The credit crunch

The U.S. mortgage meltdown of 2007 started the whole process of a global credit crunch.  Extreme bank losses, due to record numbers of defaults and foreclosures, put some lenders out of business, and caused many secondary mortgage markets to dry up.  And, to limit losses, the financial institutions that survived the meltdown have tightened the grip on their cash, becoming more cautious in granting any type of credit, whether credit card, home mortgage, or auto loan. 

What this means for the average consumer is that it's just more difficult to get credit now than it was before the meltdown.  So how do we manage to get through this credit crunch, when our society has come to depend on credit to keep up with the lifestyle we're accustomed to?

Keeping up with the Joneses has long been the American way, but that mindset and the spending habits that come with it are what got us into this mess to begin with.  Mr. and Mrs. Jones do have some pretty nice stuff, but they must be up to their ears in debt. 

Using credit, at least to some degree, is certainly a necessity for many consumers.  Most of us would never be able to buy a home or a nice car if it wasn't possible to finance those purchases.  And the convenient credit card can be an instant source of funding for surprise expenses, such an an emergency room visit or a last-minute auto repair, since many Americans don't have enough money saved.

But many consumers use credit for disposable, every day purchases, and then fail to pay the entire balance every month.  Their balances grow each month, their finance charges start taking a bigger portion of their budget, and making more than the minimum payment becomes a struggle.

And now, the home-equity loan is even more difficult to get, due to the depreciation of many area's home values.  Many American homeowners have come to depend on the equity in their home for as a source of funding for large purchases, and now that those loans are no longer an option.  What this means is that we are turning to our credit cards for those purchases.  Credit card balances are growing as consumers exhaust other financing alternatives.

If you use credit cards to buy gas, restaurant meals, and groceries, or even to pay bills, whether for the convenience or the rewards points, there's nothing wrong with that.  It really doesn't matter what you use credit for, as long as you can pay the full balance each month.  It's even okay if you want to pay for a luxury vacation on your credit card, as long as you don't drag out the payments for years and end up paying big bucks in finance charges.

The credit crunch should be a wake-up call for those who are dependant on credit.

Those who already have a firm grip on their debts should be least affected by the credit crunch.  These smart consumers limit credit card purchases to what they can pay off each month, have an adequate emergency fund built up, and limit the use of home-equity loans to pay for long-term benefits like education or home-improvement.  They probably have high credit scores, because they keep their balances low, and can pay their bills on time.  Getting additional credit isn't really that hard for these borrowers, since lenders still see them to be a good credit risk.  The main change is that lenders may require more income documentation than they used to for certain types of loans.

Those most affected by the credit crunch are those that need to use credit to keep up with their lifestyle, and have little savings for emergencies, so they must use a credit card if unforeseen circumstances arise.  Their credit cards are nearly maxed out, and they hope to get another credit card or a credit limit increase to keep the show going.  They are also more likely to attempt to consolidate already unmanageable debts with a home-equity loan.  Or even worse, use a home-equity loan for luxury items they couldn't afford otherwise, like a hot tub or a plasma TV.  Lenders have become very cautious about granting credit to already over-extended borrowers, and so it can be very difficult or even impossible for them to get more credit.  

Many consumers wouldn't fall into either extreme category, but somewhere in between.  You may find that you can still get a new credit card or home-equity loan, but the terms may not be as favorable as you've become used to.  Lenders are still doing business, but they're choosier about who they do business with, and they aren't as generous as they were before.  Assess your current financial situation and see what areas you can improve.  Learn to look at yourself through the creditor's eyes.  You wouldn't loan money to someone who already can't afford to pay their other debts or who are behind on their payments; lenders are no different. 

Survive the credit crunch.

• Draw up a budget.  You don't have to be living hard times and pinching pennies to have a budget, but having a budget can help prevent hard times and the need to pinch pennies.  A budget should be realistic; it will do no good if your budget is so strict that you feel like you're being punished because you'll have a hard time sticking to it.  A good budget should also allow you to meet your current obligations, as well as work towards your financial goals such as saving for retirement, a down payment on a home, or your children's educations.

• Reduce your debts.  Start with your highest-interest loans, most likely credit cards, and begin making bigger payments until they are paid off.  Then go on down the line until all your revolving charge accounts are at a level you can pay off each month.  It will take some discipline, but reducing your debts now will free up money in the future.

• Don't shop impulsively.  Every time you go out to shop for necessities, there's a chance that you'll be drawn to something that you never knew you needed until you saw it in the store.  Even seemingly little purchases can add up to a lot of wasted money; one impulsive purchase of twenty dollars a week adds up to over a thousand dollars a year.  Delay the purchase until the next week, and buy it then if you still want it.  But you may find that you've forgotten about the item by that time, which means that you really didn't need it to begin with.

• Have an emergency fund.  Financial experts often recommend keeping three to six month's worth of living expenses in a liquid cash account.  Use this savings if you lose your job, the furnace needs repair, or your car breaks down.  This prevents you from having to rack up credit card charges in the case of expected expenses.  Replacing the cash in the emergency fund should become a priority once you've tapped into it.

• Have a "luxuries" fund.  Too often, we stress the importance of saving for emergencies, but we're quick to pull out the trusty credit card for purchases like pricey gadgets, fashionable new clothing, or a vacation.  We all need a little luxury, but the price is high to be permanently in debt and pay finances charges on items long after we've used them up.  Keep a separate savings that you plan on using for extras, so that you can still have some fun while limiting the amount of debt you incur for those types of purchases.

• Keep your credit score high.  Your credit score has long been the determining factor for what types of credit or loan terms will be available to you, and it still works that way now.  Creditors are still granting credit, but they are taking less risks with people who have "iffy" credit.  Those with average or poor credit will find that they have less choices available to them, and even those with good credit may find that credit limits are lower, intro periods are shorter, or APRs aren't as great as they remember.  A score in the 700s is still considered favorable by creditors, and will increase your chance of gaining credit with reasonable terms. 

Sources:
money.cnn.com
smartmoney.com
wikipedia.com