (72 divided by 24), and minimum required payments are usually set for the bank’s benefit, to maximize your unpaid balance given your risk level. [3]

The see-saw of income inequality

I wrote a series of posts last year detailing how the much-talked-about rise of income equality is not so much some nefarious plot as it is the natural effect of this Rule of 72, as applied to income growth over time and offset by consumer interest rates:

Income inequality

The chart above is the smoothed and compounded effect of actual differential rates of income growth in four segments of the U.S. population over the last 30 years, with the bottom two lines comprising the bottom 90% of households. [4] Most families have averaged less than 3% annual income growth (What was your last raise percentage?), which requires 24 years or more to double family income (72 divided by 3).

Top managers and the richest corporate owners, on the other hand, have seen average income growth up to 8% per year during that same period (How big a raise did your boss get, including bonus?), which means income doubling in as little as nine years. The compounding “time value of money” naturally creates the widening curves in the graph above. My contention has been that this is the primary driver of income inequality in the United States over the last several decades. It is a very subtle widening, and you likely never saw it coming.

The counter-growth effect of credit card interest

To the point of this post, this differential is exacerbated by high credit card interest rates compared with long-time low “prime” lending rates. If you are well-off, you can get loans at lower interest rates than your overall income growth rate. The prime rate is currently 5.25%, and if you are in that 8% income growth category, you can borrow lots of money (either personally or through your corporate stock ownership) and “leverage” that difference into even more wealth. You are the big kid on the see-saw above.

As an ordinary consumer, however, even if you have a good credit rating, you are likely paying over 15% for consumer debt, or at best 4%-5% on a home mortgage debt, but receiving under 3% annually in pay raises. You are the little kid on that see-saw, not only trying to stretch a small pay raise, but also losing even more ground if you hold unpaid balances on your credit cards. Your best bet is that the house you have mortgaged is going up in value at a rate greater than that, but history shows as recently as the 2008 real estate crash that you may well be wrong.

In 2017, the Consumer Financial Protection Bureau found that, except for consumers with the highest credit scores, most Americans carry a balance on at least one credit card. According to the credit bureau Experian the average total balance carried on credit cards at the end of 2018 was over $6500, which suggests average credit card interest payments of over $1000 per year. You can think of that amount as how much behind the income inequality curve the average American is slipping every year solely due to credit card debt.

The obvious conclusion is that unpaid credit card debt is a bad thing for most consumers. The overall flow of wealth moves inexorably, in a “penny sucking” manner a couple percent at a time, toward the banks and the investor class. But that card is a hard habit to break.


Notes:

  1. The other “simple machines” are (1) the wheel and axle, (2) the pulley, (3) the inclined plane, (4) the wedge, and (5) the screw.
  2. The Rule of 72 says to simply divide the annual interest rate into 72 to calculate how long a compounding loan takes to double in value. You can also use the rule to calculate how long it takes for your net pay to double based on your average annual pay increase.
  3. If the interest is compounded monthly, however (the common practice), it only takes a 23.2% annualized rate to double the debt in three years.
  4. Here is the unsmoothed data for income growth since 1965, the four segments basically paralleled each other in growth rates until about 1985, when they began to diverge:

 

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