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Ask John: Store Card Dangers

How Saving $50 Today Can Cost You $100,000 Tomorrow

Background

Please meet Patricia, a 28-year-old teacher who lives in Memphis, TN. Patricia has had a limited amount of credit since she started teaching 4 years ago. All she has are a few credit cards and an installment loan for some furniture. She’s never financed a car or a house.

Patricia’s credit scores are very good. In fact, they’re excellent: 750 at Equifax, 735 at TransUnion and 728 at Experian. She should have no problem getting any sort of credit based on these scores.

Her Dilemma

Last December Patricia was doing her holiday shopping at the local mall. She estimates that she spent about $500 on gifts for her family and friends. In the process of shopping she was offered multiple opportunities to “save 10% on today’s purchase” by the check-out clerks at 5 of the stores. Thinking it was an easy way to save money Patricia took them up on their invitations, applied for 5 store cards, was approved and saved $50 on her purchases. Not bad, right?

Four months later Patricia decided that it was time to start looking for a house. She liked the area, enjoyed her job and felt that it was time to start putting down some roots in the area. And, what better way to do that than buying a home?

She met with a real estate agent and together they figured out how much of a home she could afford. They came up with the range of $175,000 to $200,000, which in Memphis is a pretty nice range. The next step was to look for her first house.

Patricia and her agent spent about 6 weeks driving around the area looking at new homes, older homes, condominiums and townhouses. Each had their pros and cons. New homes were, well, new but they all looked the same. Older homes had a lot of character but required more upkeep. Condominiums had basically no upkeep but she felt like she would still be living in an apartment. She had the same opinion of the townhouses.

After weighing all of her options she decided on a new house. The house was already 90% complete and she would just need to pick out some paint colors, light fixtures and carpet and within 45 days she could move in. Now all she needed to do was get a mortgage loan.

In the mortgage industry lenders will almost always pull all three of your credit reports and credit scores. Then they will look at your middle score to help them determine your level of credit risk. If your middle score is very high you’ll likely be offered the most competitive rate the lender has to offer. If your middle score is less than excellent then you’ll likely be offered a less than optimal rate. If your middle score is very low you will be offered an unattractive rate or you could be declined altogether.

This was the least of Patricia’s worries. Less than 5 months earlier her middle score was a 735. And, she hadn’t missed any payments or taken on any new debt since then. She was certain that her scores were still excellent and that she would breeze through the mortgage application process.

Patricia filled out her mortgage application and turned it in to a local mortgage broker. Three days later she got some distressing news, her application would be approved but at an interest rate that was much higher than she expected.

At the time of her application the best interest rate on a 30-year mortgage was around 5.5%. She had chosen a house that cost right at $200,000 and she was planning on putting down 5% ($10,000). Her loan amount was going to be $190,000 and she projected a monthly payment of about $1,078.

What she was being offered was a $190,000 mortgage loan at 7.75%. Her payment was going to be $1,361. That’s a difference of $283 each month. That doesn’t sound like much but that’s $3,396 more each year and over $100,000 more over the life of a 30-year mortgage. What happened?

After talking to her mortgage broker she found out that her three credit scores had dropped drastically from 5 months earlier. They were now as follows.

Credit Scores from 5 Months Earlier Credit Scores Now
Equifax – 750 Equifax – 682
TransUnion – 735* TransUnion – 657*
Experian – 728 Experian - 649

*Middle Score

Her middle score had gone from 735 to 657, a difference of 78 points. To a lender 78 points is a huge deal. In fact, the way that credit scores are designed, a 78 point difference means that Patricia is 8 times more likely to pay her bills late now than she was 5 months ago. As such, the mortgage lenders are not willing to offer her the best rate. They’ll still approve her loan but at a much higher interest rate.

What baffled Patricia is how this could happen. She went over her credit reports in depth and everything was the same. She never missed a payment, didn’t take on more debt, no collection and no public records. Everything was the same except for one thing, her inquiries.

What Patricia didn’t realize was that when she applied for those 5 retail store credit cards the stores were pulling her credit reports. And each time they pulled her credit report an inquiry was posted to her credit file.

An inquiry is a record of any access of your credit reports. The inquiry shows the date your report was pulled and by whom. In Patricia’s case, she had 5 inquiries on the same day from 5 different companies.

These 5 inquiries sunk her credit scores to the point where she was now considered a “medium credit risk.” And she was getting treated like a medium credit risk.

Her Options

Once Patricia settled down and came to grips with what had happened to her we talked about what she should do next. Here are her choices:

  • Stop the application from moving forward and wait until her scores are high enough to qualify for the best interest rate.
  • Continue the mortgage application process, get approved, move into her new house and monitor her scores. When they go back up above 700 apply to refinance the home loan to get a more attractive interest rate.
  • Have the inquires removed from her credit reports and then when her scores go back up she could reapply for a mortgage loan.

Unfortunately, #3 isn’t really a great option. Unless the inquires were made as a result of fraud you can’t get them removed. The credit reporting agencies have a legal obligation to keep a true and accurate list of all inquiries into your credit report for up to 24 months. In her case, the inquiries were legitimate because she did apply for store credit at 5 different stores.

That’s the bad news.

The good news is that inquiries only count against your credit scores for the first 12 months that they exist. So, in Patricia’s case, she only has to wait another 7 months before the impact to her scores goes away completely. And, assuming she doesn’t start missing payments or becomes overburdened with debt her scores should recover nicely.

She can refinance her mortgage loan and expect to save hundreds of dollars each month assuming, of course, that interest rates stay the same or decrease.

Whether or not to stop her loan now and wait for her scores to go back up is a personal decision and really doesn’t have a simple answer. If she really loves this house, is it worth the risk of losing it while she waits 7 months for her scores to recover? Conversely, is the house worth paying $283 more each month until she can refinance?

In her case moving out of an apartment and into her new home was worth the higher, albeit temporarily higher, payment.

How To Prevent This From Happening To You

Never, ever, ever take advantage of these types of “save 10%” offers. It’s simply not worth the damage you’ll do to your credit scores. Also, beware of the “fill out a credit card application and get a free t-shirt” offers that you see at almost all sporting events. You’ll end up with new and unwanted inquiries on your credit report in exchange for a t-shirt or coffee mug.

The people who ask you to apply are most certainly compensated financially if they can get you to apply for credit. Unfortunately, there is no law that requires them to display any sort of conspicuous warning saying that by applying for their credit card you will likely lower your credit scores, but maybe there should be.

Summary

It takes years and years of solid credit management to obtain excellent credit reports and credit scores. Irresponsible actions may lower your scores, which will cost you, as in Patricia’s case, dearly when you want to obtain credit for a higher dollar items like a house or a car.

Pay the full amount for your purchase, thank the store clerks for their offer and politely decline. Oh yeah, and don’t even bother trying to explain why it will hurt your scores. They simply won’t understand. Trust me, I’ve tried numerous times.

Using your credit as some sort of 10% off coupon is a very bad idea. Don’t let saving $50 today cost you $100,000 tomorrow.

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