What kind of cake is your credit report? (Photo Credit: CC BY-SA/Alex Gorzen/Flickr)

If you’ve had a bankruptcy, foreclosure or lots of missed bill payments, you know that your credit score was diminished. But do you know about the smaller things that lead lenders to believe you’re a credit risk? A few FICO foibles can cause credit card issuers and lenders to view you with less favor and lead them to either deny you credit or charge higher interest rates.

Too much credit is a bad sign

While it may be a fact that people who max out their credit cards tend to apply for more credit cards, such behavior does not speak well to potential creditors. Too many credit applications in too short a time raise red flags. Norm Magnuson of Consumer Data Industry Association told Bankrate that banks have “shrunk the window” of frequency in which applications for credit audits are performed.

“It used to be months and months. Now you find companies doing account monitoring monthly or every other month,” he said. “That would raise some questions.”

A short sale isn’t magic

When you’re upside down on your mortgage, the specter of foreclosure may not be far away. Lenders will sometimes tell you that a short sale is the way to go. Even though you’re taking a loss, at least you’re avoiding foreclosure. Yet, how a lender reports a short sale to the credit bureaus can be just as damaging. Experian’s Vice President of Public Relations Maxine Sweet says even though the account is technically settled, the short sale ends up hurting your credit score as much as a foreclosure.

The best thing to do, advises SmartCredit.com President of Consumer Education John Ulzheimer, is to negotiate with your lender so that the difference between what’s left on the mortgage and the amount repaid isn’t reported as balanced owed.

Co-sign at your peril

Whether it’s an auto loan, student loan or any other large scale loan, if you’re a co-signer and the primary borrower defaults, you’re on the hook. Hopefully, you keep in touch with the person for whom you co-signed. Otherwise, you may not know the damage being done to your credit until it’s too late.

Minimum effort, maximum worry

It may seem easy to settle for the minimum payment on your credit cards each month, but there’s nothing easy about what that does to you in the eyes of prospective creditors.

“It suggests you’re under financial stress,” says Nessa Feddis of the American Bankers Association. “You may be defaulting.”

A busy report can indicate trouble

The more inquiries for credit that appear on a credit report, the more tiny nibbles that are taken out of your FICO score. If you know you’ll be applying for big loans – home, auto, education – try to do it all within a two-week window. This will minimize the inquiry impact, as they will be treated as a single unit. The same does not apply to credit card applications, however.

Disputing credit report mistakes

Sources

American Chronicle

Bankrate

MSN Money

The number of people entering into strategic default has decreased slightly. Photo Credit: Gentle/Wikimedia Commons/CC-BY-SA

Over the past few years, the term “strategic default” has entered into the national consciousness. People who owe more on a mortgage than the home is worth simply stop paying and walk away because it isn’t worth the trouble. This practice had begun to increase since the 2008 housing crash, but now the tide is starting to recede, if only slightly.

Credit bureaus and banks getting wise

Banks, loan lenders and credit bureaus have been perturbed by the rise in the number of strategic defaults on mortgages in the past few years. Borrowers that owe more on a mortgage than the house is actually worth will default on their mortgage when the value of the home has dropped so low that it no longer makes any sense to continue. In order to ferret out which consumers were defaulting because the cruelty of circumstances left them unable to make payments from the ones who were just giving up, Fair Isaac and Company, one of the main credit rating agencies in the United States, devised a way to find out which troubled homeowners are likely to engage in strategic default. According to the Chicago Tribune, an estimated 35 percent of all mortgage defaults were strategic in September 2010.

New car and cards a dead giveaway

People who strategically default usually will use available lines of credit just before walking away from the mortgage. New credit cards will be opened up, personal loans taken out to finance the move and new cars will be purchased. Then the underwater homeowner walks. FICO is also working with loan lenders and banks to help them identify potential defaulters before they walk. However, according to SmartMoney, the number of people walking away when it suits them is dropping. It is estimated by the University of Chicago Booth School of Business that strategic defaults dropped to 30 percent in March of this year, down from 37 percent in January. JPMorgan Chase analysts, according to Mortgage Wire, found that the overall rate was decreasing.

Consequences of default

Fannie Mae conducted a survey some time ago that found 27 percent of respondents, according to the Chicago Tribune, found the idea of strategic default acceptable. Consulting agencies began springing up that would advise consumers about how and when to default to their best advantage, such as the website YouWalkAway.com, according to Forbes. Yet people who do strategic default face potentially stiff penalties, according to MarketWatch. Credit scores can lose up to 200 points, leading to a host of other consequences. Landlords and insurers may be less willing to rent to or insure someone who has defaulted, and Fannie Mae has declared that it will not insure a new mortgage for someone who has strategically defaulted. It is estimated that 42 percent of all homes are “underwater,” or worth less than the amount of money owed on the mortgage.

