Shouldn't the "credit score" prevent Americans from going deeper and deeper into personal debt?

Question

I'm not from the U.S but I know about the dreaded "credit score" that haunts Americans. I've seen a lot of documentaries and videos on YouTube with people that can't get a loan to buy a house because of bad decisions in the past that affected their credit score. But I've also seen a lot of documentaries and videos where people are in over their heads in debt, debt that they might never repay and it's just getting worse.

We have a similar score in my country used when one wants to take a loan but it works differently. For example:

• if I have no credit score (i.e. I have never taken on any loans, I don't have credit cards, etc) then to a bank that's a good thing. I need to prove I can pay back the interest on the loans by providing income reports and that's that. I can take for example a mortgage loan just fine like this. But not in the U.S though. If you have no credit score then most likely you won't get a mortgage loan. If you've never had debt somehow it's bad in the U.S. I don't get this.
• this score in my country is an indicator of how much I can borrow. The more loans I have, the fewer loans I can get. If all my loan repayments sum up to more than 40% of my income then no more loans for me. In the U.S. though, I see people making 20K an year but have credit card debt of 90K. How is this possible? How can you get more loans when the ones you already have are way over what you can ever pay back?
• if you are bad at repaying your debts then you get a bad credit score and you can't get any more loans. From this regard the measurement in my country and the U.S. is similar. This is what I think a credit score should work.

That's a few details to understand where I'm coming from. So I guess, my question is. How can Americans can get into so much debt and why isn't the "credit score" putting a cap on it?

A "credit score" in my country limits the extra debt you can take if you are already in debt. In The U.S. though, it seems that the "credit score" allows you to get even more debt if you already have a lot of debt. Paying the minimum monthly payment on all your credit cards and rolling the interest payments into the future somehow seems "responsible" behavior but having no debt is seen as "suspicious" and people are afraid to give you loans because they don't know how you will behave. Somehow the dude that has more loans than what he makes an year can get more loans.

Can somehow add a layman explanation on how Americans can be so much in debt but have good "credit score" that allows them to borrow even more?

Answer 1

I think the heart of the matter is that you're misinterpreting both what comprises a credit score in the US, and how they are used. This is evident in your second to last paragraph:

A "credit score" in my country limits the extra debt you can take if you are already in debt. In The U.S. though, it seems that the "credit score" allows you to get even more debt if you already have a lot of debt. Paying the minimum monthly payment on all your credit cards and rolling the interest payments into the future somehow seems "responsible" behavior but having no debt is seen as "suspicious" and people are afraid to give you loans because they don't know how you will behave. Somehow the dude that has more loans than what he makes an year can get more loans.

Credit scores are meant to be predictors of risk in the sense of using past behavior to predict future behavior. The models are built on training data which helps determine what data points about past behaviors can help us predict future behaviors. There's plenty of info on the web if you're interested in knowing what specific factors are used.

Lending decisions aren't made purely on risk though. They're also made on cash flow. If you're trying to take out a new loan, a lender will check your credit score to help them decide how to price the loan, if you're approved (riskier people will get a higher interest rate). They'll look at other factors to determine if you can afford a loan, i.e. debt to income ratio.

The point is, the credit score alone is not the decision factor used by a lender. It's not intended to be a sole indicator of creditworthiness. People who rack up a lot of debt may still have "good" financial habits. They may always pay everything on time and may never cause a loss. They may have a great credit score. However, they may not be able to afford any more loans on their current income. Or, they may have a really high income and could easily make payments on a new loan. Their credit score isn't meant to tell you which situation they're in.

You didn't tell us where you're located or the inner workings of credit scores in your jurisdiction, but it sounds like your credit score is meant to indicate risk and affordability. That's a significant difference.

To get back to the statements you made at the beginning of your post,

I'm not form the U.S but I know about the dreaded "credit score" that haunts Americans. I've seen a lot of documentaries and videos on YouTube with people that can't get a loan to buy a house because of bad decisions in the past that affected their credit score. But I've also seen a lot of documentaries and videos where people are in over their heads in debt, debt that they might never repay and it's just getting worse.

