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How Would a U.S. Default Affect Consumers?

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As recently as last week, the story about Washington's wrangling over the debt limit seemed like inside-the-Beltway baseball.

But now, with the week nearly over, and yet still no agreement, the potential ramifications of political dickering are hitting all too close to home for many Americans.

We all know the basics: If the government doesn't approve an increase in the nation's $14.3 trillion debt ceiling by next Tuesday -- August 2 -- the U.S. will be perilously close to defaulting on some of its loans. And even if Congress manages to pass the ceiling hike, rating agencies like Standard & Poor's and Moody's (which, might I add, have suddenly decided to do their jobs, after being asleep at the switch throughout the mortgage crisis!) seem ready to downgrade the triple-A rating on U.S. Treasury bonds at any moment.

President Obama summed it up best when he used the word "dysfunctional" in describing the way Congress is handling this admittedly avoidable situation. To me, it conjures up a couple loudly arguing in the mall about whether they should use another credit card when they have so many bills that they've already racked up. Debt can be overwhelming to anyone, but talk about airing one's dirty laundry in public.

Not a proud moment for America, for sure.

What's been particularly interesting about this recent situation is that expert investors have reacted to these developments with what can be called a big yawn. "The bond market has been saying this is a non-event," says Peter Crane, president of Crane Data and the country's leading expert on money market mutual funds.

Fair enough. But as more and more news reports raise red flags about the meaning of a default or downgrade for Main Street, now is the time to pay attention to the following:

1. Your investments

Although I think the doomsday scenario is overblown -- there is little chance that the government will allow itself to default -- many people are beginning to ask questions.

My biggest piece of advice: Stay the course. If you've been checking in yearly with your 401(k) and IRA statements, for instance, hopefully you have made sure that your investments are spread among the appropriate mix of stocks, bonds, and money funds. If so, whatever happens in the short term shouldn't have a big impact on your long-term retirement goals. If not, now is the time to make sure that you are truly diversified.

Here's an example. About 10 years ago, analysts recommended that individuals with retirement accounts put only 10 percent of their stock holdings into an international mutual fund. Today, a growing number of advisors I admire recommend that you put closer to 20 percent of your total stock holdings in a broad mix of international stock mutual funds. "It's smart to include Europe, the Pacific, and emerging markets," says Jason Scott, managing director of the research center at Financial Engines, the retirement advisory firm founded by Nobel laureate William Sharpe.

One of the big worries right now: What if I'm holding long-term Treasury bonds and the U.S. government defaults or the bonds get downgraded? The answer, in either case, is that yields will be pushed up to attract new investors to these bonds, which will no longer be considered as safe. When yields go up, bond values fall. That's just how bonds work.

However, most analysts I spoke to say that they are not worried about super-safe money market funds "breaking the buck," despite what some articles claim. The reason: If the rating agencies decide to downgrade Treasury bonds, they would be doing so to the long-term bonds. This would not impact money market funds, which hold very short-term IOUs. So if you keep a chunk of money in money funds, your investment is safe, according to Gus Sauter, Chief Investment Officer of the Vanguard Group. "The U.S. money markets continue to be the deepest and most liquid in the world, and will remain a safe and stable place for investors," he said. Even if there's a downgrade, he and others note, it's still among the highest quality credit available. "We believe that Treasury bills will remain liquid under any scenario -- even the extraordinarily unlikely scenario of a default," he added.

Although true diversity can mean exposure to all asset classes, despite the temptation, you may want to steer clear of gold. Since it's considered the "go-to" asset in severely troubled economic times, gold has recently hit its all-time nominal high of $1,600 per ounce. Buying at a high tends to be a bad move. And, as in the case with all investments, research shows that it's impossible to outguess the market over time. Those who try end up making big, losing bets -- and incurring expensive transaction costs since they are charged fees every time they buy or sell on a hunch.

2. Your bank account and your cash

One prominent writer recently said that it was time to pull money out of the bank to avoid long lines and panic at the ATM if Congress doesn't increase the debt ceiling. Although it makes an interesting visual, no one expects a run on the banks any time soon. Unless you have more than $250,000 in any one federally insured account at a bank or credit union, your money is protected by the Federal Deposit Insurance Corporation (FDIC). So in order for you to lose your money, the institution would have to fail and the FDIC would have to go belly up, as well. Even a so-called "technical default" by the U.S., which is the term given to a situation in which the government is unable to pay its bills, or a downgrade of our bonds by one of the rating agencies, would not result in this type of financial catastrophe, experts say.

It's possible, however, that your dollar may not stretch as far in the supermarket or at the mall if the government doesn't get its act together. If the dollar becomes weaker relative to other currencies, the cost of imports -- including cars, gas, toys, furniture, even food -- increases.

In the case of a default, you may experience a cash crunch if you are expecting a check from Social Security or Medicare, or if you're receiving unemployment insurance, Pell Grant payments, or disbursements from any other federal programs.

3. Your loans

Whether or not the debt ceiling gets lifted, or bonds get downgraded, there's a strong likelihood that interest rates will rise on all loans -- including mortgages, credit cards, car loans, and many types of student loans. That's because interest rates on these types of loans are closely correlated to the yields on long-term bond rates, which are in turn influenced by the market's expectations of how well the economy will do in the future. These days, the outlook is weak, and so many analysts expect yields and interest rates to rise.

So what does this mean? If you're locked into a home loan, currently at 4.5 percent, lucky you. But if you're just starting to house hunt, or trying to refinance your current mortgage, you should hurry to lock in a low rate as quickly as possible.

Credit card interest rates will go up, too. The average rate is currently 14 percent, but credit card companies love to use any excuse to raise rates for customers. Beverly Blair Harzog, credit expert for Credit.com, guesses rates could rise as much as 1 percent or a couple of percentage points. If you have a good credit record, look for a low-rate card at Bankrate.com.

For college and grad students, rates on private student loans will go up. Typically those loans haven't gone above 25 percent, but legally speaking, there's no real limit to the interest they can charge, says Mark Kantrowitz, founder of FinAid.org, a terrific site offering the best information on financial aid. The good news for students with federal loans is that they do have caps: 6.8 percent for Stafford loans and 8.5 percent for PLUS loans. A tip for grad students: Stick with the Grad PLUS loan, which is also capped at 8.5 percent, but does not have a maximum on the amount you can borrow. That's a real advantage of the federal program -- and an example of how, sometimes, the government really can do the right thing.

Of course, in the end, it's the best guess of analysts, observers, and pundits that the powers that be will not allow the U.S. to default on its obligations. After all, losing the value of "the full faith and credit" of the U.S. would be more than a big loss to our wallets.

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Beth Kobliner is a personal finance commentator and journalist, the author of the New York Times bestseller "Get a Financial Life: Personal Finance in Your Twenties and Thirties," and a member of the President's Advisory Council on Financial Capability. Visit her at bethkobliner.com, follow her on Twitter, and fan her on Facebook.