Friday, February 2, 2001
The Perils of Plastic in a Downturn

Entrepreneurs can cite any number of reasons for borrowing against credit cards. With the economy cooling, however, high-interest debt can be a lethal liability  

Starting her fourth year in business, Sheryl Woodhouse-Keese is planning to hire employees this spring and outgrow the space in her home devoted to designing and producing handmade invitations, cards, and other paper goods. But she's not so successful that she has the cash to pay the $4,000 it will cost to attend a trade show in Philadelphia. That expense is going on her credit card. With the proceeds from the sales she makes at the show, she intends to hire some help and pay off -- or at least pay down -- the credit-card bill.

Last year, the profits from her business, Twisted Limb Paperworks in Bloomington, Ind., were "about $20,000" on sales of "about $40,000," says Woodhouse-Keese. That represents double the sales of the year before, and she expects to see her figures double this year, too.

Like Woodhouse-Keese, most self-employed people are optimists. Also like her, many finance their businesses, at least partially, on a personal credit card.

SCARY STUFF.  Debt, both the corporate and consumer variety, is seen as the bogeyman waiting to pummel this economy into a recession. Corporate bond defaults are expected to reach a record high this year. Bad loans on banks' balance sheets are regarded by some as the reason behind the Federal Reserve Board's aggressive interest-rate cuts in January. Credit-card debt is pegged at a record $500 billion-plus. Where is small-business debt in this picture?

"We can't really get a handle on the consumer debt that's feeding small businesses," says Robert D. Manning, an economic sociologist and author of the new book, Credit Card Nation. Now that many small businesses are financed with credit-card debt or home-equity loans, rather than traditional loans from a local lender, it's difficult to measure both small-business debt load and the perils it implies as the economy cools. But anecdotal evidence suggests cause for concern:

-- At the "Shoptalk" phone line operated by the National Association for the Self-Employed, members frequently request advice about getting a loan to consolidate debts. It's a much bigger topic than it was 10 years ago, says Gene Fairbrother, the consultant who has been answering members' questions for more than a decade.

-- The percentage of self-employed households carrying credit-card debt was 47.5% in 1998, up from 29.4% in 1989, according to a Federal Reserve study of consumer finances.

-- A 1998 Arthur Anderson/National Small Business United report cited by Manning notes that 47% of small and midsize businesses financed expenses with credit cards. Nearly twice the level of two years earlier, it surpassed commercial bank loans, private loans, and SBA loans.

-- When the Texas legislature was considering changes in lending laws last year to permit home equity lines of credit, documentation in support of such a move cited the fact that 56% of the state's small businesses were financed with credit cards and needed the lower interest, home-equity "alternative."

Economists who work with small-business organizations see several reasons for the increasing use of credit cards. Begin with the consolidation in the banking industry, which has eliminated many local lenders. Next, in a service economy, there is the likelihood that a small-business owner will lack the inventory to serve as collateral for guaranteeing a bank loan. Finally, many entrepreneurs have little training -- either in college or from working in a family business -- and are ill prepared to lay out the sort of business plan that lenders require.

WHAT, ME WORRY?  Lack of a business plan is one of the reasons Woodhouse-Keese never looked into getting a bank loan. "Several times I sat down to create one," she admits, "but then I would look at my to-do list...I can barely keep ahead on creating my products." Her relatively small credit-card debts don't bother her, she says, because she takes advantage of the low "teaser" rates issuers offer, and because the interest is tax deductible as a business expense. Besides, says Woodhouse-Keese, her sister applied for a small-business loan to finance her publishing company, and was offered rates of 12% to 13 percent. "That's worse than a credit card," she sniffs.

"What's really tragic is that they're making it sound like these credit cards for small businesses are a special service," says author Manning, who notes that the cost of borrowing on credit cards (17% on average) has doubled over the past 20 years.

Small-business owners pay an average 10.4% for short-term commercial bank loans, according to the monthly survey by the National Federation of Independent Business. The majority of entrepreneurs, however, don't get such loans: one-third of small businesses received bank financing in 1999, vs. better than half in the early '80s.

"I won't even go to the bank and go through all the rigmarole," says dietician Kevin Kelly, who started his nutrition-counseling and food-safety business, Forever Healthy, four years ago in Fargo, N.D. At the time, he had trouble refinancing his mortgage because of some $20,000 in student loans. So he put "$2,000 here, $2,000 there" on his credit cards to cover business expenses.

DESPERATE MEASURES.  He knew debt would be part of the picture when he quit his job to return to school with the idea of becoming a self-employed nutritionist. "My wife and I talked for six months about what we were going to do," he says. "We knew we would get into debt. We knew our savings would take a beating." Kelly shrugs off the possibility of an economic downturn, explaining that his business has diverse sources of revenue and, if things turn really sour, he can always get a job working for someone else.

Many small-business owners, though, are very reluctant to work for wages. "If the spending decreases within the general economy, the small-business owner will go to large extremes to keep their doors open," says Fairbrother. "That means credit cards, home equity, whatever it takes."

Otherwise-prudent spenders tend to justify business expenses as investments -- even if they don't have a clear means of paying them off. Someone who wouldn't put $15,000 worth of home furnishings on a credit card may be less reluctant to spend the same amount on office equipment, says Kevin Scott, spokesman for the National Foundation for Credit Counseling. "Even though we caution people not to mix business debt with personal debt, it's not uncommon for our counselors to see serious debt load on credit cards because [clients] have financed their business with it."

The Small Business Administration office in San Antonio, Tex., formed an alliance with the nonprofit Money Management International, parent of the Consumer Credit Counseling Service, because it was seeing so many small-business owners with too much credit-card debt.

BOOM AND BUST.  "I feel bad about saying this, but business is getting better with these mouth-dropping layoffs in the economy and the overwhelming debt that consumers have accumulated in the past five years," says Rudy Cavazos, a spokesman for Money Management International in Houston. "We are seeing a lot of self-employed people coming in with high credit-card debt." After dropping slightly in 1999, personal bankruptcies are expected to reach a record high of 1.4 million next year, according to SMR Research in Hackettstown, N.J.

"Five thousand, 15,000 on a credit card is inconsequential as long as the economy is doing well," says Manning. But if a recession hits, "We don't know how strict, and how panicky, banks are going to be. If a bank is looking at a family with $25,000 in credit-card debt, will they raise the limit?"

In this economic climate, with growth nearly nonexistent and consumer optimism at the lowest point in eight years, Manning and others advise small-business owners to pay down debt and compile a business plan so they can see their finances more clearly. "The whole credit situation in this country is like an athlete on steroids. It was never as good as we thought it was," says Manning.

If the economy dips into recession, many small-business owners may decide that their credit-card financing isn't the good idea they once believed.

By Theresa Forsman in New York
Edited by Robin J. Phillips