It's probably not reasonable to evaluate the lending practices in any country based on (potentially sensationalized or inaccurate) videos on YouTube. You gave an example,

I see people making 20K an year but have credit card debt of 90K

It's likely that either that person's income or other factor has changed recently, or they were creative (dishonest) in their loan applications, or they had a co-signer you don't know about, or there was some other mitigating factor. Anecdotal stories of the system "failing" to cut someone off don't inherently condemn the system, and it's almost certainly true that any other lending system or credit scoring system (including the one local to you) also has stories of people getting upside down in debt.

After further reflection, I'm editing this answer to make another point clear. It seems that a large part of your theory is based on credit scores being a measure of how much debt someone is in. You seem to be implying that a high score is somehow correlated to having a lot of debt. That's not true. It is true that "history" is one factor in the scoring system (in terms of how many accounts you've had, of what types, for how long). Specific to this factor, having more credit accounts for a longer time can mean that your score is higher. However, history is not the most important factor, and "amount" of debt isn't (directly) a factor at all. It's possible to have a very high score with zero outstanding debt. It's also possible to have a very low score with years of high balance outstanding debt.

The bottom line is, the score predicts risk. Having a history of using credit gives scoring models data to base that prediction on. The most important factors are based on being able to show that the consumer will reliably pay debt (i.e. they have a history of making payments on time, they do not have charged off accounts, they do not have accounts in collections) regardless of the amount of debt they're in.

Answer 2

Can somehow add a layman explanation on how Americans can be so much in debt but have good "credit score" that allows them to borrow even more?

A credit score measures the risk of not making monthly payments.

That's all. Nothing more.

If a creditor thinks you're a larger risk, they'll likely just demand a higher interest rate, or some form of collateral on the loan. Assuming they're wiling to take on that risk.

Answer 3

One aspect that may not be obvious from outside the US is the prevalence of medical debt. A quick Google shows that about 2/3rds of bankruptcies are due to medical issues. The easiest way to end up $100k in debt is to find out you have cancer. While putting people into crippling debt because of medical issues is messed up, denying life-saving care to people with low credit scores would be worse.

Answer 4

How can you get more loans when the ones you already have are way over what you can ever pay back?

Credit scores don't exist to help the consumer; the exist to help the lender. A person who will never pay back their loans can be a fantastic investment.

The poor debtor still has to eat, so they will get a job. The court system will then let you garnish their income until the loan is paid off (i.e., forever).

So why aren't people getting unpayable loans in your country? The safety valve in this system is that people with loans they can never repay could file for bankruptcy. People in your country probably can file for bankruptcy. But bankruptcy in the US is a long, difficult, and expensive process. Moreover, recent laws in the wake of the 2008 financial crisis have tended to make bankruptcy harder, not easier to get.

TL;DR: The equilibrium amount of debt isn't determined by credit scores; it's determined by regulation, particularly the availability of bankruptcy.

Answer 5

In the U.S. though, I see people making 20K an year but have credit card debt of 90K. How is this possible?

You don't see that. I don't know what sort of fear-mongering sympathy extracting nonsense you've seen on the internet, it is not common at all for someone earning $20k to have $90k of credit card debt. In fact, at $20k of income a normal limit would a few thousand. That person lost their job or most of the debt is student loan related (because underwriting for student debt throws away the obvious income driven risk assumptions thanks to government support).

Credit score measures your history of repaying your obligations, that's it. Your credit score doesn't know your income. There are lots of people who seek, needlessly, to optimize their credit score by having the "right" blend of debt and the "right" utilization. But all a credit report lists is your:

• reported debts (some debts aren't reported, interpersonal promissory notes being the most obvious example)
• the original balance (in the case of installment loans)
• the high balance (in the case of revolving debt)
• the current balance
• a minimum payment due
• whether or not the account is in good standing
• history of payment

It doesn't know your income history, level of education, whether or not your under/over paid, etc. If you want a car loan, the lender is going to request your employment information and some proof of income. That lender's underwriters will determine whether or not it's reasonable to assume you'll properly service the debt. Your score will be used primarily to set an interest rate, but your proof of income will be used to assess whether or not to issue the loan at all.

