Ask John:
Buried in Credit Card Debt
Background
Meet Ellis, a 37-year-old father of 3 who lives in Denver, Colorado
with his wife Rebecca. Ellis and Becky are both lawyers working
for large corporations. Their household income is over $400,000
each year. They drive expensive cars, eat at expensive restaurants,
live in an expensive house and send their children to expensive
private schools.
On the surface, they are living a great lifestyle filled with great
vacations and lots of “stuff.” They’ve got it
made in the shade…or do they?
Ellis’s Dilemma
In addition to their impressive collection of expensive assets, they
also have a less impressive collection of credit card debt, $52,000
of credit card debt to be exact.
Ellis lives by the motto, “If I am paying my bills on time
then my credit is good.” Unfortunately, this couldn’t
be further from the truth. Paying your bills on time is very important
if you want a good credit score, but it only makes up 35% of the
points in your score. The other 65% of the points have nothing to
do with whether you are making your payments on time or not.
In fact, your level of debt makes up a surprising 30% of the points
in your credit score. That makes “debt” a close second
to “payment history” as far as their impact on your
score.
About a month ago, Ellis and Becky found out the hard way how important
debt is to their scores. They went to refinance their $875,000
home loan to take advantage of lower mortgage interest rates.
But, when their loan officer pulled their credit reports, their
scores were less than 700. The score range is 300-850 and the
median score is around 725. So, while Ellis and Becky have a household
income that is in the top 5% of all U.S. households, a staggering
70% of all consumers have credit scores higher than theirs.
How much did this cost them? They were unable to refinance their
house, so they are still paying an interest rate of 6.75% versus
a 5.75% interest rate. That 1% will cost them $570 each month,
$6840 each year, or $205,000 over the life of their mortgage loan.
All of this because they thought that paying their bills on time
was the key to having good credit.
When I explained this to Ellis, he was understandably upset. For
years he has worked hard to earn a solid living but missed the
mark when it came to good credit. What I had to explain to Ellis
was the difference between credit worthiness and capacity.
Credit Worthiness versus Capacity
What Ellis simply could not understand was how someone like him,
a lawyer making a six-figure income, couldn’t have great
credit. He could easily take on more debt because he could easily
generate the income to pay the bills.
What Ellis’s finally came to learn from our conversation is
that YOUR INCOME DOESN’T MATTER when it comes to your credit
reports or your credit scores. Ellis was all wrapped up in the “I
make so much money”
mindset, but what he failed to realize was…
- Neither his nor his wife’s income is on their credit reports.
Credit reports are a measurement of credit worthiness. And, since
credit scores are calculated from the information on your credit
reports, he was getting no credit in his scores for having a solid
income. Nobody does. Conversely, lower income consumers are not
penalized for not having higher incomes.
- Credit scores and credit reports are designed to show how well
someone manages their credit. They are not designed to show lenders
how much money you make. That’s why lenders (especially
mortgage lenders) ask for copies of your tax returns, paystubs
and W2s. They use those items to validate your income or your “capacity” to
pay a bill.
Ellis’s Options and Best Course of Action
In this case Ellis has very few options on how to address his problem.
Here’s the best course of action:
- STOP!! The more credit card debt Ellis takes on, the deeper he
gets. He needs to stop the presses right now until he can do an
inventory of all of his cards, the amounts he owes on each, and
the interest rates he is paying.
- One problem that Ellis shared with me was that he infrequently
questioned the bills as they came in. He simply paid the minimum
and moved on assuming that all was well. This is a bad idea because
he was largely unaware the he was getting deeper and deeper into
debt until it was too late.
- He needs to figure out what his revolving utilization is by
dividing his aggregate credit card balances by his aggregate credit
card limits. For example, if I have $10,000 in balances and $20,000
in credit limits, then I am .50 or 50% utilized. In Ellis’s
case, he was 80% utilized. This is way too high and it is killing
his credit score. He has to get that number to below 10% if he
wants to max out his score.
- Ellis ended up with 12 credit cards with balances. He figured
out that he could pay off about half of them right away and eliminate
about $10,000 of his debt. This would lower his utilization percentage
to 65%. It was better, but not good enough. If he wants to refinance
his home loan at 5.75%, he’ll need to pay off another $30,000
or so of his credit card debt.
So Who’s at Fault?
There are two parties who need to share the blame here.
- Ellis – Ellis is clearly at fault for
not being more responsible with his credit cards. But, his case
is not unique. Real Stories receives numerous emails from people
who are buried in credit card debt and the majority of them have
nobody to blame but themselves for letting it happen.
-
The Credit Card Companies – There’s
a reason that the credit card industry sends out billions (that’s
right, BILLIONS) of solicitations each year. Their persistent
hammering will eventually crack even the toughest nut.
And, don’t expect any friendly disclosure explaining that the
higher your balances the lower your credit scores.
Summary
The lesson that Ellis learned was that a good credit report isn’t
necessarily a credit report that is void of delinquencies. It takes
solid performance from a number of categories, one being your level
of debt, to achieve a great rating.
Hopefully, he can reign in his family’s unchecked use of his
credit cards and get his balances down to a more respectable level.
Go for it Ellis. Best of luck!!
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