I am not an expert in consumer debt, so if this is incomplete or incorrect, I welcome comments on this. However, here is an article from Yahoo Finance on how FICO scores are calculated, and specifically walking through the hits to your score taken for various credit events, ranging from maxing out a card to bankruptcy. I was particularly interested to see that the better your starting credit score, the bigger the hit in points for each event. Meaning, if your score started out at 680 and you had a late payment, the hit was 60-80 points. But if you started out at 780, the same late payment was a 90-110 points hit.
PS. My feelings about consumer debt are much the same as Megan McArdle’s, particularly as my daughter starts getting to those ages in which “consumption smoothing” looks like a possibly good idea … I’m not about to sign onto the Dave Ramsey program (and I don’t sign onto his investment advice, except in the sense of the importance of savings), but I wouldn’t be unhappy if my child did … McArdle can retire now, if she likes, on her laurels for having written a post that I took Strong Measures to Persuade my kid to read, where McArdle talked about what it was like to be unemployed and not be able to afford Chinese food with friends, and how she practiced at home saying in the mirror the words, she said, that were about the hardest she’d ever had to say, “I can’t afford it.”
PPS. Just in case anyone misunderstood, I was complimenting McArdle in talking about retiring now on her laurels, and high praise indeed.
Anderson says:
McArdle can retire now, if she likes, on her laurels
Excellent suggestion.
… I’m not sure how anyone gets through grad school without easily internalizing “I can’t afford it,” but it’s a big country.
November 29, 2009, 7:34 pmSuperSkeptic says:
she practiced at home saying in the mirror the words, she said, that were about the hardest she’d ever had to say, “I can’t afford it.”
What a shame, that that is the hardest thing she ever had to say…
Shameful and pathetic, too, beacuse most of the rest of us know it – and know how to say it – without plodding or practice.
November 29, 2009, 7:47 pmLaura(southernxyl) says:
My daughter graduated from college this spring (with very little money from us and zero debt, I’m happy to say – combination of modest state school and good academic scholarships) and has an apartment and a job. I think she’ll be getting a copy of Financial Peace this Christmas. I’m glad I read this post.
November 29, 2009, 8:07 pmBenP says:
I wouldn’t take things to the extreme that Dave Ramsey does, but that’s more or less how my parents always raised me. If you have a credit card, you pay it off every month. A mortgage is ok, but consumer loans are never an acceptable alternative to “I can’t afford that right now.”
I’ve taken out student loans, but with the way the economy turned while I was in school I’m glad I made the choice of going to a state law school where I had a nearly full scholarship, as opposed to some friends of mine that have four figure monthly debt payments now and no jobs.
November 29, 2009, 8:13 pmEric Rasmusen says:
I wonder if being a stamp or coin collector as a child helps teach about budget constraints. It’s a harmless way of inciting strong desires that can’t possibly all be satisfied.
November 29, 2009, 8:38 pmMalvolio says:
I don’t know about you, but I have lots of practice.
Of course. A poor score means you miss payments; a good score means you don’t. If you have a good score and you miss a payment, that means you shouldn’t have had the good score in the first place. If you have a poor score and you miss a payment, well, par for the course.
All this is particularly poignant for me, because over this summer, my credit-card number was stolen. My bank was alert and called me before the hacker could spend anything (how they accomplished this feat I don’t know). I canceled the card and ordered a new one. Last week, I was applying for a loan and the fact of a “new account” dropped my FICO by (at least) two points, just under some previously undisclosed line between “excellent” and “excellent enough that we will lend to you like we said we would”.
I’ve got a new lender (at an eighth of a point lower, so up yours, Citibank!) but I’m hanging fire hoping that Met Life can get through all the paperwork in time for the scheduled closing, without hitting some new limit of their own.
November 29, 2009, 8:40 pmMahan Atma says:
I went into debt to go to a top-ten law school, and I’m extremely glad I did. The interest I’m paying on the loan is piddly, but the degree has already paid for itself.
If I had followed Ramsey’s advice, I wouldn’t have done this. I don’t know where else I would have gone to law school, but something tells me it wouldn’t have opened the same doors mine did.
November 29, 2009, 10:20 pmKenneth Anderson says:
Mahan Atma: I agree with you on that … the virtue of Ramsey’s program is its simplicity, but that is also its vice. Of course, I’m speaking only from McArdle’s summary, I haven’t looked at it directly. However, there is room for a lot of self-deception in what is consumption and what is an “investment in human capital.” I recently tried to convince my wife that the XBox was necessary as a capital investment in my academic in robots, war, and cyberwar. My wife is something like the Domestic CBO, ruthlessly scoring fiscal impacts.