Paying the minimum monthly payment on all your credit cards and rolling the interest payments into the future somehow seems "responsible" behavior

The minimum payment on a credit card in the US will include the interest due. A normal minimum payment is interest plus 1% of principal.

The debt systems in many countries differ in a lot of very interesting ways, a lot of times, these differences are really in the details. To some extent these differences are cultural. There are pros and cons to everything.

In general I'll agree with you that a lot of people have bitten off more than they can chew and in some cases it's not clear who's really at fault. The whole point of debt is that you commit future earnings/productivity for liquidity now. Zero people should be buying a TV on a credit card that's not being paid in full. That TV, that dinner, those shoes, won't get more valuable as time goes on. It's one thing to use debt to buy a more expensive more reliable car than you could with cash because the car will facilitate your productivity. It's one thing for a company to borrow money to expand rather than waiting to fill the war-chest because it can be important to beat competitors to market, so giving up some of the future profit is worth it. But, I've heard the craziest rationalizations for consumer debt spending.

I think getting in to debt problems when you're young is far too common in the US. A $1,000 debt at 20% interest is $16.67 per month of interest. When I was working my very first job $16 was the better part of 2 hours of work, before taxes. $1,000 feels small. The "problem" is not the ones you illustrate. The problem is young and poor people committing 2 hours of work every month to service the interest on the TV, night out at the club, wheels for their car, they bought on their credit card. Young people get crushed by somewhat inadvertently committing relatively huge amounts of their productivity to service interest for innocuous consumer goods. In these situations it's not really clear who's at fault. Kids just don't understand that $1,000 is actually a difficult hole to fill at $8/hour.

But there's another group of young people today are giving postmates their credit card to spend $9 in taxes and service fees and $5 tipping the driver for a $12 sandwich so they "can work an extra 30 mins" because it's "less expensive when you consider my time." It's these folks that will also complain about their student loans while they lease a $6,000/year car. Then lose their $120k/year job for whatever reason when they have $90k of debt (comprised of watches, jewelry, clothes and vacations) and become the example you heard about. My grandparents, who lived through the depression, would have bought the ingredients for the sandwich from the grocery for less than these folks tip the delivery driver and spent a couple minutes preparing lunch for themselves, then saved the rest. There's been a culture shift.

Banks use statistics to underwrite large pools of people. None of the examples above is a "problem" for the bank. The bank knows X% of people will never pay the money back, it's built in. The issue is the stories are sad for the individuals who populate the X% of people who default. There are the genuine people who are hit with some unfortunate circumstance beyond their control and it crushes their finances. For every one of those stories there are 100 of someone who just made a long series of bad spending decisions until the situation became unsustainable then some catalyst event, like a job loss, causes the financial house of cards to collapse. But rest assured, for almost everyone with debt problems, their problem was not that they lost their job, their problem was spending and not saving. And spending habits are not included in credit score.

Answer 6

One part of the reason is that bad credit scores do not stop people from getting loans, it just means that they'll pay higher interest rates. At the lower end, they may resort to predatory lenders. From the point of view of such a lender, having the loan repaid is almost the last thing they want. They'd much prefer you to just keep paying the (very high) interest on the loan forever.

OTOH, those of us with really good credit scores tend not to borrow, except for a mortgage or similar.

Answer 7

Shouldn't the “credit score” prevent Americans from going deeper and deeper into personal debt?

The credit score is often used as a indicator of financial risk as @RonJohn stated.

Here is where it gets perverted in US Financial... Banks know low income folks and others with low credit scores are riskier, so they still make the loans but at a higher rate. They make lots of money on the high interest loans. When the loan goes bad they sell the debt to a collector and still make money.

US Banks recognize how lucrative a market it is to lend to low income/high risk customers. In fact some banks, like Capitol One and Bank of America, specifically targeted low income/high risk folks because it reaps so much profit even with the loans going bad.

