A credit crisis, also known as a “credit crunch” or “credit shock”, occurs when there is a rapid reduction in the availability of loans from banks. This occurs when loans go sour, forcing the banks to tighten up lending standards.
Credit shocks create both positive and negative effects in the economy. By examining these effects carefully, we can gain a greater understanding of how credit shocks work and what we can learn from them. Read on to find out more.
The Downside of a Credit Crisis
Credit shocks have several negative effects on both consumers and businesses. Some effects are felt right away, while others take time to be seen.
Consumers Cut Spending
As a credit crunch runs its course, the economy continues to slow. This creates a situation in which consumers are less optimistic about the future prospects for the economy and cut back dramatically on their spending. Since consumer spending accounts for 70% of economic activity, even a slight cutback in spending can cause the economy to slow dramatically. (Learn what consumer spending can indicate about the market in Using Consumer Spending As A Market Indicator.)
Banks Fear Making Loans
Credit shocks can create a situation in which banks are afraid to make new loans. This fear causes many businesses and consumers to cut spending dramatically, or even close their doors. This causes a ripple effect in the economy as more businesses struggle to survive and consumer wealth erodes.
Businesses Lose Access to Capital
When businesses do not have access to the capital they need to expand, pay expenses or pay bills, a liquidity squeeze can occur. This squeeze can force many businesses that have been thriving for years to shut their doors and let their employees go. (Find out how this economic cycle affects both small and big businesses in The Impact Of Recession On Businesses.)
Rising Foreclosures May Bring Property Values Down for Communities
If banks are forced to foreclose on too many borrowers, this can have dire consequences on communities. Not only do property values decline in communities where foreclosures are high, but there are several untold economic consequences as well. These include a loss of property tax revenues for both state and local governments, economic blight for areas being affected by waves of foreclosures and the failure of local businesses that are dependent on the community to survive. (Learn what you can do if your home is at risk in Saving Your Home From Foreclosure.)
The Crisis May Force the Government to Take Emergency Measures
As the economy becomes weaker and the credit shock spreads from Wall Street to Main Street, a cycle of economic weakness spreads throughout the country, creating rising unemployment and negative growth. This forces the government to take drastic measures to break the cycle once and for all by spending hundreds of billions of dollars to revive the economy. (Learn what measures the Federal Reserve takes in this situation in The Federal Reserve’s Fight Against Recession.)
A Falling Stock Market Eats away at Wealth
The credit shock and uncertainty about future earnings cause many investors to sell their stock holdings and move into safer investments. This causes the equity market to go into a free fall that eats away the values of 401(k) plans, IRAs and pension plans. Diminished nest eggs force many who were planning on retiring to work longer. (Learn how understanding the business cycle and your own investment style can help you cope with an economic decline in Recession: What Does It Mean To Investors?)
Consumers and Businesses Start to Panic
Left unchecked, credit shock can create a loss of confidence in the nation’s financial system. This causes many people to assume the worst and take drastic steps to protect what little wealth they have left. It is at this point that bank runs become more common and even more financial institutions collapse. (Learn how the SIPC and FDIC insure against personal financial ruin when banks or brokerages go belly up in Bank Failure: Will Your Assets Be Protected?)
The Upside of a Credit Crisis
Credit shocks can also create many lasting, positive changes. These changes can be seen in the aftermath of the crisis. Some of the positive effects of a credit shock include the following:
The Economy cCeans Out Excessive Debt and Spending
During good economic times, many businesses and consumers increase their overall debt. This behaviour is fuelled in part by businesses’ need to expand and in part by consumers who are feeling good enough about the economy to make large purchases without worrying about what will happen in the future. (Read Five Signs That You’re Living Beyond Your Means to learn whether you’re in this risky group.)
But while the economy will continue to expand and debt levels will rise for a while, at some point, the economy will slow down and many who overextended themselves during the good times will be forced to live within their means or may even fall behind. As businesses and consumers are forced to cut back, some will stop making payments on their debts, forcing financial institutions to write the bad loans off. These forced write-offs, either by the banks themselves or through government intervention, will cleanse the financial system so that businesses can have strong balance sheets and consumers who were once tapped out can increase their spending without being burdened by large amounts of debt.
Corporations Clean Up Their Balance Sheets
Businesses can use debt to expand and increase their overall profits. However, debt can be a double-edged sword: during recessionary times, the amount of overall debt that businesses took out during the last expansion can cause the company to face liquidity problems. By writing off the bad debt on their balance sheets, businesses become leaner, can weather the slowdown and can expand even more when positive growth returns to the economy. (Learn about the role of debt in determining corporate health in Debt Reckoning.)
