Every month, about four in ten households get a bill for credit card debt they will not pay off. That's according to a 2010 Survey of Consumer Finances conducted by the Federal Reserve Board.
Stereotypes abound for these families. Typically, we think of them as people who, for whatever reason, are on the brink of bankruptcy. We envision the woman with no self control and a closet full of shoes or the middle-class family with the laid off dad.
However, research published in The Review of Economic Studies points to a perhaps unexpected reason for living with credit card debt. It's not that families can't pay their balance; it's that they don't want to.
Cash vs. credit card debt
According to Irina A. Telyukova, an associate professor of economics at the University of California San Diego and author of the research, more than a quarter of households may have enough liquid assets to pay off their credit card balance.
The 2001 U.S. Survey of Consumer Finances found 27 percent of households had credit card debt averaging $5,766 while at the same time holding $7,338 worth of liquid assets such as money market accounts and savings accounts. The average APR for the credit card debt was 14 percent while these assets were earning around 1 percent interest. The numbers today may not be exactly the same, but 2010 figures are similar.
The question is, why pay 14 percent interest on debt when you have the money sitting in the bank? The answer, Telyukova says, is that families want to have a stash of money available to pay bills their credit card cannot cover such as:
- Mortgage or rent
- Day care or babysitting
- Major household or auto repairs
Smart use of credit card debt
So essentially, these families want the cash as an emergency fund and figure the credit card bill can wait. And it can certainly make sense to keep cash on hand, particularly if you think a pink slip or major expense may be in your future.
However, quite frankly, it seems silly to pay 14 percent interest on $5700 when you have $7200 in the bank. If you are one of the families hoarding cash while carrying a significant credit card balance, consider using these strategies instead:
- If your job is stable and you make more than enough to pay the monthly bills, you may want to take the plunge and simply wipe out your debt completely. Using the average numbers from 2001, you could pay off the credit card debt and still have $1,572 left for an emergency. Live lean for a few months and you probably could build back up the balance in short order.
- If you have reason to believe you might need the money in the future -- such as the 20 year old furnace in the basement -- but can pay the bills using your income, think about paying down a portion of your balance and reducing the amount of interest you'll pay. You could pay off half your debt and still have enough in the bank for when the furnace gives up the ghost.
- If you are living hand to mouth and can't imagine losing your safety net, at least look at moving your balance to a zero interest or low interest credit card. When comparing balance transfer offers, don't forget to consider any transfer fees as well as the APR.
Regardless of which strategy is right for you, don't forget to rebuild your savings account balance as needed and limit future credit card purchases only to what you can pay off each month.