Sources

Chicago Tribune

Chicago Tribune

HousingWire

SmartMoney

Forbes

MarketWatch

Don't fret – overdrafts and other checking account shenanigans generally will not affect your credit score. (Photo Credit: CC BY/Dan Foy/Flickr)

Most people know that not paying bills on time or maintaining a high balance on several credit cards can result in negative marks against their FICO scores. However, there are some gray areas. For instance, will overdrafts affect a credit score? The answer may surprise you, suggests Bankrate.com’s Dr. Don Taylor, a Certified Financial Planner and Certified Public Accountant.

Bad checks won’t harm your credit by themselves

A college student worried that a checking account scam would harm her fledgling credit appealed to Bankrate’s “Dr. Don” column for advice. Someone had stolen her checkbook and written checks that caused her checking account to go into overdraft. While she was able to get her bank balance back into the black within a couple of weeks, she wondered whether going into overdraft would have an immediate effect on her FICO. Thankfully, no further identity theft occurred after she sent her bank and one of the three major credit bureaus a fraud notification.

According to Taylor, transactions on a consumer’s checking ledger do not have a direct affect on credit scores. Missing bill payments will, but overdrafts won’t in most cases. One exception is when a banking institution does a “hard pull” of a consumer’s credit history when a new checking account is opened.

Keeping tabs on your banking history, free of charge

Taylor suggests that all consumers who are interested in monitoring their banking history as a matter of periodic maintenance look into ChexSystems. This company enables consumers to pull one free banking history report every 12 months, as stipulated in the Fair and Accurate Credit Transactions Act (FACTA). Negative marks remain active for five years.

For those who have ever been denied when trying to open a fresh account at a bank or credit union, ChexSystems is often the perfect place to go for the information that can help consumers understand why they were denied. Even if that isn’t your scenario, it’s worth checking out ChexSystems Consumer Assistance page once per year to review your financial record.

Protect yourself from scams

If you are the subject of a financial scam involving fraudulent checks, contact your banking institution and law enforcement. In the event that you desire to contact your state’s banking commissioner so that others may be protected from similar scams, HSH.com has a list of relevant contact information.

Sources

Bankrate

ChexSystems

HSH.com

Get your bank account history once per year

The people who strategically default may be doing so because of their financial savvy. Photo Credit: Kelseyman749/Flickr.com/CC-BY

People who engage in “strategic default,” purposely defaulting on a mortgage when it’s no longer worth the effort, may be more financially astute than other homeowners in default. A recent study indicates that strategic defaulters have higher credit scores than people who stick out a bad mortgage. However, there are not many people who engage in the practice.

Higher credit scores among those who default on purpose

A recent study by Fair Isaac And Company (FICO) found that homeowners who engage in a practice called “strategic default” usually have higher credit scores than normal defaulters, according to USA Today. FICO found that people who strategically defaulted on their mortgages usually had most other aspects of their personal finances in order and took steps to protect themselves. For instance, only 10 percent of strategic defaulters had maxed out their credit cards and usually would open card accounts with new companies before defaulting. That way, they didn’t have to worry about having to get bad credit loans when a default showed up on their credit report.

Many disapprove of the practice

Not everyone approves of the practice of strategic default. A survey by legal website FindLaw, according to NASDAQ, found that six of 10 people surveyed did not approve of strategic default. However, 34 percent of respondents said that default was acceptable if the mortgage was underwater. People 65 and older were more accepting than those aged 35 to 44, who were the least accepting of strategic default. Strategic default makes sense from a business perspective. Homes are assets, and it doesn’t make sense to pay more for an asset than it is worth on the market. However, people often feel a moral obligation to meet commitments such as making payments on a mortgage, car or personal loans of any sort.

Foreclosures slowing

The rate of foreclosure slowed during the first few months of 2011, according to CNN. RealtyTrac announced that in the first quarter of this year, it observed 681,000 filings, which includes foreclosure filings, evictions and realty auction notices. RealtyTrac also observed 215,046 homes that had to be vacated by the residents. A filing doesn’t mean a family has been kicked out, only that a notice has been filed. Both figures were reduced from last year. Overall filings fell 27 percent from 2010, and evictions fell by 17 percent. Strategic default has increased during the recession, but is only estimated to have made up 35 percent of all foreclosures overall.