November 29, 2009, 10:27 pmCalderon says:
Maybe this reflects my own biases (I always pay my bills eventually, but during busy periods at work I’ve been known to forget and get nailed by late payments …), but I was very surprised that a single 30-day late payment has such a large impact on your credit score. If someone had multiple late payments or a 90-day unpaid bill then sure, that would typically indicate that the persons is having credit problems, but one 30-day late payment does not seem to say a whole lot.
I was especially surprised that 30-day late payments hit your score more than maxed out credit cards. I’d think a maxed out “general” credit card (that is, not some card you get for a single purchase, like a department store card you get for a 12-month no interest deal) that lasted for more than one billing period would be a sure sign that the person was having serious credit problems.
November 29, 2009, 10:52 pmFran A says:
Your FICO score is also lowered if you have no car or house loan. And your income is decreased so that your credit limits are decreased when you leave money in your IRA (allowed this year) to attempt to lower your income so that your Medicare B payment will decrease next year.
November 29, 2009, 10:52 pmBenP says:
I’d agree to the extent it’s an investment like any other
I’ve argued on ATL before, I think there’s one big difference.
With the exception that if you want to be a law professor you more or less have to go to a top school, the difference is that at a non Top 14 or Top 10 or whatever school you need to have law review/top 10% grades to get your foot in the door at many places. Whereas from a top 14 school you don’t necessarily need outstanding grades to have good career prospects (again unless you’re shooting for a career choice that’s competitive even there).
Thinking about it in a differnt light. It seems to me Dave Ramsey is very much a “dry drunk” sort of person. The short bio in the McCardle article mentions him making millions being a real estate developer before the house of cards fell apart in the 80′s. Since then he’s developed the outlook that all debt, no matter the source, is bad.
I would just say that people need to have good awareness of what debt is actually costing them. It’s often far to easy to underestimate what that “time” is costing you when you have low monthly payments.
November 29, 2009, 11:41 pmBill says:
If the degree has paid for itself already, why are you still paying interest on the loan that financed it?
BTW, Ramsey’s investment advice is simplistic, but he was absolutely right about one thing: he counseled staying invested even when the market was looking particularly bleak earlier this year. Selling your stock in a panic because the market is down is a great way to ensure you remain behind.
November 29, 2009, 11:53 pmbystander says:
I would like to ask the same question.
November 30, 2009, 1:05 amMahan Atma says:
You’re seriously asking?
Because the investment return I’m getting on my salaried money is greater than the interest I’m paying on the loan.
November 30, 2009, 1:07 amMahan Atma says:
What was his counsel when the market was at its peak?
November 30, 2009, 1:10 amDavid Chesler says:
I agree, Calderon. My father was in commercial collections (ironically, or confusingly, for the leading commercial credit ratings company) and I heard him advise someone that a single late payment is meaningless, much more likely to be from some good explanation (dispute, lost mail) than any pattern. Of course he also claimed no bank examiner would care about $8,000 missing from the Bailey Building and Loan but would write it off as a bookkeeping error.
I’m surprised if the FICO formula is all that secret. It wouldn’t be hard to run regressions on enough credit histories. (It also wouldn’t be hard to reproduce Coke.)
But I’m surprised a lot. I’ve just had a credit card I didn’t use very much closed for derogatory information and “length of time accounts have been established”. The derogatory information is correct, but it was three years before I got this credit card four years ago. I intend to call them during business hours to find out if the length of time is too long or too short.
One’s mileage may vary. It was my wife who led me to that derogatory situation. After a bout with cancer in her early 20s she lived every day as though it might be her last, and one day she was right. You can take it with you if it’s personal unsecured debt, and she did. (The credit card offers come to the wage-spender, not the wage-earner, so the cards were in her name.)
If you’re debt-free and intend to remain that way (including for house mortgages), what difference does your FICO number make?
November 30, 2009, 1:19 amJeff Walden says:
Can you win your own thread? I think I’ve just seen it happen.
November 30, 2009, 1:22 amneurodoc says:
What exactly constitutes a “30-day late payment”? Surely it isn’t overlooking a credit card bill one month, incurring the late payment charge and interest, then paying the balance in full the next month. So, is it missing a couple of months in a row?
And “maxed out” on a credit card? If you charge the full amount allowed on a given card, then pay it in full, there’s a ding to your FICO score?
