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Saturday, April 30, 2011
Out of control consumer debt could sink the recovery
The latest statistics show that the total amount of consumer debt outstanding in 2010 in the United States is nearly $2.4 trillion. Based on the 2010 Census statistics, that works out to be nearly $7,800 in debt for every man, woman and child that lives here in the U.S. This, of course, does not include mortgages and other types of debt. About one-third of this consumer debt, or about $800 billion, is revolving debt-mostly credit card debt. The other two-thirds is comprised of car loans, student loans, and other non-revolving types of debt.
With such extreme levels of consumer debt, and the additional debt burden on the country from mortgage, commercial, and government debt, the U.S. economy will certainly struggle for many, many years to overcome the negative impact this debt will have on our economic future. Lenders will need to rethink how the evaluate the creditworthiness of borrowers, especially in light of the huge number od defaults we are experiencing on every type of debt.
Banks traditionally look at many factors when considering making loans, but one of the key statistics they use to determine whether or not to lend to an individual is the FICO score. An individual's FICO score is derived through a complex and proprietary formula, but the just of it depends on prompt, on-time payment of outstanding debts and the ratio of that outstanding debt to available credit. Late payments and defaults on debts reduces the FICO score dramatically, which can mean no loan. FICO scores typically below about 680, especially in today's tight lending environment will typically spell doom for a would-be home or car buyer.
Credit card companies offer revolving, unsecured loans to consumers. Because these loans are unsecured, credit card companies can justify charging much higher rates of interest, as compared to loans with collateral, like a mortgage or car loan. However, these days credit card companies are selling debts in default to third-party collection agencies that are increasingly using the court system to basically turn unsecured credit card debts into secured debts. Once the collection agency sues the consumer and wins a judgment, they can garnish wages, attach assets, put liens on property, such as cars and houses, etc.
Many of these unscrupulous collection agencies will basically lie and state (to the courts) that they have served the consumer with papers on a lawsuit, when if fact they have never done so. The court date comes and goes without the consumer ever knowing about it, and the collection agency then secures a default judgment against the consumer for the full amount of whatever they have claimed the consumer owed, plus interest and court costs in some cases. Once the default judgment has been obtained, it is open season on the consumer and there is little that the consumer can do, other than pay the collection agency in full.
There are many so-called debt consolidation and debt clean-up companies, that claim they can help consumers deal with credit card companies and collection agencies, once debts have gone into default. Most of these are either complete scams, or at best are ineffective.
What is the consumer with debt problems to do? Most credit card companies, if the debt has not already been sold to a collection agency, will negotiate with a consumer, to either reduce monthly payments, or to settle a debt in full for less (sometimes 50% less or more) than what is owed. When credit card companies sell debts to collection agencies, they typically only get 5% to 20% maximum on the debt owed, so they will gladly take the 50% from the consumer. This does not mean, however, that the consumer's credit report will be undamaged. A settlement will show-up on credit reports, and will negatively affect the FICO score, etc. Most collection agencies, once the debt has been sold by the credit card company, will negotiate a settlement as well, usually for some reasonable percentage of the total debt.
Consumers entering into negotiations either with the credit card company, and especially with the collection agencies, should be sure to get all terms in writing, and should ensure that the agreement states clearly that the debt will be shown to be settled in full, and that any remaining amount will never be sold to another collection agency, and no additional attempts will be made to collect any remaining balance, etc.
The process of dealing with debts in default, or a full blown bankruptcy, can be complicated, and there are specialist attorneys out there that can help. Consumers can do a lot of the necessary work themselves, however, if they take their time, research the issue, and work the problem through to conclusion. Doing nothing is the worst thing one can do in this situation, so if you find yourself in default, take action, be proactive, and do your homework. There is life after credit card debt, it just takes a long time and a lot of work to discover that life!
Craig D. Allen, CFA, CFP, CIMA