Why Consumer Credit Will Remain Frozen

One topic that is vastly misunderstood is a consumer’s credit score.  It is not taught in school and it is seldom a point of discussion.  This is frightening as we enter what appears to be the perfect storm of a frozen consumer credit cycle.  While there are several variables that contribute to one’s score, the two main factors are punctuality and credit utilization.  In fact, these two variables account for 2/3 of one’s credit score.  Unfortunately, macro-economic factors are making it difficult for many Americans to remain whole in these areas.

For the past several years, easy credit has been a substitute for low wages.  Beyond the well-known mortgage debacle, credit card issuers doled out lean credit terms and high credit limits.  Drunk consumers continued to drink and pushed their debt balances to those limits, hoping to just be given more credit when they needed it.

Now strapped for cash due to layoffs and a shrinking economy, these consumers are not able to make their minimum payments on time.  That crushes the punctuality component of the credit score.  The other component I mentioned – credit utilization – is being sabotaged by the credit card companies who will no longer grant credit line increases.  In fact, many credit card companies are going so far as reducing credit limits and canceling cards that haven’t been used in a while.  Alas, many consumers will soon see their previously decent credit score plummet even if they refrain from making any more purchases with credit.

A credit score is a proxy for a consumer’s cost of capital.  With these scores tanking, money will be very expensive to borrow and hence the consumer credit cycle will remain frozen.  To make matters worse, newly-risk-averse lenders now have stricter credit score requirements.  A thaw will only come if either:  1) ratings agencies employ more lenient scoring metrics (e.g. forgive some late payments and allow higher credit utilization), or 2) banks re-calibrate their definition of a good credit rating.

Should things progress the way they are with plummeting credit scores and rising credit requirements, there will be a large funding gap to fill.  Therein lies the opportunity for peer-to-peer lending companies like Prosper and LendingClub.  Yes they have recently run into issues where they need to register with the SEC, but they will get past the regulatory hurdles (LendingClub already has in most states).  We may also see credit unions rise in popularity, given their lower interest rates on loans and higher rates offered for deposits compared to traditional banks.  Either way, profits will migrate away from monolithic banks and move toward the people.  The bad news is that this market will take a long time to develop, and until then the consumer credit cycle will remain frozen.

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2 Responses to “Why Consumer Credit Will Remain Frozen”

  1. Mark LaRosa Says:

    Andres,

    One of my many sales jobs was for an enterprise collection firm – and the way people deal with things when they get into trouble is staggering – and actually compounds their problems.

    When you get your “late” score, its because you ignore the bill completely. Few people realize that your credit card company, your mortgage company, etc. want to know that you haven’t forgotten them. That doesn’t mean that they won’t penalize you, but you can keep a “late” payment off of your credit score by simply calling them and telling them that you only have say $10 to give them, but that you will send them $10 and get back on track once you have a job again, or whatever your hardship is.

    Likewise, companies ultimately only want their principle back. You can often negotiate away all of your interest and your late fees if you just call and talk to someone. Understand that if your bill goes to a collection agency, the company will give up nearly 30% of the amount you send in… so you can see why when you are dealing with the company directly, you can often strike a deal.

    The tendency with most people is to avoid the call, duck the letter, avoid the hard conversation about the debts. This compounds the problem and destroys the credit. People that face the debt, admit the problem, and face it head on, can avoid a lot of pain – and make it easier to get back into good credit graces once their particular crisis is over.

    Oh – and welcome to blogging!

    Thanks for adding me to your blogroll!

    Mark

    • keepingperspective Says:

      Mark,

      Thank you for the insightful response. That is great information for anyone wanting to eliminate the impact of hefty credit card financing charges. Taking measures as the one you mention should help preserve one’s credit score for future capital needs (once it is safe for the supply side of the credit equation to loosen the pursestrings).

      Thanks again, and please keep the comments coming in the future.

      Andres

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