I understand the “concept” of late payments and spending to the very limits of one’s available credit lines, but I wonder if the criteria are really these. What does it say about one’s creditworthiness if they max one credit card but have a great deal more untapped credit remaining on other cards, credit lines, overdraft protecction, etc.? I have “maxed” a card to take advantage of special offers (e.g., double miles for using card to pay taxes, so miles at <1.245 cents each and extra benies too) and seen no damage to my FICO scores.
And some other things like dings for closing accounts that are not in arrears seem strange. There is some negative implication to that? (Yes, I know there regression analyses must point to some correlation with likelihood of default on debt, but why should there be any correlation? Opening new accounts can result in dings too, I believe.)
I have directed my daughter not to accelerate repayment of her 3% interest rate loans from law school. If they were 5% or higher, I’d probably tell her to pay them off and be done with them, but not at 3%. Just too bad that the interest on school loans isn’t tax deductible.
November 30, 2009, 1:41 amJeff Walden says:
I too wonder about FICO scores decreasing drastically for a single late payment. I’m also somewhat confused that more loans make you more trustworthy and that closing credit card accounts can actually be bad if they’re old credit cards. I have one I’d love to cancel, but because it’s ~5 years old and my other one’s ~6 months I’ll get dinged heavily for doing so, so it sits almost as dormant as I can make it, maybe a purchase or two a month to keep it “in shape”. It would be sensible if closed-in-good-standing accounts remained on your credit score a few years or so, but I assume it’s some privacy regulation that makes the FICO score not track that data. It would be nice if there were less homogeneity in credit-worthiness scoring, maybe add a few more scoring methods that look at you in different ways, to avoid rough edges like this.
On the other hand, I have no plans in the next couple years to avail myself of a good credit score (mine could take a good knock or two and still be in decent shape if it had to), so perhaps I shouldn’t even worry about it.
November 30, 2009, 1:44 amDavid Nieporent says:
She means saying it to her friends. It’s easy for anybody with discipline to say it to herself. But when your friends are all doing something, and try to include you, and you can’t, that’s harder.
November 30, 2009, 4:14 amDavid Nieporent says:
Well, for one thing, the fact that you ‘intend to’ remain debt-free doesn’t mean your life will work out that way.
For another, other people pull credit reports besides lenders. Landlords. Employers. Insurance companies. A poor score can cost you money, a residence, or a job.
November 30, 2009, 5:16 amSecond Amendment Sister says:
Funny you should say that, as there are 12 Step programs for people with financial issues. The “dry drunk” is the one who isn’t in recovery but doesn’t engage in the behavior anymore.
November 30, 2009, 7:19 amTracy W says:
Superskeptic – if everyone but Megan McArdle knows how to say “I can’t afford it”, then why are there such high personal debt levels around the place?
November 30, 2009, 9:03 am(Admittedly they could all be from people whose problem is not saying the words, but recognising that they can’t afford something in the first place).
Ken Arromdee says:
Because you’re thinking of a credit score as a measure of responsible financial behavior on your part. That’s not what a credit score is.
November 30, 2009, 9:18 amMike says:
My credit score is 806 as of last week. I am a poor civil servant (cop) who has no debt other than my mortgage which stands at agout $55k right now. I do have a zero percent credit line at Apple for the Christmas iMac, but otherwise debt free.
People need to learn to pay as they go, and not just to use credit. They also need to learn how to use it (house, car, etc, not PF Changs).
November 30, 2009, 10:17 amJanon2 says:
November 30, 2009, 10:27 amPubliusFL says:
It is deductible, the cap is just low ($2,500 IIRC). On the plus side, it’s above the line, so you benefit even if you don’t itemize deductions.
November 30, 2009, 10:35 amuh_clem says:
I can understand someone with little education needing the simplicity and inflexibility of Ramsey’s approach, but someone with an MBA? Either she didn’t pay attention in class (which perhaps explains why she was unemployable upon graduation) or she missed some life lessons along the way somewhere.
Anyway, the more I read McArdle the more I come away with the impression that she’s pretty wet behind the ears. I have a hard time taking financial/economic advice from someone who needs the help of a personal financial program aimed at people with the mental age of a seven year old.
November 30, 2009, 11:17 amConnie says:
I just skimmed the article, but it doesn’t really tell how your score is calculated to begin with, right? So the title of this post should be “How your FICO score is affected.”
Also, what’s with recommending something to your daughter that you wouldn’t do yourself?
November 30, 2009, 11:24 amDan Weber says:
Seriously? A fire causes more damage to a mansion than to a wooden shack.
If you have a better credit score, you have a lot further to fall if/when you screw up.
November 30, 2009, 11:29 amDavid Chesler says:
It goes both ways, Dan. If you drop a match in the shack it catches fire; in the mansion it bounces harmlessly off the marble floor while the smoke alarm alerts the staff to put it out.
