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| The Basics | The real victims of deadbeats? Other deadbeats
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Lenders would have you believe all borrowers suffer when some don't pay. Fact is, unless you're a credit risk, too, you're unlikely to feel a thing.
By Liz Pulliam Weston
The conventional wisdom is that the rest of us pay when someone walks away from their debt. The banking industry has even put a number on this cost by claiming the $40 billion or so wiped out in personal bankruptcy filings each year translates into a cost of about $400 per household.
As is so often the case, the conventional wisdom is more wrong than right. The reality is many of us pay very little for other peoples defaults. The widespread use of credit scoring, plus the way lenders manage and insure their risks, means the true victims of bad debt can be very different than you might think.
Lets take a look at some major types of debt, and who pays when borrowers dont:
Credit cards
If you dont carry a balance on your credit cards, you dont pay higher interest rates for other peoples bad financial habits simply because you arent paying any interest at all. If youre late on a payment or max out your cards, you might get hit with a fee thats higher than it might need to be because of other peoples defaults. Otherwise, though, youre getting a bit of a free ride.
Even if you do carry a balance, youre not paying much of a penalty if you have good credit. Like other lenders, credit card companies tier their customers with interest rates reflecting their perceived credit risk. The lenders use credit scores to create these tiers, and they say the three-digit numbers have proved remarkably accurate at predicting risk. Those with FICO scores over 800, for example, have a 1% chance of defaulting; people in the 650 to 699 range have a 15% chance, while those with scores under 500 have an 83% risk. Lenders set their interest rates to reflect those risks of default.
Thats why people with excellent credit can qualify for 0% teasers and rates as low as 4%. The average variable rate on a platinum card for these folks is 10.9%, according to Bankrate.com, compared with 13.78% for standard cards that are marketed to people with good, but not perfect, credit.
The people who really pay are those who carry a balance and who have troubled credit or who do things that make a lender suspicious, like carrying high balances or missing payments. Their rates can quickly spiral above 20%, and theyll face more of those punitive fees.
They might also find it tougher and more expensive to get credit when defaults rise and issuers tighten their lending standards. Those with good credit will continue to get plenty of solicitations, said chief economist Sung Won Sohn of Wells Fargo Bank, but offers for people without good credit typically dry up.
Higher-than-expected default rates can depress a credit companys earnings and hurt its stock price, so shareholders might be expected to pay a penalty for defaults. But that hasnt been a problem lately. Banks have been enjoying record profits, said Sam Gerdano, executive director of the American Bankruptcy Institute.
Institutions and pensions that buy credit card debt, which increasingly is bundled into bonds and sold to big investors, also could theoretically take a hit. In reality, that rarely happens; Fitch Ratings Service managing director Michael Dean says only twice have default rates been so high that investors in securities backed by credit card debt received less than they expected.
You can make a better case that taxpayers are picking up a good chunk of the tab for bad credit card debts.
Credit card companies wrote off $35 billion in bad credit card loans last year. Those deductions translated into a tax break of up to $12.2 billion, assuming the companies paid the top 35% corporate tax rate.
If you assume the rest of us have to pay more when some other taxpayers pay less, that tax break cost the average household about $100 last year.
More realistically -- since were in deficit-spending mode -- the write-offs added a few more rain drops to the ocean of national debt, which could someday push up the general level of interest rates and thus cost borrowers more.
Mortgages
Even when foreclosures hit an all-time high last year, mortgage rates continued near all-time lows. Clearly, home-loan defaults werent spoiling the party.
Like other lenders, mortgage makers tier their risks, charging different interest rates to different people based on their perceived risk of default. But the spread might be a percentage point or 3 -- not 10 or more, as can be the case with credit cards. Unlike credit card debt, mortgage loans are secured by an asset that can be seized. Most lenders are also pretty cautious about keeping loans to 80% of the value of your home, which gives them a healthy cushion if you default and they need to foreclose. (You can borrow more, but youll typically pay higher interest rates that help compensate the lender for the extra risk.) Rising real-estate values have kept lender losses low, even when the loans extend over the 80% mark.
The ones who may suffer if you walk away from your home are your neighbors. Lenders sometimes dump foreclosed homes at fire-sale prices rather than hold onto them and incur added costs. Appraisers may factor in these below-market sales when determining the value of other homes in the neighborhood, so the foreclosure sale can dampen temporarily the resale value of surrounding houses. If your area is gripped by a real-estate recession -- a fairly rare occurrence, but one thats hit Southern California, Texas and Boston in recent decades -- the cycle of foreclosures could feed on itself, with more borrowers abandoning their homes as prices drop.
Student loans
The default rate on federal student loans just hit another low. Only 5.4% of borrowers with newly issued loans are failing to pay, according to the U.S. Department of Education, compared with a peak of 22.4% in 1990. Experts credit lower interest rates and laws that made it harder for trade schools to abuse the system.
Still, when you consider that the government guarantees about $40 billion in new student loans each year and that there is $342 billion in outstanding student loans, theres a lot of money not being repaid. So who picks up the tab?
Often, its not the lender that made the loan. Both federal and private student loans are typically insured by guaranty agencies, state or private nonprofits that reimburse lenders for most or all of their losses. (How much money the lender can get back depends inversely on how many defaults it experiences; those with a low default rate can get back 100%, while those with higher default rates get less than full reimbursement. This system is meant to encourage lenders to work with students to create affordable repayment plans.)
Guaranty agencies are financed in part by a 1% fee charged on each student loan. That 1% fee, however, doesnt cover the high cost of defaults, said Brett Lief, president of the National Council of Higher Education Loan Programs, which represents guaranty agencies.
The guaranty agencies turn to the federal government for reimbursement -- to the tune of $2.9 billion last year. Once again, you and I, the taxpayers, pick up the tab.
Auto loans
In some ways, auto loans are like mortgages, because lenders have an asset to grab if you fail to make your payments. One of the big differences, though, is that most new home buyers have at least some equity in the property, while 80% of new car buyers are underwater as soon as they drive off the lot, owing more than the vehicle is worth.
Since theres a good chance they wont be able to recoup all the money theyve lent you, auto lenders, like credit card companies, charge a wide range of interest rates that fairly precisely reflect the individual borrowers perceived risk. Someone with a 750 score might pay 5% on a loan, according to Informa Research Services, while a person with a 650 score might pay 8%. Someone with a months-old bankruptcy might pay as much as 16%. So the worse your credit, the more you pay for others defaults.
Thats not the end of who pays, however. As with credit card companies, auto lenders can have their profits and stock price dinged by high defaults, hurting their investors.
And car owners can be hurt, as well. Auto lenders tend to get rid of their repossessed cars at auctions, and auction prices are factored in when companies like Edmunds.com calculate the resale value of used cars. If your auto manufacturer experiences a lot of repossessions, the value of your car could drop.
Mitsubishi was very liberal (with extending credit) and repos went sky high, said Jeremy Anwyl, president of Edmunds.com. Their resale values have really been hurting in part because of that.
Liz Pulliam Weston's column appears every Monday and Thursday, exclusively on MSN Money. She also answers reader questions in the Your Money message board.
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