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.

1. 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.


2. 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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