Debt is a massive problem in America. We’re up to our eyeballs in debt of all types: mortgage loans, credit cards, student loans, automobile loans.
Moreover, the average mortgage balance in the U.S. is about $200,000; the typical family carries a monthly credit-card balance of $10,000; the average college graduate owes more than $20,000 in student loans; and the median car note now exceeds $27,000.
Is it any wonder that Americans owe $2.5 trillion in consumer debt, excluding their mortgages? Throw in another $14 trillion in home loans, and it’s clear why our collective debt won’t go away any time soon.
From a credit standpoint please understand that the type of debt you’re carrying matters tremendously when it comes to your overall rating. (Remember the FICOâ scoring formula?).
I’ve experienced firsthand the impact that being weighed down with debt has on one’s credit. I’ve also heard from countless individuals all around the country whose credit scores were suffering due to their having “bad” debt.
What precisely counts as “bad” debt? Nearly 100% of the time it’s credit-card debt. If the balances on your Visa, MasterCard, American Express, or Discover cards have gotten out of control, you’re likely doing serious damage to your credit.
But other types of debt aren’t good for your credit rating either, such as a department-store card you opened to get 10% off your purchase or the retail credit account you got to buy household furniture. Don’t feel bad if this scenario describes you. I’ve made the same mistakes.
Your FICO score is tied strongly to the credit-card debt you have. Do you recall from earlier in this book that 35% of your FICO score is based on the amount of debt you have? With regard to this percentage, FICO is overwhelmingly concerned with your current credit-card debt.
Let me explain why.
The FICO scoring system evaluates three forms of debt in your credit files: mortgage, installment, and revolving. Mortgage debt is very straightforward.
This is the house note you have on your primary residence, the home-equity loan or line or credit you may have, and the mortgage you pay if you’re lucky enough to have a vacation home or investment property.
In short, if you own a piece of real estate, and you have a loan for which the house is collateral, you have some form of mortgage debt. Generally speaking, this is the most highly rated form of debt in the FICO scoring system.
Next is installment debt. This refers to one-time loans that you are paying off over time by making fixed payments at regularly scheduled intervals. For instance, assume that you received a $10,000 student loan five years ago and are now repaying it.
You may be making $125 payments every month. In this case your loan balance declines every month, part of your payment reducing the principle and part repaying interest on the loan.
The same scenario applies to car loans. In both cases the lender knows exactly what its risk is at any given time: the outstanding balance on your loan. But the lenders also know that your balance isn’t going to rise.
Thus installment loans are “good” forms of debt from a credit-scoring standpoint. They are unlikely to hurt your credit ranking as long as you pay on time.
The last debt category, however, represents a potential minefield for lenders and borrowers alike. Revolving debt, such as credit cards, is the riskiest from a lender’s standpoint because the lender has far less control over this debt, and you call the shots in many ways.
Assume, for example, that you have a MasterCard with a $5,000 credit limit. Your balance one month might be $1,900, but last month the balance was $1,255, and the month before that it was $1,641. As it stands, neither the lender nor FICO has any way of knowing how much you’re going to charge in any given month.
They can try to predict it—and they do try, as you’ll learn later—but they can’t know with certainty whether you will charge $30, $300, or even $3,000 on your card in the following month.
Revolving debt isn’t scored favorably in the FICO model because no one knows how much you will pay on your credit-card balance. You might decide to make minimum payments; you might opt to pay $500 against the overall balance; or you might decide to pay off the entire balance.
Whatever the case, the payment amount is pretty much up to you, provided that you meet the mandated minimum. But that’s not much, since most banks and credit-card issuers require only that you pay about 4% of the outstanding balance in any given month.
This means that on a card with a $1,900 balance your minimum payment would be just $76 while the bank’s exposure is still $1,824. The latter is the amount of money at risk for them if you don’t pay up for any reason. Moreover, if you fail to pay, that credit-card balance due is no longer a “risk-weighted asset.”
It swings over to the “non-performing” asset section of the bank’s balance sheet. Extending credit via cards can be a high-stakes enterprise. When a bank approves your credit-card application, it basically is agreeing to let you take out a loan.
Issuing that credit card can be far riskier than making a loan to someone buying a car because in the latter case the bank knows exactly how much the monthly payments will be.
Speaking of cars, one final difference between installment loans, such as auto loans, and revolving debt, like credit cards, demonstrates why the latter is deemed riskier. A car loan is a secured loan.
If you don’t pay what you owe, the lender can come to your house and repossess the vehicle. (And don’t even think about trying to hide it around the block when your payment is past due. I tried that many years ago while I was in college, but the repo man still found my Hyundai Excel and hauled it away.)
A credit card, on the other hand, is an unsecured form of debt. If you charge $800 on your Visa card for that flat-screen TV you just had to have, what is the bank going to do if you don’t pay your credit-card bill? They can’t come into your house and snatch that 40-inch TV off the wall.
So they’re mainly stuck with reporting you to the credit bureaus if your payment is 30 days or more late. Of course, your account could go into collection, or they could get a judgment against you if they felt it was worth the time and money to go those routes.
The central concept you need to understand is that secured loans, whether it’s on real estate or automobiles or something else, are always less risky to lenders than is unsecured debt such as credit cards.
As a result, that unsecured debt on your credit report, courtesy of the cards in your wallet, will always get judged more severely in the credit-scoring world.
In summary, not all debt is created equally. Credit-card debt is the form of debt most closely watched by the credit industry because it’s unsecured and largely controlled by your choice of payments.
Credit cards are more frequently used than other form of debt, thereby providing more insights into your overall financial habits.
Excerpt from Perfect Credit: 7 Steps to a Great Credit Rating.