Sources

USA Today

NASDAQ

CNN

Used responsibly, credit cards can help consumers build a credit history. (Photo Credit: CC BY/Andres Rueda/Flickr)

Many consumers looking to establish a credit history are denied credit because they don’t have enough credit to begin with. Even if a person has an excellent FICO score, it’s still possible to be denied something as weighty as a mortgage because the credit report reads more like a leaflet than a book.

Avoid being financially super-responsible with credit

People who are super-responsible can never enjoy their own parties, and the same is true for consumers who are financially super-responsible with their credit. Paying off student loans right out of the gate, avoiding excessive use of credit and generally living debt-free will save money in the long term, but some creditors do not view the credit-phobic kindly. Even for those who use credit but are choosy, an excessive number of credit inquiries can also have a negative impact on the credit score.

Having little credit history and being a serial credit card applicant can impact credit negatively, says Rod Griffin, public education director for the credit bureau Experian. Showing an ability to manage a reasonable number of open, active credit sources over time is paramount in illustrating credit-worthiness to creditors, including mortgage lenders.

Pay off loans, but keep some credit active

Griffin claims that contrary to what some so-called credit experts say, it doesn’t hurt to pay off loans early. Positive marks on the FICO report remain visible for approximately 10 years, whereas negative aspects generally only hang around for seven years. Paying off loans with excessive zeal can lead a consumer into the “No, thank you” zone with some potential creditors, however. If there aren’t at least three open, active accounts on the credit report that have been around for 24 months of more, it’s possible some creditors will pass on a credit application.

Use credit cards, but sparingly

It’s a myth that college students who are just beginning to build credit should take on multiple credit cards. Used responsibly and in moderation, having one credit card or two is a fine path toward building credit.

But the weather may be changing, says Griffin. Credit bureau insiders see the new Credit Card Act established under the Obama administration as a possible hindrance to young people’s ability to build a credit history. By restricting credit card company access to college students, some experts see more limited opportunities for building credit history.

Avoid the cash-only lifestyle if you want good credit

While you won’t rack up revolving debt by living a cash-only lifestyle, you also won’t build your credit. Maintain active credit accounts where you pay more than the minimum each month, and look to such products as installment loans and no credit check loans when emergency funding is necessary. While such products do not traditionally report to the credit bureaus – and hence do not provide an opportunity to record positive marks on a credit report – they will enable you to avoid building up excessive revolving debt on credit cards.

Sources

MSN Money
U.S. News and World Report

Understanding the Credit Card Act

Renters, Experian wants to help you with credit repair. (Photo Credit: CC BY-ND/Christopher/Stumble Forward)

Renters interested in rebuilding their credit scores now have another tool at their disposal, reports The Detroit News. The credit bureau Experian, which acquired the property management database company RentBureau last summer, will begin factoring rental history into credit scores. This move will help scores of consumers, but it may also hurt, experts say.

Millions affected by Experian’s decision at launch

Experian RentBureau, which collects rental history data from property management companies across the U.S. on a daily basis, makes renter data available almost instantaneously through a powerful database delivery system. Before the acquisition, RentBureau had collected up-to-date payment history data on about 8 million renters, a number that is expected to expand exponentially thanks to the new connection with Experian’s database of more than 215 million U.S. consumers. A few million consumers will appear in the Experian RentBureau database at roll-out.

Not only will Experian RentBureau make it easier for consumers interested in credit repair, but it will make the tenant screening process much simpler for resident screeners and property managers, enabling them to better protect their investment. Debt collector recovery rates have also increased through the use of the RentBureau system.

Getting credit for being on time

Experian RentBureau Managing Director Brannan Johnston said the service could help one-third of Americans who rent rather than own.

“It’s a huge thing for those individuals who don’t have a credit history, whether they are a recent college grad, an immigrant or maybe even a divorcee,” said Johnston.

Experian began adding positive rental history data in December, reports The Detroit News. By 2012, the company will also begin uploading negative information regarding evictions and skipped rent. Experian currently has no plans to add late payment data, which is not easily reflected in the company’s credit reporting system, but that doesn’t mean that renters can slack off and expect their credit to get off Scot free.

“If you skip out on your apartment, chances are that the manager is going to turn it over to collection and the collection agency will report to a major bureau,” said Johnston.

The credit reporting industry hasn’t caught on – yet

Credit bureaus Equifax and TransUnion, as well as credit-scoring company FICO, do not have plans to incorporate RentBureau information at this time. FICO spokesman Craig Watts said that once FICO has analyzed RentBureau data internally, the company will make a decision as to whether it should factor in to a consumer’s overall credit score.

