Attitudes toward Using Credit for Loss of Income

Lee, Jonghee, Hanna, Sherman D., Consumer Interests Annual

The non-business bankruptcy filing rate doubled between 1990 and 2004, and then increased even more because of the impending change in bankruptcy rules. Was part of the increase due to changing attitudes toward credit use? This study analyzes consumer attitudes about whether it was acceptable to borrow money to cover living expenses when income is cut. Based on a logistic regression model with a combined sample of the SCF datasets, respondents in 2001 and 2004 were more likely than respondents in 1998 to think it was acceptable to use credit to cover living expenses, but attitude changes do not seem consistently related to changes in the overall bankruptcy rate. The rate of having a positive attitude toward credit decreases strongly with age and increases with income, even after controlling for other factors. Households that spent more than income, had low comprehensive assets and non-couple households were more likely to have positive attitudes toward using credit to cover living expenses. A better understanding of this credit attitude can assist consumer educators, financial advisors, and policy makers

in helping consumers who might be engaging in risky financial behaviors.

Introduction

Access to credit has increased substantially during the past 30 years in the United, with the increase in credit cards. Along with the increase in credit access, bankruptcies have increased in the past 20 years, to the point where almost 9% of all households have experienced a bankruptcy (Marcuss, 2004). Figure 1 shows the increase in non-business bankruptcy rates over the past 25 years. The decision to file for bankruptcy is typically triggered by unforeseen adverse events such as job losses or uninsured illnesses (Athreya, 2004). However, Marcuss (2004) suggested that the frequency of such triggering events has not increased. The increase in filing rates might be attributed to a decline in social sanctions for promise breaking and the loss of a sense of shame people feel when such values are internalized (Buckley & Brinig, 1998). Changes in social norms related to credit might have led to changes in consumer attitudes.

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It might be rational to plan on using credit rather than to save for emergencies (Chang, Hanna, & Fan, 1997; Hatcher, 2000), although such a strategy has risks for those who do not consider the potential costs of not being able to pay off credit balances. Financial educators suggest that households hold enough emergency funds in cash equivalent accounts to cover three to six months of expenses (Greninger, Hampton, Kitt & Achacoso, 1996). However, only 30% of households in 1998 had enough monetary assets to cover three months of expenses (Bi & Montalto, 2004). Using credit for living expenses may be risky, because they do not create assets that the lender can claim (Black & Morgan, 1999). It could take a household many years to pay back credit card balances over a period of time and end up costing them much more in the future, therefore leaving them in a more vulnerable financial position. Further, filing for bankruptcy results in a lower credit rating and a constrained access to credit in the future (Board of Government of the Federal Reserve System, 2006).

Some observers have suggested that attitudes toward credit have become more relaxed, as consumers are willing to borrow more, and to borrow for seemingly riskier purposes (Black & Morgan, 1999). Castellani and DeVaney (2001) analyzed attitudes toward credit use for living expenses, using the 1995 Survey of Consumer Finances. They found that a positive attitude for using credit to cover living expenses was related to age groups younger than 55, racial groups other than White, low income groups, and those with a history of late credit payments. A better understanding of the likelihood of risky credit usage when income is cut can assist consumer educators, financial advisors, policy makers and counselors in helping consumers who have potentially risky credit behavior.

The remainder of the paper is organized as follows. Section II describes background information, the theoretical framework, and reviews the determinants of attitudes toward credit used in the current study. Section III describes our model of determinants of having positive attitudes toward credit when income is cut. In Section IV, we present descriptive results for the patterns during the 1995 to 2004 period for attitude toward credit when income is cut. We also present multivariate results. Finally, Section V includes our conclusions and implications.

Created by authors based on information from uscourts.gov and census.gov.

Background Information and Theoretical Framework

Economic Perspective: Life Cycle Theory

The life cycle theory of consumption attempts to explain household consumption and saving over lifecycle stages. This theory focuses on the systematic variations in income and in "needs" which occur over the life cycle as a result of maturing and retiring, as well as changes in family size. Because the retirement span follows the earning span, consumption smoothing leads to a humped-shaped age path of wealth holding (Modigliani, 1986). Therefore, consumers are expected to borrow against future earnings during their early stages when income is low, save more during their most productive period, and consume accumulated assets after they retire. If we assume that attitudes toward credit are related to whether borrowing is a good idea based on the prescriptions of the life cycle model, consumers' willingness to borrow and use their credit will change over the life cycle. Consumers will have more positive attitudes toward credit earlier in life and more negative attitudes toward credit in later life. Consumers' willingness to use credit will depend on expected changes in their income and changes in household size.

Fan, Chang & Hanna (1993) demonstrated the importance of the consumer's expectation of income growth, as well as the probability of that income growth taking place, in determining optimal credit use. For a plausible level of risk aversion, a consumer who was at least 95% certain that real income would increase substantially would optimally use credit even at high real interest rates. Chang, Hanna, and Fan (1997) showed that the expected income growth and the probability that income would grow should be related to holding emergency funds, and that the probability of holding enough emergency funds was negatively related to expected income growth. Therefore, households that expected income to grow might rationally decide to rely on credit for emergencies rather than building an emergency fund. Hanna and Rha (2000) presented an expected utility analysis of the effect of children on optimal credit use. All other things being equal, a household with children would rationally use more credit in order to have higher consumption while the children were at home, compared to the future periods when the children would have left home.

Thus, from a life cycle perspective, when current period income exceeds permanent income, people are expected to save, and dissaving is expected when current period income is less than permanent income. The purpose of an emergency fund is to cover unforeseen events or emergencies that result in the current period income being insufficient to meet the current period consumption. Emergencies can result in unexpected decreases in or loss of current period income, or unexpected increases in consumption. When current period income is less than consumption, resources other than savings, such as the use of credit or borrowing against assets, may be available in the event of an emergency and may be useful substitutes for emergency savings to cover the temporary gap (Bi & Montalto, 2004).

Empirical Studies With Attitudes Toward Credit

Durkin (2000) used interviews with …

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Publication information: Article title: Attitudes toward Using Credit for Loss of Income. Contributors: Lee, Jonghee - Author, Hanna, Sherman D. - Author. Magazine title: Consumer Interests Annual. Volume: 53. Publication date: Annual 2007. Page number: 59+. © 2007 American Council on Consumer Interests. COPYRIGHT 2007 Gale Group.

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