Every economy has good times and bad, but the current credit crisis and recession are the worst seen by older generations and the first national crisis witnessed by the 20-something crowd. Still, this recession plants the seeds for the next expansion. And we should make sure we do everything possible to learn the lessons from the mistakes that contributed to the current crisis.
The key questions become what were the mistakes and how can we learn from them in order to make us stronger and wealthier in all aspects of life.
We’re all faced with financial decisions large and small. How much (if any) credit card debt is manageable? How much do I need to borrow for my first house or first car? Our relationship with credit and borrowing remains important for our entire lives. A better understanding of that relationship will pay huge dividends along the way.
Loans let you take money from the future and use it today. But borrowing carries a cost – interest and a future claim on income earned. Borrowing makes sense if, and only if, having the money in the present produces value. That is, by borrowing today you will be able to earn more income in the future than without borrowing.
For example, consider borrowing to get a bachelor’s degree. By borrowing today and agreeing to pay back the amount plus interest in the future, the education received today and the degree earned will help you earn higher income. This type of borrowing makes sense. But problems arise when people begin to borrow irresponsibly.
Between 1989 and 2009, Americans’ credit card debt quadrupled in size. Millions of people built up revolving debt by buying high-def TVs, designer jeans, and even everyday items like lattes and lunches out. Others got neck deep in adjustable rate mortgages with equity lines of credit that they didn’t understand. When interest rates went up or homeowners joined the ranks of the unemployed, they found themselves in McMansions that they couldn’t really afford. The aftershocks are being felt in every part of the economy.
One effect of this fallout is pressure for reform. Unfortunately, some interest groups are pushing legislation that would actually limit future access to credit without addressing the root problems. One group, the Center for Responsible Lending, is embroiled in an attempt to cap the interest rate lending institutions can charge, which would eliminate some of the only loan options available to Americans with few alternatives.
A better solution is increasing responsible use of credit through financial education. Paying for education is a great example. Another is creating capital for small businesses.
Start-up businesses that create wealth for the whole economy aren’t possible without credit. In 1982, an entrepreneur named Jimmy John Liataud took out a $25,000 loan to open a small sandwich shop. A few decades later, Jimmy John’s Sandwich Shop employs thousands of people at its 850 stores in 35 states, and sponsors NASCAR driver Kevin Harvick!
Credit isn’t just for big loans and businesses, it’s also vital for families trying to make ends meet. When a family has an emergency expense like a car repair that exceeds their savings, getting a short-term payday loan can be the difference between driving to work or losing their job.
Once the current credit crunch passes, as it eventually will, it is critical that Americans learn to use credit responsibly and constructively. We should all be more like Jimmy John Liataud, and less like those who got into mortgages they couldn’t afford.
The best way to achieve this is a new commitment to personal finance education in schools, as well as providing resources and education for adults trying to navigate a complicated web of mortgages, 401(k)s, and Roth IRAs. We should not eliminate financial options that, used responsibly, are vital resources for the health of the American economy.
Tawni Hunt Ferrarini, Ph.D., is the Sam M. Cohodas Professor and the Director of the Center for Economic Education and Entrepreneurship at Northern Michigan University.