Tips for renting without a credit check

In some cases, it is possible for a consumer to rent an apartment without undergoing a credit check. Much like consumers with bad credit who are able to take out short term loans, other methods of evaluating a tenant’s worthiness are available. Ask around. About.com suggests using Craigslist and Sunday newspaper classifieds to find landlords who do not use traditional credit checks. In general, a no credit check rental agreement will need a co-signer and should expect to pay more each month.

Sources

About.com

The Detroit News

Experian

How RentBureau works

Experian is the first major credit reporting agency to include rental payment data as a factor in a credit score. Image: CC TheTruthAbout/Flickr

If you’re looking for ways to boost your credit score, add paying your rent on time to the list. Experian, one of the major credit bureaus in the U.S., has started to factor in timely rent payment data in credit reports. Experian is the first credit bureau to use data about paying rent on time, instead of paying rent late, to affect credit scores.

Experian pioneers positive rental data

Until Experian started using positive data, only negative rental data would show up on credit reports. Such negative data often results from a landlord sending an renter’s account to collection. Now Experian is tracing rental information through its RentBureau division. RentBureau is a specialty credit bureau that collects rental payment data from a property management network renting to more than 8 million households in the U.S. In a statement announcing the service, Experian said there are nearly 96 million renters who always pay their rent on time that are not getting the credit terms they deserve.

Both renters and landlords benefit

The news from Experian cuts both ways. Whereas before only getting sent to collection would result in negative rental data, simply getting behind on rent payments could become an Experian criterion starting in 2012. But industry experts agree that adding rental payment data to credit reports is by and large a positive development for consumers. It removes a key obstacle for building good credit from young people in particular who have not yet obtained credit cards, auto loans or mortgages. There’s an upside for landlords as well. Landlords in the RentBureau network can access its database to determine if applicants will be good renters.

With the other credit bureaus jump on board?

An emerging credit bureau called VantageScore, which ranks consumers on a scale from A to F, has been already using rent payments in its credit score model. Experian’s arrival could increase demand from lenders and underwriters to include rental data in credit scores. FICO has said that it will evaluate and compare Experian credit reports that factor in rental payment data. Over time, rental data in credit scores could be a boost to the mortgage lending industry by helping more people qualify for credit they deserve.

Sources

Huffington Post

The Baltimore Sun

Wallet Pop

Factoring savings into credit scores won the grand prize in a contest for ideas on how to boost a falling national savings rate. Image: CC Bureau of Econoic Analysis/Wikimedia Commons

Earlier this year an asset management company announced a contest for the best ideas to increase the U.S. savings rate. The winner of the $50,000 grand prize suggested a “Savings Credit Score” that factors savings into a person’s credit score. A FICO spokesperson praised the idea but said current credit scoring models made it impractical.

Credit based on saving instead of spending

“Raise the Rate” was a contest promoted on Facebook by TIAA-CREF asking for ideas about how to raise the national savings rate to 10 percent in the next two years. The winning idea was the Savings Credit Score proposed by Johnathan Chan, a 2009 graduate of Northwestern University. By incorporating savings rates into the credit scoring system, Chan told American Public Media’s Marketplace that currently credit scores are based on spending and debt. If savings were factored in, people would be motivated to improve their chances for going to college or buying a house by tucking more money away. Chan’s definition of what would qualify as savings included investing in home equity as well as personal savings accounts.

Can a Savings Credit Score work?

To incorporate personal savings into credit scores, Chan suggested such things as reporting savings on income tax returns and coordinating credit bureaus with online financial tools such as mint.com. FICO spokesperson Craig Watts told the New York Times that banks already consider savings and checking account history in lending decisions. Since lenders don’t report that information to consumer credit bureaus, it’s not available for FICO to factor into credit scores. Watts said, however, that FICO wasn’t discounting the idea of having more information available for better lending decisions

Saving needs a shot in the arm

According to the Bureau of Economic Analysis, personal saving as a percentage of disposable personal income in the U.S. was 5.7 percent in October and has been rising since the financial crisis. A survey by TIAA-CREF released in November showed that most Americans realize saving is essential for financial security. However, 82 percent surveyed didn’t know what it takes to save and 39 percent aren’t saving for retirement. The interest rate on savings accounts isn’t helping. According to Money-Rates.com, as of July 24, 2010, the average interest rate for savings accounts under $10,000 was 0.80 percent.

