Surviving Debt

From outward appearances, you'd never know it. Went, 43, has a master's degree in education, and every day she drives a sensible Saturn from her home in leafy, affluent West Lafayette to her job as an auditor at the Indiana Department of Health. But under the veneer of respectable routine, she's something of a financial disaster. By 2006 her credit card bills and other debts had soared to $55,000, the financial fallout of a layoff she endured a few years earlier. Unable to keep up, she chose the nuclear option, filing for Chapter 7 bankruptcy, which involved selling most of her belongings to pay her creditors.

Today Went and her teenage daughter cut costs wherever they can: canceling their landline phone service, seeing movies only on DVD and splitting entrees during their rare dinners out. Went says, "I look at my life and I wonder, how did this happen to me?" But for a reminder of how she got here, she need look no further than her mailbox. Only a few weeks after the end of her bankruptcy proceedings, at a time when her credit score had plunged, she was preapproved for a $1,000 line of credit on a MasterCard. "It scares me that I could get a card," she says. But that hasn't stopped her from using it — after all, she needs to rebuild her credit history so she can borrow more someday.

It's no secret that the nation is swimming — drowning — in borrowed cash. According to the Federal Reserve, U.S. consumer debt has reached $2.43 trillion, or about $21,900 per household, a number that has nearly doubled over the past decade — and doesn't include $10 trillion in mortgage debt. Looked at another way, consumer debt today equals 132% of the average household's annual disposable income. It is a nationwide problem, of course, affecting a wide range of people, but it's become a growing headache for well-paid professionals who never envisioned having such problems. And increasingly, people like Catherine Went are proving unable to carry the load, a trend that's resulting in a steady flow of home foreclosures, credit card defaults and personal bankruptcies.

What's causing the debt crunch? Obviously, a lot of people have only themselves to blame, for an insatiable appetite to consume, for not saving enough and for poor financial planning. But bad habits are far from the only factor. Economists point out that debt has never been easier to acquire — or more unavoidable for those seeking the basic components of the American dream. Consumers didn't choose to raise the sticker price of a year at a public university by 35%, adjusted for inflation, in the past five years alone. They didn't anticipate that the median price of a home would increase by a third between 2003 and 2006, or that the income required to afford it would jump 55%, according to the Center for Housing Policy, a research organization, even as real wages fell by 1%. And consumers certainly didn't choose to be assaulted by the sophisticated information-sharing and marketing apparatus of an industry that netted record profits lending money. "There comes a point when access to credit is not a good thing," says Lauren Saunders, an attorney at the National Consumer Law Center. "Debt is being pushed and pushed and pushed on people."

In an environment where the average household credit card balance has more than tripled since 1990, survival means discipline — like being able to resist the lure of deals that bury the bad news in the fine print. And it means making sacrifices to free yourself if you're caught in the snare. To see how the credit struggle is playing out on a personal scale, SmartMoney caught up with a handful of solid middle-class Americans who are buried in debt trouble — but are starting to dig themselves out.

For most people, consumer debt is synonymous with the rectangular pieces of plastic stuck in their wallet. But it wasn't until the late '70s and early '80s that credit cards really took off as vehicles for debt accumulation. Improvements in data-processing technology and consumers' desire for convenience helped fuel the boom, but one of the biggest spurs was a landmark 1978 Supreme Court ruling. In Marquette v. First of Omaha, the court allowed the "exportation" of interest rates from state to state. In the financial-services world, this was a potential gold mine: Banks could issue their credit cards out of states like South Dakota, where legislators struck down state usury laws, applying those states' higher rates to their customers across the country. As a result, millions of cards are now issued every year nationwide with interest rates that top 30%.

Profit potential from the soaring rates has given banks even greater motivation to push their plastic. Today there are 1.5 billion cards in the U.S., almost five per person, and the average household has nearly $8,000 in credit card debt, up from an inflation-adjusted $1,800 in 1980. Credit cards are now considered a mature market — just about everyone who wants a card has one — so banks that issue them have ramped up the sales pitch. "Credit card companies want to hook people on credit," says Linda Sherry of advocacy group Consumer Action. "It's a way to get people into a life of debt."

For many Americans, that first credit card experience happens on college campuses: Three out of four college students now have one. Indeed, they're so ingrained in campus life that many schools are making marketing deals with the biggest card issuers — and raising a few eyebrows in the process. The University of Oklahoma, for example, recently signed a 10-year, $13 million contract allowing what was then First USA to offer a credit card with the school's logo. But many college kids aren't exactly wired for responsible debt management: Only seven states require a financial literacy course to graduate high school.

When Susan McLaughlin went off to college at Ohio Wesleyan, she didn't just get her first credit card; she got four of them. Her financial inexperience quickly showed, and she soon had rung up so much debt — "I bought myself some Gucci purses and a stereo system" — she needed her parents to bail her out. She cut up three of the cards, but kept a MasterCard all the way through a master's degree at the University of Maryland. Relatively low-earning entry-level jobs in education followed, and by the time she had settled into a job as a fifth-grade teacher in Hilliard, Ohio, she had accumulated about $15,000 in credit card debt. A third of it was on a card that jumped from 8% to 29.9% APR, after a single missed payment, and the rest was on a card that, at one point, reached 24%. Meanwhile, her husband, Erik Burgeson, himself a Spanish teacher, was juggling about $20,000 in loans he took out to pay for his master's degree. It was a precarious situation, and when Erik was forced into a lower-paying job in another school district, the powder keg exploded: Despite a combined income of around $115,000 a year, the couple was forced to borrow money from McLaughlin's father just to keep up with payments. No longer able to afford even Christmas presents, Susan felt humiliated and kept her woes a secret from her friends. "My colleagues would invite me to lunch and I'd say I couldn't go," she says. "I'd make up some excuse. I wasn't about to tell them I didn't have any money."