Transparency and Regulation in the Financial Sector Improve
A financial crisis can expose the loopholes in regulations that people were taking advantage of – loopholes that may have contributed to the crisis. The government then reacts by creating new regulations to address the situation. Over time, these laws bring confidence back to the U.S. financial system and leave investors feeling secure again. (Learn about the role of confidence in the economy by reading Understand The Consumer Confidence Index.)
Hard Times Force Consumers to Regain Control of Their Spending
During times of expansion, many consumers try to keep up with the Joneses by living beyond their means and accumulating more debt than they can handle. Credit shocks force consumers to rein in their spending and lead lifestyles that are more appropriate to their incomes. People then regain control of their finances and cause the national savings rate to increase. (Learn how to keep your spending under control every day in Squeeze A Greenback Out Of Your Latte and Nine Reasons To Say “No” To Credit.)
Declines in Stock Prices Create Great Long-Term Valuations.
During the crisis, when everyone is panicking and selling both good and bad investments, many smart investors are buying those good investments and holding them long-term. Once the crisis is over and the chaos has died down, they make tremendous profits. Some of the more well-known investors who have employed this strategy, include Warren Buffett, Sir John Templeton and Benjamin Graham. (Bear markets can terrify even seasoned investors. Learn how to invest safely in Four Tips For Buying Stocks In A Recession.)
Credit shocks have many negatives, but they also create opportunities. During times of economic crisis, it is important to keep a clear head and not get caught up in the fear. Left unchecked, large-scale fear can wreak havoc on the world economy. But over time, every crisis will end and the economy will begin to expand once again.
At first, the credit crisis didn’t affect consumers unless they were shopping for credit cards or loans. Not anymore, anyone who has a credit card is at risk of the effects of the credit crunch. As credit card issuers cut credit limits and increase interest rates with little notice, it’s more important than ever to pay attention to what credit card issuers are doing and to adjust accordingly.
Interest Rate Increases
In November 2008, Citibank announced it would increase interest rates for nearly 10 million cardholders. About Credit/Debt Management readers reported double and even triple interest rate increases that skyrockets their cost of carrying a credit card balance.
Consumers have a few choices when it comes to responding to interest rate increases. While many choose to opt-out, it’s not always the best decision. Opting-out nearly always leads to your credit card being closed. Since a closed credit card can affect your credit score, opting-out could hurt you worse than it hurts your credit card issuer. In some cases, paying off the balance at the higher interest rate is better, especially it if means saving your credit score.
Credit Limit Cuts
Neither good credit nor customer loyalty seemed to matter as American Express slashed credit limits by thousands of dollars. One reader, Jennifer says of her credit limit:
“SLASHED! And I have a credit score of over 800! I got my email yesterday that my AMEX Blue, credit limit of 30,000 was being reduced to 6000. I ‘was’ a very loyal and happy customer. I have never had a late payment, etc etc. I use this credit card for my consulting business so I charge a lot of things for my clients. I need at least 20K per month. [...] Bye bye AMEX.”
And ‘jab’ comments,
“I have been a loyal AmEx customer for over 12 years… never late with a payment and always paid more than the minimum… They cut my limit from $14,000 down to $2000 today (I have a balance of about $1500)…Now it looks like I’ve used 75% of my credit!”
Credit limit cuts are another thing to look out for during the credit crisis. You might not receive your notice before the credit limit decrease takes an effect, so it’s a good idea to double check your limit before making purchases on your credit card. You can’t take for granted that your limit is the same as it was the last time you checked.
Difficulty Getting New Credit
Credit card and loan delinquency rates continue to increase. As a result, banks are unwilling to lend to each other and even less willing to lend to consumers. Without an excellent credit score, you’ll have a hard time getting a credit card or loan during the credit crisis.
Interest rate hikes and credit limit cuts characterize the credit crisis. No one with a credit card is safe. Learn what you can do to protect yourself from the effects of the crisis.
Read Your Billing Statement Inserts
A lot of people simply throw away the extra papers that come with credit card billing statements, but many times that’s where your interest rate and credit limit notifications appear. Make sure to read everything that comes with your billing statement. Even double check your interest rate and credit limit on your actual billing statement so you’ll be aware of any changes.
Transfer Your Balance
You can respond to interest rate increases and credit limit cuts by transferring your balances to a credit card with better terms. Unless you have an excellent credit score, low introductory rate balance transfer credit cards may be difficult to find. You may be able to transfer credit card balances to one of your existing credit cards that has a lower interest rate or higher credit limit (or both).