Sources

New York Times

Denver Post

Marketplace

Creating a debt management plan helps consumers pay debt, reestablish credit and begin to regain control over their finances. However, many avoid doing so because of misconceptions about the way that debt management plans work. In some cases, people have been purposely misled by debt counselors to believe myths about debt consolidation. For others, insecurities about being unable to pay debt obligations have convinced them that they are precluded from creating a debt management plan that works.

Debt management plans explained

A debt management plan (DMP) is created with a trained counselor who is willing and able to help consumers pay debt and rebuild credit profiles. In order to do so, a consumer agrees to regularly deposit money into an account and allow the counselor to pay debt that it owed from that money. An added bonus of a DMP is that many debt collectors are inclined to lower or eliminate fees that have accrued on the account due to previous non-payments. When a counselor is allowed to pay debt on behalf of the consumer, most creditors realize the opportunity to collect what is owed to them and are willing to cooperate in making it affordable to do so.

Dispelling myths about debt management plans

While many creditors view a debt management plan positively, it is never guaranteed that they will do so. It should be clearly understood that the creditor is under no obligation or expectation of reducing amounts owed, but such is done as a courtesy at the creditor’s discretion. Therefore, existing fees should always be factored into the overall budget used to pay debt.

People are also sometimes reticent to participate in a DMP because they have heard rumors that doing so will hurt their credit. For the most part, this is false. In fact, more often than not, the opposite is true. Many creditors view DMPs as a person being serious about regaining control of their finances and repairing their credit. While it is up to individual creditors as to whether or not they will grant future credit, many are inclined to do so as they see a person taking serious strides to pay debt. Also, creating a debt management plan does not adversely affect one’s FICO score at all and, in fact, the Fair Isaac Company does not give reference to debt counseling on one’s credit report.

A Word to the Wise on Debt Counseling

Many have also been afraid of creating a debt management plan because they have been in contact with unscrupulous debt counselors. Unfortunately, charlatans exist in every industry and financial planning is not exempt. In some cases, people have been told that the best way to repair their credit is to pay an exorbitant fee to a counselor, while ignoring past debts. In these scenarios, people have trusted supposed experts to do the right thing and, instead, their credit has been further ruined as their hard-earned money has been pocketed, while their debts have sometimes worsened.

Rebuild credit and a new financial future with a debt management plan

Overall, a debt management plan is a great way to pay debt while reestablishing one’s credit. Often, perks such as lower fees on existing debt and new credit is extended, though not guaranteed. As people become more educated on options available to them to pay debt and rebuild credit, the allure of a debt management plan becomes a perfectly reasonable option and one that can realistically give people control over their financial futures, once again.

Almost everyone has had blemishes on his or her credit history at some point. In these tough economic times, this is more common than ever. Maybe you have had to let payments slip past 30 days or maxed out a credit card or two to bridge the gap between paychecks. Worse, you may have had to file bankruptcy or been foreclosed on. Whatever the situation, almost everyone has had to live through it, but at what cost?

How much do mistakes cost?

One of the problems many people encounter is that they do not know how bad a credit hit they will take with a given action. For example, people don’t know how much their score will drop if they delay payment for their car or mortgage. They might not know what kind of shape they will be in after a debt settlement in terms of their credit score. To make matters more confusing, it seems like the same mistakes hurt some people more than others. There appears to be no consistency and no way to predict the effects of a given action. Not having clear information makes it difficult for many people to make good decisions during difficult financial situations.

The air has cleared

Finally, FICO has shed some light for the public on just how their credit is affected by common credit mistakes. FICO has recently made public its guidelines for point reductions in credit scores for given offenses: bankruptcy, 30 day late payments, debt settlements, foreclosures, and maxing out credit cards, for example. The formula tends to hurt people with higher scores worse than those with lower scores. For example, if your credit score is 680 a maxed out credit card will cost you between 10 and 30 points. If your score is 780 the damage is between 25 and 45 points.

Big mistakes equal big reductions

As one would assume, the greater the problem the bigger the point reduction is from your credit score. Once again, the higher your score the more damage is done by the same mistakes. Among the largest reductions are foreclosure and bankruptcy. Foreclosure will deduct between 85 and 105 points if for a score of 680. If the score is 780 the foreclosure will cost between 140 and 160 points. Bankruptcy ratchets things up a notch with a 130-150 point reduction for a 680 score and 220-240 for a 780 score.