I think 30 days late means you not only missed the payment due May 1 but you didn’t make it up in the payment due June 1 — you’ve missed 2 payments. That’s in the real world, anyway.
@Ken, what is a credit score? One might think it’s an actuarial measure of an individuals likelihood of defaulting. We think the borrower who has been more responsible in the past is the better risk; in the perfect world Fair Isaacs has determined that closing an old account while charging a purchase at WalMart on a Tuesday precedes defaulting to a statistical significance. In a cynical world they’re a mysterious means to justify putting almost everyone into the lending equivalent of the assigned risk pool.
A poor score can cost you money, a residence, or a job. Does anyone have numbers? Suppose someone has $X,000 unsecured debt. Paying it off has (by definition) a NPV of $X,000 (or more because the interest rate on debt is higher than what’s earned, if they can’t pay it off all at once.) Nuclear option, a Chapter 7 bankruptcy (with so much protected in a homestead) will cost the filing costs and fees, plus $Y,000 over the next decade in higher interest rates on a car loan, higher rents, worse jobs: What’s an estimate for Y? I suspect that Y might be quite a bit less than a bad pile of consumer debt, even factoring in that something worse happens in the following 7 years and the homestead has to be liquidated (compared to having liquidated it now to avoid the bankruptcy and the same bad thing happening anyway.)
At the tactical level, and especially with the current credit card environment, failing to make a minimum payment can be relatively expensive for someone carrying a balance.
November 30, 2009, 12:52 pmKirk Parker says:
Jeff Walden,
Well, Wretchard does it all the time over at Belmont Club, albeit in the Serious Commentary genre rather than Humor.
November 30, 2009, 1:09 pmFico-victim says:
i’ve gotten a “30 days late” due to a legitimate charge appearing on a card that I thought was closed, and the bill getting lost due to personal disorganization.
in other words:
month 0: balance of $0.00
month 1: balance of $20.00 due to new charge of $20.00
month 2: balance of $25.00 due to late penalty of $5.00
month 3: balance of $0.00 due to payment of $25.00
and I got a “30 days late” ding for month 1.
November 30, 2009, 1:12 pmBen P says:
I think what Fico Victim posted is correct.
I’ve occasionally reviewed credit reports through work.
When you get a credit summary you’ll see different kinds of debt which includes “revolving,” “current,” “0-30 days overdue,” “30-60 days overdue” and “90 or more days overdue.”
Your statement comes and it says it’s due on Dec 15th, you lose the statement for a week or two and Dec 15th passes. The morning of the 16th that payment goes into the “30 days overdue” Column. Realistically, the credit card company is perfectly happy to charge you $25 (or whatever) for the privilege of making your payment a day or two late, but it still gets reported to your credit score as overdue.
November 30, 2009, 2:01 pmPubliusFL says:
I disagree. My understanding is that the credit reporting bureaus classify their late payment categories as 30-59 days late, 60-89 days late, 90-119 days late, and 120+ days late. See, for example, the TransUnion Credit Report Training Guide. So a 30-day late means you paid at least 30 days but less than 60 days past the original payment due date. Some creditors sometimes misinterpret the categories as “up to” rather than “at least,” though. That’s another good reason to check your credit report regularly. If you get a 30 day late for paying less than 30 days late due to a creditor’s misunderstanding of the credit bureau’s payment status categories, that’s a derogatory item that’s ripe for dispute.
November 30, 2009, 2:53 pmBill says:
Exactly the same. Avoid debt and invest for the long term.
November 30, 2009, 2:55 pmGramarye says:
I’d actually be interested in knowing what Ramsey would say about going into debt for professional school. Perhaps he really would be against it, given that he doesn’t even suggest that people use credit cards even with the intent (and ability) to pay the full balance every month. It does seem to draw on many of the same themes as recovering alcoholics who have to avoid alcohol entirely–i.e., who are unable to drink socially without succumbing to the temptation to drink irresponsibly. That seems to be a “second best” alternative in my book. What we should really be teaching our kids is the genuinely responsible use of debt. (Hint: it’s not what Citi or the car dealership say it is.) Using a credit card is fine if you’re going to be able to pay it off every month. Some debt for education is probably justifiable, too, though I do think there’s merit to the argument that four years of private undergrad and three of private law still carries too high a price tag.
November 30, 2009, 3:02 pmneurodoc says:
Yes, I think many people are unaware that FICO scores are looked at by those “non-lenders” and low scores can have unhappy consequences.
