How the American Credit Score System Encourages Debt
For Americans, there's good debt and there's bad debt. For Latinos, there's debt
Ah, the credit score. That social stamp that tells others that you can be trusted. That mysterious number that will determine whether you can afford to buy the house of your dreams. It's clear that many Americans worry about their credit score. Just google "credit score" and see the number of ads offering a free credit report or promising to get you a credit score boost. And there's good reason for it. If you apply for a credit card, the credit score plays an important role in determining how much credit you'll get. Buying a car or a house? Your credit score affects the interest rate you get. Moving to a new apartment? Your credit score will determine your deposit.
What the credit score is and how it is used
The credit score is simply an indicator of our creditworthiness. It is a number that attempts to summarize how risky it is for someone to loan you money or, in other words, what are the chances that you'll pay back. Lending is always risky. If you have a low your credit score, you'll be considered a high-risk borrower and lenders will be cautious about extending credit to you. If you have a high credit score, lenders are more likely to trust that you will make your payments on time. The credit score not the only creditworthiness indicator. When you apply for credit, lenders typically use other information as well. For example, they'll want to know about your income. But the credit score is always a critical part of the puzzle.
Good debt, bad debt
My friend Gustavo, an American Jew who was born in Bolivia, once told me:
For Americans, there's good debt and there's bad debt. For Hispanics, there's debt.
That may be oversimplifying, and I am sure he just did it to make a point, but it is true that different cultures have different relationships with money. As a kid growing in Spain, I was taught that debt, in general, is best avoided. In my teenage years I noticed that credit card debt was the most frequent source of conflict between my parents. It was hard to see how debt could be good. In fact, it is hard to say whether debt is good or bad. In their blog post, "11 Credit Myths", Experian shows "debt is debt" as myth number 1. "Not all debts are equal", the post claims before comparing a) a $150,000 credit card debt used to cover the expenses of a party (the best party ever held, I'd imagine) against b) a mortgage that "is giving you a warm place to lay your head at night". It's a valid point, not all debts were created equal, but debt is debt. You still have to pay it back and failure to do so may result in delinquency, whether you blew it on $150,000 on a party, on a very responsible monthly mortgage that allows you a very modest place to live or whether you donated the money to an honorable cause or used it to pay medical bills.
Ways the credit score system encourages debt
1. No debt, no credit score, no credit
Credit scores are calculated using different pieces of data in our credit history reports. The main factors are the percentage of used credit versus available credit, payment history, type and amount of debt, length of credit history and recent inquiries to your credit report. In other words, the way to prove your trustworthiness to lenders is to show evidence of how you handle debt currently and in the past. Income has no effect on the credit score. Savings have no effect on credit score. Your word, obviously, has no effect on credit score. Since lenders rely heavily on credit scores for approving credit and loans, even with an immaculate payment history, a very healthy economic situation and an excellent reputation, most lenders will consider it risky business to lend you money.
2. Cancelling debt may even hurt your credit score
As Experian points out in their "Myths" article, cancelling a credit card may even hurt your credit score. Since credit scores value a low use of your available credit, when you cancel a credit card or a loan, your available credit decreases so, if you keep using the same amount of credit, your relative use of available credit increases.
3. It is used for non-credit applications
If you have such a strong stand against debt, why worry about your credit score? You won't be applying for credit anyway. Am I right? No I am not. Credit scores can and are used for many other purposes other than extending credit. A few examples are:
- Apartment renters with a low credit score or lack of credit history face higher deposits and sometimes are asked to provide a guarantor or to pay in advance.
- Utility companies use credit scores to determine deposits and even eligibility to plans
- Insurance companies sometimes use credit scores to determine their prices and policies
- Employers cannot see your credit score, but in some states they can use other information on your credit report to make hiring decisions
- Even government agencies can check your credit report under certain circumstances
Conclusion
The credit score system helps Americans in many ways. If banks did not have credit scores to help estimate the specific risk of lending to each specific individual, they would not be able to customize their offers and good payers would not be able to benefit from lower rates. At an aggregate level, credit scores help lenders understand the overall risk of their customers. Without that knowledge, lenders would need to be more cautious about extending credit. Credit opportunities would be more limited and interest rates would likely rise At the same time, the credit score system incentivizes debt and debt, good or bad, plays a big role in the economic health of a household, a company, and even a nation. For this reason, it is important to acknowledge how American credit score system encourages household debt.