Settlements can cost you, too

Foreclosure and bankruptcy seem like obvious problems that would cost points on a score. One item that is a significant reduction that may not be so obvious is a debt settlement. People may think they are getting their finances together and making a positive move when they settle a debt for a percentage of the total. However, they may take a larger credit score hit than anticipated. FICO lists debt settlement as a 45-65 point deduction for a 680 score and a 105-125 point deduction for a 780 score; compare this to a 60-80 point and a 90-110 point deduction respectively for a 30 day late payment. At least now people can make an informed decision on whether or not to settle or continue to pay late.

Work hard to keep what you have

Looking at the penalties, one can see how important it is to keep good credit once you have it. The penalties are higher for better scores emphasizing the need to retain a high rating. The fall is precipitous, but the climb back up is longer and more arduous.

That's a monster of an APR you've got there, First Premier Bank. Give me a payday loan instead!

Back in June of 2009, Deborah Weiss of Personal Money Market reported about how the new credit card laws could backfire on hard-working Americans. It’s unlikely that President Obama or most members of Congress could have predicted then just how much of an end-around some credit card issuers would take in order to avoid the teeth of the new legislation. While the new law caps fees at 25 percent of a card’s credit line, it does not set a cap on interest rates, reports Candice Choi for the AP. Thus, we have a 79.9 percent APR subprime credit card monster, courtesy of First Premier Bank.

Not a Premier to Write Home About

Yes, First Premier Bank is known for offering subprime credit cards – a niche that has its place in a market filled with consumers with less than perfect credit – but this is ridiculous. The new laws are intended to curb abusive practices, and First Premier is taking full advantage of a gigantic loophole. Perhaps Mr. Obama and Congress should have considered that a few months ago? Now that First Premier Bank has set a precedent, I wouldn’t be surprised to see more of this kind of highway robbery.

From Inauspicious Beginnings

Here’s how First Premier’s toxic subprime credit card used to work: there was a minimum of $256 in fees for the first year for a credit line of $250. The consumer was in the hole from the beginning. Once the new credit card laws go into effect in February 2010, that fee will be cut down to 25 percent of the credit line.
Starting in February, however, a new law will cap such fees at 25 percent of a card’s credit line. For a card with a $300 limit, that would still be a $75 fee for the first year. So to make up the difference, First Premier puts on the full court press with a 79.9 percent APR. It was previously 9.9 percent.
“It’s the highest on the market. It’s the highest we’ve ever seen,” Anuj Shahani of research firm Synovate told the AP.

But That’s Not All

If paying $20 per month on a $300 isn’t enough for you, there’s a $29 penalty if you pay late or go over the limit. Mess up just once and that’s likely the road you’ll be traveling. First Premier Bank has been offering this kind of credit card black hole primarily to subprime homes with FICO scores under 700. Their catchy come-on is “You might have less-than-perfect credit and we’re OK with that.”
They’re also OK with a 79.9 APR credit card, clearly. A company PR note claimed that they “price (their) product based on the risk associated with this market.”

And This isn’t Some Fly-By-Night Operation

Based out of Sioux Falls, S.D. (a credit card hotbed, along with Minneapolis, Minnesota), claims that First Premier’s card-issuing arm (Premier Bankcard) is “the 10th largest issuer of MasterCard and Visa cards in the country.” They sport “more than 3.5 million customers.” I hope each of them know what they’re in for, potentially.

You Could Have Had a Payday Loan

Imagine the possibilities to save. If you use your credit card in emergencies, you’re paying so much more. And if you have the 79.9 percent APR First Premier Bank card, you’re paying beyond belief. With a payday loan (which isn’t a revolving line of credit in most cases), you’re only paying 15 to 30 percent on the short term loan. If you use a credit card like this monster instead and carry the balance over month to month, you may as well sell yourself into indentured servitude.
Should subprime credit like this be available? Unfortunately I’d say yes, because having choice is better than no choice. But please… friends don’t let friends apply for a 79.9 APR credit card. First Premier Bank will just have to come to their senses.

Apply for Payday Loans HERE!

The primary reason to know and understand how your credit rating is calculated is to help you learn what actions to take or avoid in order to keep your rating as high as possible. If your credit rating is low, understanding how the score is calculated can help you determine what problems can and should be corrected to improve your score. Understanding how your score is calculated also helps with your financial planning by allowing you to take in account the effects of any given action on your credit rating.

FICO

In the United States, FICO is the leader of the credit-rating industry and each of the “Big Three” credit reporting agencies – Equifax, Experian, and TransUnion – use various FICO-developed systems to calculate credit scores. The exact formula used by each of the Big Thee is a closely guarded proprietary secret; however, FICO has provided the public with a basic outline of what factors are taken into consideration and what importance they have in the calculation.

