US fintechs: Helping consumers avoid the debt spiral
Credit cards are a mainstay of American life. As many parents teach their kids, using a credit card responsibly from a young age can lead to both financial and practical benefits later in life, such as better rates on loans and greater access to housing.
But many Americans who start using credit cards with the intention of boosting their FICO score eventually fall into a debt spiral. As of January 2020, Americans owed nearly $1 trillion in credit card debt, with the average consumer owing $6,194.
Pragmatism with risk
For Americans, doing the bulk of their spending on credit cards is a question of pragmatism. Some of the benefits these cards offer:
Security. A credit card adds an extra layer between a person's bank account and fraudsters. Americans are less anxious about spending online when they can reclaim the amount from the card company in the event of fraud.
Rewards in the form of air miles, cash back and other gifts. For many consumers, not using a credit card feels like missing out. If you’re going to spend the money anyway, why not get something for it?
Protection from overdraft fees on checking (current) accounts Consumers don’t want to be penalised for mistakes. As long as it's paid off each month, a credit card essentially provides a free 30 day loan, which removes fear of slipping into the red.
Knowing the above, a sensible approach might be to do the majority of one’s spending with credit cards whilst paying off the balance each month.
The debt spiral
Whilst many start with this intention, life often has other plans. An expected bill can lead to carrying a line of payment, high interest rates kicking in and the start of a debt spiral.
Millions of Americans still lack health insurance, and those who are covered endure high deductibles and excesses.
This means many households are one minor health incident away from financial catastrophe, and if disaster strikes, many are forced to rely on their credit cards.
Once they start using their card, it’s hard to escape. Ideally, every family would have an emergency fund of 1-3 months’ living cost — but when high interest rates kick in and debts spiral, this becomes less of a priority than making minimum credit card payments. What’s more, since 2005 legislation makes it harder to declare bankruptcy, many feel their only choice is to sink further into debt.
There are signs that Americans are waking up to the risks of credit cards.
Dave Ramsey, a popular finance guru, recommends building an emergency fund before paying off debt. He preaches “the snowball method”, paying off the smallest lines of credit first to boost morale and gain momentum. His popular 'envelopes model' encourages people to assign each dollar a purpose and stick to it — i.e., sticking this amount in an envelope at the start of the month. Whether they know it as Ramsey’s method or not, most American households recognise the envelopes model, and many do something similar using a spreadsheet.
The fintechs taking on the Jobs of credit cards
Fintechs are helping in the fight against the debt spiral. Several have attempted to infuse some of the customer “jobs” that make credit cards attractive into their products.
Chime (the most established of the US challengers) offers a 0% interest credit card which lets customers build their credit rating without the associated risks. Similarly, Credit Karma tells customers the factors that influence their credit rating and recommends financial products specific to their situation, such as 0% balance transfer credit cards.
Several products including Chime, Varo Money and Current allow customers to get paid up to 2 days early, making them less likely to dip into a line of credit each month. They also offer consumers a $100 overdraft to cover unexpected expenses, without the usual crippling fee.
Mint and Clarity Money, which were recently acquired by Marcus, use open banking to aggregate account balances and transactions. This helps their customers make sense of their spending habits and plan for the coming months, effectively trying to replace the beloved budgeting spreadsheet.
Several fintech products are trying to integrate the envelopes model popularised by Ramsey. Chime has an automated savings feature that moves money into pots as soon as it’s received, and early-stage fintech Envel is building a proposition specifically around the notion of envelopes.
Challengers are even starting to offer rewards on their debit products. Revolut and N26 did just that on their entry into the US market. So-Fi’s credit card product offers rewards towards financial goals. Eco, a new product, leverages its ability to cut out intermediaries in the payments process to reward its customers.
Is it working?
It seems so. Chime, which leads the challenger pack, saw its customer base rise by 50% to 12 million during the pandemic. This was, in part, driven by customers’ desire to move more of their banking online. The share of “megabank” customers dropped nearly 7% between January and December of 2020.
There are also signs that Americans are moving away from credit cards. According to BAC data, debit card spending bounced back much faster than credit card spending after the initial pandemic- induced shock last year, perhaps reflecting a desire not to spend beyond one’s means during an uncertain period.
Americans paid off a record $83 billion in credit card debt in 2020, benefitting from reduced spending and stimulus checks.
At 11:FS we regularly speak to US consumers on behalf of our clients. Several consumers who have previously fallen into the debt spiral now do the majority of their spending with debit cards. This reduces the temptation to “dip into” a line of credit just because it’s available.
There’s a long way to go before America weans itself off credit cards, but there are signs that a personal finance revolution is underway — and that fintechs are leading the charge.