The interesting thing to me about FICO scores is that they take no notice of your net worth or liquidity, matters that a bank would certainly take into account before making a very substantial loan.
November 30, 2009, 4:13 pmBill says:
He’s big on getting in-state tuition rates at state schools.
BTW, my parents followed an approach very similar to what Ramsey now recommends — live frugally, avoid debt, save a lot — and as a result I was able to attend a world-class engineering school without incurring any debt.
Absolutely, and that’s what I do. But the credit card companies are threatening to jack up fees on people who don’t carry a balance — if that happens I’ll be making a lot more use of debit cards instead.
November 30, 2009, 4:19 pmneurodoc says:
They are supposed to predict your likelihood of you defaulting on any of your debts. Is that really different from “a measure of responsible financial behavior”? And why should it adversely affect your FICO score if you decide to no longer stay with one of your credit cards and close it with no history of missed or late payments? The longer your history of timely payments on any debt, the more that may boost your score, but what difference should it make if you keep open inactive accounts?
November 30, 2009, 4:20 pmneurodoc says:
If that is true, then so much the better, and still less reason to repay early very low interest loans. (I assume that cap refers to a limit on the amount of interest that can be deducted, not a limit on the amount of principal eligible for a tax deduction of the interest paid.) I’ll ask our accountants.
November 30, 2009, 4:23 pmLeo Marvin says:
Does that mean you didn’t and won’t get the XBox?
November 30, 2009, 5:16 pmBen P says:
I think the mistake is that you’re not considering the audience. I don’t think your FICO score is really intended to be useful to you. More, I think it’s a score that’s supposed to tell prospective lenders how likely you are to be profitable for them. A person who carries a balance is going to be more profitable than a person who does not, and a person who keeps inactive accounts is a drain on the creditors resources (administration etc) without bringing in any income. Likewise a person with high debt and even higher credit is likely to have a “higher” credit score than a person with low credit, but a large pool of assets, because the person who’s willing to incur debt is more profitable.
November 30, 2009, 6:06 pmneurodoc says:
I think you are wrong about the “audience” and the purpose FICO scores (there are more than one) are supposed to serve. A mortgage lender is not going to profit any more (or less) from a borrower who carries balances on their credit cards than from a borrower who pays in full each month. What is going to affect a mortgage lender’s profits is how many defaults they experience, and they look to the FICO score as one predictor. (Mortgage lenders look to more than FICO scores, including one’s assets and source(s) of income, which FICO scores don’t.) And credit card companies don’t know from FICO scores or credit reports whether you are going to carry balances and generate a lot in interest income for them.
I wonder if credit card customers who always pay their balances in full each month, ever “cost” the credit card issuer money other than what it might have cost to sign them up. They may not be nearly as profitable as those who generate lots of interest income and fees, but so long as they never default, do they really cost the credit card company money?
November 30, 2009, 11:53 pmLaura from viewonlinecreditreports.com says:
We should all have a basic understanding of our FICO score, and we should make our children aware of it as well
December 1, 2009, 2:09 amKen Arromdee says:
They are supposed to predict your likelihood of you defaulting on any of your debts. Is that really different from “a measure of responsible financial behavior”?
Yes, it is. There’s a difference between something which is irresponsible, something which is related to something irresponsible, and something that is related to something irresponsible on a statistical basis only. Imagine that people who go to Wal-Mart sales on Tuesday are more likely to be unemployed and thus to default (people with jobs go on weekends). Being unemployed by no choice of your own is not irresponsible, and even if some unemployment can be caused by not being responsible, the association of it with going on Tuesday is only a matter of probability, not a certainty. If you go on Tuesday, it still lowers your credit score; you’ve done nothing irresponsible, but statistically, you are in a category which is a higher risk.
Of course, the credit companies could try to distinguish unemployed Tuesday shoppers from employed Tuesday shoppers, but that may end up costing more than what they would gain from defining the category more narrowly. (This is a contrived example, so you can ignore the fact that it’s fairly easy to tell if someone is unemployed.)
December 1, 2009, 9:28 amAleks says:
Insurers, landlords and employers use the whole credit report not the FICO score. The latter is mainly useful for lenders as it is believed to be predictive of default risks. Insurers have their own scoring formula which they refuse to reveal. Landlords generally don’t care about thing like old bankruptcies or maxed out credit cards, but are looking for a history of late rental payments, judgements by former landlords, and maybe late utility payments. Employers have their own criteria which probably varies from firm to firm, though scanning for overal indebtedness may be a way to spot possible embezzlement and theft risk in potental employees.
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December 22, 2009, 11:33 pm