Payment history

The most important factor in calculating your credit score is your payment history. This is the record of your payments to creditors.   Your payment history shows whether or not payments were timely. Defaulting on outstanding debts, missing payments, and making payments late are all part of your payment history. In general, this element constitutes 35% of your credit score, which means that having a bad payment history is the worst thing that can happen to your credit rating. Most notations related to payment history remain on your credit report for seven years, regardless of whether the debt has been paid or settled.

Credit usage ratio

Your credit usage ratio is a comparison of the amount of credit you have immediately available to the amount of credit you have actually used. The more unused credit you have available, the higher the score. This is a somewhat tricky metric because it only takes into account your open credit accounts, so sometimes paying off an account and closing it can hurt this part of your score. Having a lot of open credit accounts, but keeping them paid down, generally boosts this portion of your score. Your credit usage ratio is usually weighted at about 30% of your score.

Length of credit history

The third factor, the length of your credit history, counts for about 15% of your credit score. The purpose of a credit score is to give lenders a clear view of your debt-paying habits, so the longer your credit history, the more information there is for lenders to consider. This is one factor that the consumer cannot really affect in any meaningful way, but it does suggest that it is to your benefit to begin establishing credit as soon as possible. The less history there is, the less value your credit score has to potential lenders.

Types of credit used

The various types of credit a persons uses are also taken into consideration, with diversity of credit being viewed favorably. If you have had only one type of loan, such as a revolving credit card account, this portion of your score will be lower. Having several different types of debt – credit card debt, non-revolving bank loans, a mortgage, a car loan, and so on – will increase this part of the score because it indicates to lenders that you understand how to manage different types of loans. The types of credit you have used constitute about 10% of your score.

Recent credit inquiries

Although credit scores are used for other purposes than applying for new loans, the FICO system generally assumes that recent credit checks mean you are actively applying for credit.  If there are several recent inquiries, it is assumed that you have been trying to borrow from multiple lenders and this is viewed negatively. The more recent inquiries you have, the lower this part of your score. This factor is weighed at roughly 10% of your credit score.

How does this information help you?

By understanding how your credit score is calculated, you can make more prudent financial decisions that can help improve your score. For example, since your credit usage ratio is so important, when you pay off a credit card account, it may be a good idea to keep the account open and not use it, rather than close it.  Likewise, when you’re presented with the choice of applying for an additional loan to keep other obligations current, or missing payments on an existing loan, understanding how the score is calculated can help you make a better decision about the right course to take.

This Federal Reserve/Vanderbilt/Penn study tries to connect payday loans to credit ruin, but what they leave out suggests a rosier alternative. (Photo: flickr.com)

Credit cards have proven to be both a useful tool in establishing a credit history and a bane to those consumers who hope to maintain a good credit history. The temptation to “swipe and go” has been actively cultivated by the American media. With the magic plastic in hand, consumption is quick and easy. Those who pay off their credit cards each month may escape the revolving interest trap, but the vast majority of credit card users must not pay their balances in full. If they did, why would credit card companies offer reward programs? If consumers weren’t tied into earning points and paying interest fees, the programs wouldn’t be profitable for the companies.

What about Payday Loans?

According to multiple sources, over 10 million U.S. households use payday loans each year. These short-term loans are paid off over a set period of time, typically two weeks’ time. They fulfill a need and are not a swipeable ticket to impulse purchases. Certainly payday loans CAN be used for impulse buys, but lenders make it clear that this is not advisable. Furthermore, the amount available is finite, typically smaller than the credit limit available on a credit card.

Yet Sources Continually Try to Connect Payday Loans to Financial Ruin

Take the January 2009 interdisciplinary study “Payday Loans and Credit Cards: New Liquidity and Credit Scoring Puzzles?” Written by Sumit Agarwal (Federal Reserve Bank of Chicago), Paige Marta Skiba (Vanderbilt University Law School) and Jeremy Tobacman (University of Pennsylvania), this study attempts a statistical correlation between credit card default and payday loan use. In particular, the trio attempts to make the case that consumers consistently make bad decisions by choosing to take out payday loans when they have credit card liquidity.

There must be a reason that consumers make such a choice, however. Agarwal, Skiba and Tobacman do not define such reasons, so I will attempt to fill the crucial gap.