I believe Bank of America boasted 30% of their profits came from the lowest 20%-income folks (the poor people, not the rich people). I don't know if that continues as of 2019.

In the US this is one of the practices known as a "ghetto tax". US law does not forbid the predatory behavior.

(I've got a PBS documentary on DVD that discussed this. I'll try to find it for a proper reference).

Answer 8

I have moved recently to the US from Europe. The simplest answer I can think of is the ability of the Credit companies to trap you further by giving loans at "higher interest" rate.

For example, it is common to see Ads like "Have bad credit score? Don't worry! we have loan for you". Apparently such a loan is given at a significantly higher interest rate trapping the people further with a further bad score. This goes like a infinite loop.

In Europe, credit companies do not venture high risk/high interest lending at all, possibly due to regulations from the governments too.

Answer 9

I would like to add a few contributions on my experience in European contries.

First, in the majority of EU countries there is a so called usury tax rate, which is a limit on the effective APR (% of interest plus fees computed as if they were interests) above which the lender cannot issue a loan. This is regulatory and prevents interests from growing indefinitely. So lenders will try to charge customers up to that rate, and that includes in particular revolving credit cards.

Second, there are procedures and more likely chances to go bankrupt for the private consumers (according to each country's regulation). A consumer defaulting can be erased both debt and credit score, and while they won't probably get any more loans forever, the lender will suffer a huge loss. So lenders won't take the risk of lending too much money if the interest rate is not sufficient to be profitable and the customer is requested excessive payments.

There is also a third factor I have seen but can't really explain in this context. In Europe, it is more common for people in difficulty to settle an agreement to repay all the debt one shot at a significant discount rate, provided that the consumer proves their objective difficulty (lack of job, last property to sell...). A settlement agreement means just that the lender can choose between 1) continue stalking a problematic payer for life or 2) get X% (where X can be 70, 50, 30...) of the entire debt tomorrow and say bye forever to the customer. In this scope, it looks like a number of lenders prefer the egg to the chicken.

Answer 10

The mistake you are making is thinking that "having debt" means having a good score when, in fact, the opposite is the truth. The credit score that most lenders in the US use is your FICO score (developed by the Fair Isaac Corporation). In this credit score calculation 35% is made up of payment history and 30% is made up of credit utilization. When it comes to credit utilization, the lower the better. Having below 30% utilization is good but even lower is ideal. So in other words, if all my credit cards have a combined limit of $20k, then I should have balances of no more than $6k. So really if you're applying for a Mortgage you must prove you have enough income to pay it back AND that you have demonstrated responsible credit usage. The bank avoids risk because they do not assume that just because someone has the money to make the payments that this means they will consistently and reliably make the payments.

As far as how people with low income can have such huge balances and high debt... That is a tougher question. The US has pretty strict laws regarding how much a lender can approve for a Mortgage (many enacted after the mortgage crisis) perhaps there should be similar rules for credit cards? Make no mistake though, regardless of what you may have heard, if an individual has high balances on their cards or they're maxed out, then they most likely DO NOT have a good credit score.

Answer 11

I won't delve into the technical answers to your question, as they're a beaten dead horse. I'll give a more philosophical aspect.

A lot of it boils down to worldview.

In your country, it appears that there are safeguards in place to keep you from going into debt. America is more sink or swim. Those ubiquitous "freedoms" you hear us bragging about allow us to do many things; but they're also a double-edged sword.

The US credit score is a suggestion- not a restraint. As long as Company A is willing to lend you the money, your score could be 0...it matters not. America is the land of dreams. Everybody wants a house, car, beautiful spouse, and their friends' attentions. The freedom of credit means they can suffer the consequences later, but scratch the itch today. It's been that way for 70+ years. I have personal opinions on that, but this isn't the vessel for such conjectures.

Additionally, the total amount of debt is not always correlated with your income. Case in point, a famous football player retires- but has a materialistic wife, three kids in private school, and a freeloading brother. His previously high income will allow for an astronomical debt limit. So even if he makes $30k a year working for Wiener World now, he can still plow further into the red than if he never was rich.