Financial illiteracy and the perils of the credit debt trap

Recent revelations that more than one in six Australian consumers are struggling to pay off their credit cards, and that outstanding credit card balances in this country have reached $45 billion, do not surprise John Vaz.

One reason credit card debt is growing is because “our consumer system almost mandates that you have a credit card,” says the senior lecturer in banking and finance at the Monash Business School.

People on low incomes are particularly vulnerable. He gives the example of the electricity and gas retailers who provide a 30 per cent discount if bills are on direct debit and paid before the due date, an incentive that drives consumers to set up direct debits on their credit cards.

“If you are an ordinary person who is struggling to pay your bills, this looks like a 30 per cent impost if you don’t use a credit card,” he says.

Higher earners are also encouraged to use the cards – and some transactions are impossible without them.

“Have you ever tried hiring a car without a credit card?” he asks. “Or booking a hotel?”

He only uses two credit cards but owns more – he has been given cards, or offered them as a reward with loyalty schemes.

“You can get free credit cards with your mortgage regardless of need, or when you take out an investment loan, all as an incentive for banks to tie you in as a customer for growing profits,” he says.

A report on credit card lending by the Australian Securities & Investments Commission (ASIC) released in July identified scenarios where credit card debt is potentially problematic. These include “persistent debt” where for 12 months the average balance on the card is 90 per cent of the credit limit, and interest has been charged; and “repeated low payments” where the consumer has made eight or more repayments on the account at or below 3 per cent of the credit limit over the previous 12 months.

The report found that these categories of customer “are profitable for credit providers”, with 930,000 people experiencing persistent debt and an estimated 435,000 people making repeated low payments. As a remedy, ASIC proposed that consumers only be issued credit cards that can be repaid within three years.

Dr Vaz says consumers falsely believe the debt is “ok” if they are managing to pay the minimum amount each month – not realising that these payments may not even cover the interest, and that the amount repaid in this way will far exceed the initial amount put on the credit card.

He is frequently asked for his advice on managing debt, and says step one is to make a basic budget “so that you understand your cash flow over the near term – what is going in and what is going out”.

Credit cards can be a useful tool for filling the gaps in monthly payments, but risk becoming a drain on cash flow if they are not paid off as quickly as possible.

His second rule is to shop around for a cheap, no-frills credit card.

The ASIC report estimated that $621 million could have been saved in a single year if Australians with credit card debt had switched to a basic card with a lower interest rate.

The report was also critical of the widespread practice of “balance transfers” in which consumers swap to a credit card offering zero interest, or lower interest for a set period.

The report examined credit card use in the five years to June 2017 and found that $12.4 billion in balances had been transferred in that time, with 53 per cent of consumers reducing their debt by 10 per cent or more, and 8 per cent wiping their debt completely. But almost one third of customers increased their debt by more than 10 per cent, sometimes accumulating debt on their old card, which they retained after the transfer.

Financial illiteracy and the banks

Dr Vaz believes a lack of financial literacy has resulted in the take up of financial products such as costly credit cards without understanding their consequences. Helping consumers acquire a basic level of financial literacy and better explanation about financial institutions offerings is critical.

He argues that banks should take more responsibility by helping customers understand what financial products will best suit their needs, rather than offering products that increase their own profits.

"Banks should do so as they gain great benefits because they are in a unique position to create money in our system and are protected during bad times as they are seen as too big to fail," he says.

Self-regulation within the banking sector has failed, he added, and the regulatory bodies – ASIC and the Australian Prudential Regulatory Authority (APRA) – “have been afraid to rein in some of the poor practices of the big banks for years, probably due to concerns about the impact this would have on the political economy”.

The Royal Commission into the Banks has thrown light on some dark places, but Dr Vaz believes the inquiry should have looked more broadly into credit providers – including payday lenders, for instance, or car dealerships that offer loans on an agency basis.

Banks are not the only institutions who should be concerned about a customer’s ability to pay, he says. Generally speaking, significant profits can be earned from the poorest, most desperate consumers because they can be charged the highest interest and have limited choice.

Dr Vaz points out that Australia’s 26 years of positive economic growth has not only been built on the mining boom but also on easy credit. “We have a credit-driven economy. We need capital to continue growth.”

This is particularly true in the housing market, where Australians have been taking on unprecedented levels of debt. And this long period of growth has been good for Australian banks, which have gained from all the money they have loaned to developers, investors and householders.

Will there be a day of reckoning?

Dr Vaz believes the populist policies that got Donald Trump elected president in the US will see him go on to win a second term. Like him or loathe him, Mr Trump is now doing what he said he would do – he is shaking the foundations of geopolitics, of global trade and of fiscal policy. As a trading nation in the Asia-Pacific, Australia is vulnerable to changes in US-China relations and to trade wars. Dr Vaz foresees “pressure on interest rates in the longer term” with consequences for the local housing market.

He hopes that before our long term of positive economic growth comes to an end, the banks will respond by reining in their growth driven lending policies. When credit is harder to come by Australians might once again learn the virtues of managing within our means.