Methodology and Results

Agarwal, Skiba and Tobacman analyze a sample of 102,779 people who took out payday loans from a single lender (this is significant, as I’ll show in a moment) and 143,228 with credit card accounts in states where the same payday loan company operates. They discovered that while credit card issuers used FICO scores as the primary means of determining a consumer’s credit worthiness, the payday lender used Teletrack scores instead, which tend to track borrowing history more on the subprime scale.

According to the study authors, Teletrack scores were eight times more effective at predicting payday loan default than FICO scores. Thus, it can easily be assumed that the more effective credit evaluation device creates more successful payday loan transactions that it would defaults and additional fees. The mainstream media is too often ready to accuse the payday lending industry of wielding such fees like a fire hose on unwitting consumers, but the truth of the matter is much less dramatic.

Payday Loan Customers Have Access to Prime Credit

Even though the authors’ study indicate that on average, consumers who use payday loans have a lower average income compared with those who just use credit cards, the same study indicates that their average FICO score is still in the 620 or slightly lower range. Thus, they can still access prime credit cards.

Why is it then that, as the authors indicate,

Two-thirds of people in the matched samples have at least $1,000 of credit card liquidity on the day they take their first payday loans, much more than the typical $300 payday loan.

It’s an interesting question. A 2001 survey by Elliehausen and Lawrence regarding credit card availability and usage found that 56.5 percent of respondents who used payday loans had bank-issued credit cards with liquidity available, but 61 percent “hadn’t used them in the past year in order to avoid exceeding the cards’ credit limits.”

People Don’t Like to Admit When They Fall to Temptation

The authors show us that there is a steady decline in credit card liquidity leading up to the time when consumers take out payday loans, but the liquidity doesn’t disappear entirely. The authors comment that

This is interesting because it speaks to the question of why people borrow on payday loans. If liquidity were flat until a large drop one month before the payday loan application, we would suspect that a single large bad shock had unexpectedly arrived. Since we find average liquidity falling steadily, impatience, general financial mismanagement or persistent shocks seem more likely explanations.

Perhaps what Agarwal, Skiba and Tobacman define as “impatience” or “financial mismanagement” could include the psychological temptation having a credit card that needn’t be paid off in full each month (advisable, but generally not required). It would be worth studying that factor in greater detail, as I know from first-hand experience that having access to credit, using it and allowing it to revolve month-to-month is an easy trap. In my opinion, such situations are not out of the ordinary. Closer study is warranted.

The Author’s View of Payday Loans is Limited

Obviously, if you only survey financial results based on the clientele of a single payday lending operation, your results will be far from definitive. When the authors claim that credit card holders who take out payday loans are 92 percent more likely to experience credit card delinquency, such a dramatic number indicates to me that the statistical sample is much too small to be meaningful. If consumers evaluated by Teletrack are generally less prone to payday loan defaults, why would credit card defaults be all that different?

It is significant to note here that applying for payday loans does not generally depend upon or impact one’s FICO score. That is one of the major selling points of the product, as consumers with less than perfect credit can take out a payday loan for a set amount when necessary. There is no system of revolving credit at work with payday loans; the balance is paid in full at a set date two weeks in the future. Furthermore, since payday loans obtained after Teletrack reference are generally not recorded in a consumer’s credit history, other lenders cannot use a consumer’s payday loan history against them when they apply for large-scale loans for homes, vehicles, education, etc. If banks could use payday loan information against consumers, they most certainly would. Their track history of penalizing and confusing consumers with credit card terms prompted President Obama to step in with fair credit practice legislation, which in my mind only serves to support my argument that banks will charge whatever they can.

Why Don’t Credit Card Companies Use Teletrack?

You’d think credit card companies would find any subprime information about a consumer to be valuable in their attempts to justify higher rates and limiting practices. The study authors indicate that the reason credit card issuers don’t normally use Teletrack is that the credit bureaus charge them for each credit query. Perhaps the leverage they can glean on a consumer is not valuable enough to counteract the fees?

Temptation Yields to Payday Loans

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Considering how much damage a consumer can do to their credit history by allowing revolving interest credit cards to spiral out of control, the set maturity period of payday loans could readily be considered a better option. From a psychological standpoint, not having a tempting credit card in hand when you surf E-commerce sites or drift through the local shopping mall could be advantageous to the consumer. While Agarwal, Skiba and Tobacman have the beginnings of a useful study here, a larger sample of both credit card issuers and payday loan businesses is needed to make a more meaningful assessment of the payday loan’s supposed correlation with credit destruction. Perhaps then consumers can more easily see that the practices of banks who issue credit cards may be the most harmful advice out there. See the video below if you aren’t convinced of that yet…

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