For many people, the response to debt is more debt, as they open one line of credit to pay off another, a vicious cycle that becomes extremely hard to break. In McLaughlin's case, the cycle involved refinancing into a new mortgage that doubled her payments after the introductory rate expired. Things deteriorated further when the couple bought a new home before selling the other one, leaving them juggling two mortgages for nearly a year. When she finally sat down to figure out how far in the hole she was, she "almost fainted," then went out and got a second teaching job. She sold off possessions and seriously curtailed spending on anything but necessities. Today she has precious little time to spend with her two-year-old son, Elijah, and her relationship with her husband is often strained. "Two master's degrees between us and we can't balance a checkbook," she says.

McLaughlin is one of countless Americans for whom appealing home loans have recently turned into debt traps. Adjustable-rate mortgages, or ARMs, have been hybridized into an array of products designed to appeal to buyers who have little cash up front or weak credit; they were aggressively marketed in the first half of this decade as home prices rose and interest rates declined. Interest-only ARMs are particularly popular; a cousin, known as an option ARM, has initial payments so small that they don't even cover the interest, and the principal on the loan actually grows over time. Once an introductory period ends, the interest can shoot up dramatically and, in some cases, become too expensive for the homeowner to pay. Default rates on subprime ARMs — those for borrowers with poor credit — hit 14.4% in the fourth quarter of 2006. Even in the broader "prime" population, default rates are 50% higher for ARMs than for fixed-rate mortgages.

Christine Wilson of Park City, Ill., fell afoul of the ARMs race. Four years ago Wilson, a legal secretary, and her husband, who is disabled and can't work, decided to respond to offers to refinance their 30-year fixed mortgage at historically low interest rates. At their bank, Wilson says, the mortgage expert quickly ran some numbers before suggesting an interest-only ARM. When pressed for details, Wilson says, he eagerly emphasized how low the early payments would be. Wilson, whose credit at the time was decent, had never heard of an ARM before. But she liked the sound of it and even transformed the loan into a cash-out refinancing, using the extra money to make improvements to the home and pay down her credit cards. She now realizes that she walked away with little understanding of the fact that rates would increase substantially down the line.

For two years she enjoyed slightly smaller payments, but when the mortgage reset in 2005, the payments increased by more than half. "The roof caved in," says Wilson, who blames herself for not researching the loans more thoroughly. Wilson, who makes about $50,000 a year, started racking up credit card debt in order to keep up with the mortgage. When the card balance swelled, she found herself scrambling to the bank again to beg for a home-equity loan, a move that in the long run made things worse. In a common practice, her bank had sold the loans to a second bank, and Wilson says the new banker declined to offer her further refinancing. Wilson fought for a few months, but ultimately, she had no choice but to surrender her home. For a 51-year-old woman beginning to think about retirement, it was a major blow. "We raised our kids in that house," she sighs.

As a recent Saturday Night Live parody of the debt crisis pithily put it, "Don't buy stuff you can't afford." Millions of Americans live far beyond their means, egged on by a product cycle that rolls out new iPods every six months and five seasons of clothing in a four-season year. But because personal discipline can curb this habit, many individual debt dilemmas are far from hopeless, as even hardened cases like Chicago's George Malleris have discovered.

Malleris first found himself on the wrong side of the debt equation in 1994, when he took on his new wife's $12,000 credit card debt. After a period of making only the minimum payments, he stopped to figure out how long it would take to pay the card off at that rate: 204 months, over which time he'd pay about seven times the balance. Alarmed, Malleris sought help from a credit-counseling company. Credit counseling is a surging industry that has come under scrutiny because many of the outfits function like glorified collection agencies, receiving fees from clients' creditors on recovered debts. Still, for Malleris, the counselor he chose, Debt Free America, proved a godsend. "I needed a payment program to get me straight," he says.

Malleris received a rigid schedule and was told to limit his spending. It wasn't easy, especially giving up the shopping excursions his wife enjoyed; indeed, fights over money eventually brought the couple to the brink of divorce. After two years Malleris slipped off the wagon, missing payments, incurring late fees — and he found himself in a worse hole than before. When he started looking for a house, he discovered, to his shame, that his credit was so bad he couldn't qualify for a loan; he had to pay a friend to take out a mortgage on his behalf. The irony: Malleris works for a big lender as a mortgage adviser.

After Malleris and his wife resolved their differences, they got back on their debt-reduction program and stuck to it, this time for good. In 2002 he and his wife, a full-time mom to the family's four kids, paid off the last penny of credit card debt. Then Malleris went to work on his credit score, buying a little bit each month with his cards, but always paying the balance in full. By the end of the year, he was approved for a mortgage. He could qualify for no better than an ARM with a whopping 8.25% intro rate that would balloon after two years. "At least it was something," says Malleris. Later, while continuing to repair his bullet-ridden credit, he refinanced. This January he finally signed on the dotted line on a good, old-fashioned 30-year fixed-rate mortgage. "I feel like a first-class citizen again," he says.