Watch Out for False Promises of Help
There is no shortage of ads made by businesses who claim to be able to help you improve your credit or get out of debt or even both. The truth is many of these companies will take your money and leave you with just as bad, if not worse, credit than when you started out.
Debt settlement, debt negotiation, debt consolidation, and credit repair companies are a few of the businesses to watch out for. Seldom will any of these actually help you. There are legitimate credit counseling agencies, but you should be careful when choosing one because bad apples are out there.
Know Your Credit Score
Check your credit score before applying for a loan or credit card. These days, a good score is 720 vs. the 620 cutoff in the days of easier credit. If you don’t have a good credit score, delay your applications until you’ve had an opportunity to improve it.
Get a copy of your free credit report and review it to make sure there are no errors bringing down your credit score. Bringing any delinquent accounts current and paying down high credit card balances will improve your credit score and your chances of getting loan or credit card approval.
Can Anyone Dodge the Credit Crisis?
Consumers who don’t carry a credit card balance will be least affected by the effects of the credit crisis. Without a credit card balance, higher interest rates mean little since there won’t be any finance charges to worry about. A credit limit cut could hurt depending on whether there are other credit card balances and the amount you charge on your credit card monthly.
Tax hikes, state spending cuts, spiralling debt, growing unemployment and rising base rates will test even the bravest throughout 2019. Are you tough enough for it?
Defuse the debt timebomb
The clock is ticking, you have to act fast. Even if you can handle your debts now, what happens when interest rates rise? Hunt down every debt, starting with the most expensive first, and dispatch them with extreme prejudice.
Snowballing isn’t a game. Slay that store card. Crush your credit card. Take that overdraft down. Then turn your sights on your mortgage, because when interest rates climb it could blow up in your face. Debt is your biggest enemy – Destroy it now, before it’s too late.
Slash your spending
To survive, sometimes you have to be cruel. So line up your soft little luxuries, and hack them to shreds. Take a knife to your daily cafÃ(c) latte, choccy biccy binge, after-work pint or regular takeaways.
Next, tackle the essentials. Spending too much on your weekly shop? Website Mysupermarket.co.uk can help you forage for the best deals.
Stalking a bargain? Try Frugal Friday, our weekly round-up of the week’s top bargains. Scavenge through your kitchen cupboards for forgotten tins, jars and packets of chow. Some people could live for weeks on what they find. Or brave the elements and grow your own fruit and veg.
Outwit the taxman
He’s clever, he’s cunning, he’s cruel and he understands the tax game better than you ever will. But that’s no reason to admit defeat, because you have some pretty mean weapons at your disposal, such as your tax-efficient ISA allowance.
It’s got quite a kick and, better still, it automatically reloads every 6 April. You have £7,200 worth of tax-free ammunition this financial year (£10,200 if you’re over 50), and £10,200 next year. If you want more ammo, there’s also pension tax relief. You hate tax so much you can taste it. Use that to your advantage. Lock and load!
Know your enemy
Your bank is not your friend. Your credit card is not your friend. Your overdraft is not your friend (even if it is authorised). Your utility supplier is not your friend. Retail therapy is not your friend. You owe them zero loyalty. Once they have served their purpose, get rid of them.
And watch out for enemies lurking in the bushes. Hide your identity from ID thieves. Evade foreign currency thieves. Protect your credit record.
Keep a clear head
Your mobile phone is a practical tool, not a costly symbol of your identity. If you’re selling your house, make sure your estate agent doesn’t rip you off. Don’t pay when you can get stuff for free. Be rational, fight superstition. Feeling cold? Don’t turn up the heating, put on a jumper.
Get some back-up
Even the toughest can’t do it all on their own. If you’re up to your neck in debt, there is no shame in calling in free and confidential support from a specialist such as Citizens Advice, the Consumer Credit Counselling Service or PayPlan. These guys know what they are doing.
But watch out, others will betray you, such as debt advisory services that charge a fee for setting up a debt management plan or IVA. Stick to those you can trust.
Adapt and survive
OK, so you can’t switch mortgage now, because your loan-to-value is too big. That may change, as lenders ease their criteria. Keep watching, keep waiting, and when you spot a better deal, pounce.
Your savings account may have been a killer when you took it out, but today you’re the victim. Turn the tables on your bank by switching to a better deal.
Lost your job? So fight back, right here, right now. Spare a thought for the future. If you don’t have any pension, retirement really will be a survival course.