Living on Cash to Avoid Debt?

TheStreet.com

NEW YORK (MainStreet)—Living on cash has several distinct advantages for consumers who are seeking to slash their budgets by spending less and saving more money.

Using only cash or debit cards to pay for your expenses is becoming more popular as consumers are shying away from amassing large amounts of credit card debt and accruing interest.

Creating a budget that eliminates all non-essential expenses and evaluating it weekly helps consumers get started with this option, said Rakesh Gupta, a professor in the Robert B. Willumstad School of Business at Adelphi University in Garden City, N.Y.

Heeding the rule of paying yourself first is also critical, he said.

"This means setting aside a tangible sum, say 10% of each paycheck in savings or investments, before spending it," said Gupta.

Before you stop using credit cards completely, it is a good idea to set aside at least six months of savings and the cost of any potential repairs or emergencies, said Mike Sullivan, chief education officer for Take Charge America, a national non-profit credit financial education and counseling agency based in Phoenix, Ariz.

"The big advantage is you are never going to be in debt," he said. "It's a wonderful thing. A lot of people don't have the discipline and need to try this. It is a good alternative."

Paying for expenses only with cash is becoming a growing trend, but some people were forced into this choice when credit became tight and obtaining debt became difficult.

"We have just gone through an age whose hallmark was instant gratification, and the financial system made it possible through easy credit," Gupta said. "The result was mounting consumer debt to the point that people had negative savings. Then the financial crisis hit and easy credit dried up."

Eliminating or decreasing the use of credit cards can easily enforce a consumer to save more, Gupta said.

"If people begin to live within their means, with the provision for some savings, then over time those savings will accumulate," he said.

Boosting your savings is becoming more popular in this economy, Gupta said. For the first time in many years, consumer debt has declined and the savings rate has increased. According to the NY Federal Reserve, U.S. household debt had declined from $12.68 trillion in 2008 to $11.34 trillion in 2012, he said.

Choosing not to pay your bills with a credit card can increase your credit worthiness, he said.

"If you are living on cash and paying your bills including credit card bills, the chances are that your credit score will improve because your debt balances will be declining and your credit worthiness will be improving," he said.

Since using debit cards do not help build a credit history, consumers should consider making small purchases using a credit card and repaying the full balance on time every month, said Kevin Gallegos, vice president of Phoenix operations for Freedom Financial Network, a consumer credit advocacy services provider

Payment on a student loan or car loan helps build a credit history, as does paying every single bill such as rent, phone, Internet and utility bills on time and in full, he said.

Using only debit or pre-paid cards over the long run will affect your credit score. Most lenders use the FICO score to assess your credit, the amount of money you can borrow and the amount of interest you will pay.

"The system is definitely tied in favor of people who use a lot of credit," Sullivan said. "You get penalized if you decide not to use credit. It is the way things are. It is unlevel playing field."

Eliminating the use of credit cards also affects other aspects of your personal finance. It will affect your insurance rates, make it harder to lease an apartment or house or obtain a security clearance for a job, he said. Some companies require a credit check as part of the employment process.

"There is a cost or disadvantage of living off the credit grid," he said. It can really define your life more than you intended."

Instead of relying solely on debit cards, Sullivan recommends that people pay off their credit card debt and use it a few times a year to maintain their credit history.

Consumers have shifted their spending habits since the recession, said Ben Woolsey, director of marketing and consumer research for CreditCards.com, an online credit card marketplace, based in Austin, Tex.

Credit card ownership has been relatively flat over the past number of years, he said. The number of debit cards tied to checking and pre-paid usage has taken off significantly in the past five to ten years.

"It seems to be a continuing trend," he said. "It forces you to live within your means because you make an immediate sacrifice. It reins in your spending and keeps you from getting into trouble."

Consumers who use credit cards for purchases tend to spend 20% more, according to some studies.

Since debit cards do not operate like credit cards, there are several drawbacks, said Woolsey. When you need to access a credit line such as purchasing an airline ticket or making a hotel reservation, some companies require using a credit card. Even paying for gasoline at the pump requires a certain balance on the card before the transaction can be processed.

Buying items with a credit card can also give you other free benefits such as merchant dispute rights, protection against fraud, extended warranties or car rental insurance, he said.

"It's not a bad idea to use credit to only use when it's needed," said Woolsey. "It comes out to be a win-win situation if you use it that way."

One drawback to using debit cards is the potential to incur overdraft fees, said Claes Bell, a senior banking analyst based in North Palm Beach, Fla. for Bankrate.com, an online personal finance publisher.

Linking your checking account to your savings account will help prevent this problem since the average overdraft fee for one purchase is $31.26, he said. Checking your balance online or obtaining text or email alerts when your balance falls below a set amount will help you avoid unnecessary overdraft fees.

"Overdraft fees can be a big deal," Bell said. "They can cascade quickly by buying a few small items and wipe out the benefits."

The number of people using pre-paid cards nearly tripled from 2008 to 2012, he said.

Be aware of other fees that pre-paid cards charge. While some of them allow you to have your paycheck direct deposited, not all accounts are FDIC insured.

Keith Tully, 38, a financial representative with Northwestern Mutual who lives in Queens, N.Y., has relied on using his debit card solely since 2007 even though his wife still uses a credit card for her purchases.

"I didn't like being in debt and I was determined to get out," he said. "I had always hated carrying cash and I used my credit card for everything. As soon as the debit card came out, I started using it and I never turned back."

Tully said this choice has helped him and his wife stay out of debt for the past seven years.

"It seems to be working for us," he said. "We have never run out of money as I feared we would. At first, I thought it was going to be harder to spend well and instead I used only what was there in the account. We have actually budgeted better. I now plan to do use our new system forever."

--Written by Ellen Chang for MainStreet

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