A Fate Worse Than Debt:
Are You a Walking Junk Bond?
By JONATHAN CLEMENTS
March 19, 2008;
Banks are shaky. Bonds are suffering cuts in their credit ratings. Even bond insurers are hurting. Next up for a downgrade: people.
As the economy sputters and the housing market slumps, folks are struggling to pay their bills, and growing numbers are seeing their credit scores tumble. The result: Among Americans with credit histories, maybe a fifth are now akin to walking junk bonds, with lenders viewing them suspiciously and offering them credit only at steep rates.
Here is a look at what’s happening — and how you can avoid junk-bond status.
Unraveling Fast. To get a handle on the state of U.S. consumers, I turned to Equifax, the Atlanta-based credit bureau.
For every consumer with a credit history, the firm calculates an “Equifax risk score,” which ranges from 280 to 850. The average credit-risk score for U.S. consumers climbed fairly steadily for much of this decade, in part because many Americans used home equity to keep their credit-card debt under control.
But over the past year, the average score has slipped slightly. More notably, there has been a 7% increase in consumers in the bottom category, those scoring below 580. These folks now account for 17% of the consumers tracked by Equifax.
“I think it’s directly related to the subprime consumers who are behind on their mortgages,” says Myra Hart, a senior vice president with Equifax. “They’re late on their mortgages or even going into foreclosure.”
As the economy slows, she says most consumers will maintain decent credit scores because they will hang on to their jobs. But among those unlucky enough to get laid off, we could see a further jump in rock-bottom credit scores as these folks struggle to pay their bills.
Indeed, for the unemployed, things could unravel fast. Ms. Hart notes that debt-service payments have jumped 39% over the past five years, outstripping the 25% rise in disposable income. On top of that, the annual savings rate this decade has ranged between a meager 0.4% and 2.4%, which suggests families don’t have much of a financial cushion to fall back on.
Dodging Disaster. Don’t want to end up as a subprime consumer? To maintain a top-notch credit score, the standard advice is to pay your bills promptly, avoid applying for credit too often and use only a small percentage of your available credit lines.
Such strategies are important — but they aren’t exactly a prescription for savvy money management. Instead, what you really need to do is shun the sort of foolishness that can put your family in peril. To that end, stick with these two guidelines:
Cap your core living expenses at half of your pretax income. We’re talking here about things like groceries, car payments, mortgage or rent, utilities, student-loan payments and insurance premiums.
That will leave the other half of your income for savings, income taxes and fun stuff like vacations and eating out. If you lose your job, these other expenses should shrink sharply — and you can live on half of your old income, says Michael Maloon, a financial planner in San Ramon, Calif.
“The key is to have enough savings to cover a minimum of six months of those core living expenses,” he says. “Me and my clients, we don’t take any risk. That money goes into a money-market fund.”
Don’t be short-term clever and long-term foolish. Since the early 1990s, there has been a gradual collapse in financial discipline, as Americans quit saving, spent home equity and, more recently, started raiding their 401(k) plans.
All this has been excused as perfectly rational. Not saving was okay, people believed, because stocks and homes were rising in value. Tapping home equity made sense because rates were low and the interest was usually tax-deductible. Taking a 401(k) loan was fine because you pay interest to yourself.
Indeed, with enough of these clever strategies, you could wreck your financial future. What if you lose your job, get hit with unexpected medical bills or decide you want to retire? Trust me: Things could be mighty rough if you haven’t saved, your home is fully mortgaged and you’ve drained your 401(k).