One reader with a 805 credit score e-mailed me saying he recently got denied for the Barclays Arrival World MasterCard. As part of the FICO Open Score Access initiative, he got his credit score in the mail plus the nice rejection letter. The reason for the rejection was a high debt-to-income ratio.
The credit score is supposed to encapsulate everything from outstanding debt, number of credit lines open, and debt to income levels, yet here he is being denied a credit card with just a $3,000 monthly credit limit to start! If someone with a credit score that’s in the top 10% can’t get a credit card, what hope is there for the other 90%? Let’s find out more about his story.
The reader used to make about $200,000 a year for the past three years, but is currently unemployed and earns $40,000 a year from his various passive income streams + his $1,800 a month unemployment checks. He’s only got two other credit cards and always pays them off in full. The problem with his financial profile is that he has a $800,000 mortgage on a $40,000 income. With the industry standard of a mortgage amount no more than 5X your annual income at existing rates, it’s easy to see why a 20X ratio would cause concern.
But here’s the kicker. The reader also has $500,000 in cash, CDs, and liquid after-tax stock investments! Surely if you were the credit card company you’d be OK with approving a potential lifelong client even if he does have a high debt-to-income ratio of 20:1. What’s missing here is the calculation of debt-to-total-assets.
STRINGENT CREDIT STANDARDS
Although it stinks the reader cannot get approved for a great credit card which provides double the points on everything for travel before he takes off for two months to South America, the stringency by credit cards today bode well for the future economy of America and potentially the world.
The reason why there was such a financial crisis in 2008-2009 was because of loose credit approval standards by banks and credit card companies. No doc stated income loans were commonplace. I remember doing two stated income mortgage refinances during my day for example. The worst were the negative amortization loans which grew your principal amount instead of lowering the principal amount with each mortgage payment in order for the debtor to save cash flow.
If banks and credit cards only gave out loans to people who could afford to pay their loans for the entire duration, then the financial meltdown would not occur. But of course finance isn’t this simple.
Since the financial crisis banks have been super stringent in allowing people to refinance. Their stringency was frustrating for many, including myself as it took over 100 days to refinance my last mortgage in the Spring of 2012. But with every new mortgage that makes it through the ringer, our financial system is that much safer from future meltdowns.
I argue that stringent credit card approval standards are even more important than stringent mortgage approval standards because credit cards are often used to buy non appreciating assets such as food, clothing, travel, toys, etc. If you combine an irresponsible spender with a credit card, bad things are guaranteed to happen.
Whereas if you combine an irresponsible buyer with a mortgage, there is a CHANCE the irresponsible buyer may get bailed out by appreciating home prices or by our omnipotent government with programs such as the HARP. Obviously it’s never good to buy more than you can afford. I’m just saying there’s a better chance for a home buyer.
WE ARE BUILDING A STRONGER ECONOMY
The credit score only takes a snapshot of your financial history. If it so happen to take a snapshot of when your income is low for whatever reason, you’re going to have a much more difficult time getting credit. Therefore, the solution is to apply for credit when you don’t need credit to avoid such situations.
I recently applied for an unsecured $50,000 line of credit from Citibank because they asked me whether I’d be interested. I’m friends with my personal banker and asked her, “Will me applying for this line of credit help you?” She said yes, so I gave her the go ahead by signing the application document. The line of credit has a mediocre interest rate of 5%. I plan on NEVER using the line of credit, but it’s nice to know that I do have $50,000 at my disposal in case I have a credit crunch.
The way I keep razor thin amounts of cash in my bank accounts, I can see myself coming up short several thousands of dollars for property taxes for example. Now I can simply withdraw whatever I need from my line of credit and pay it off the next month. The cost is cheap because I’ll only pay 5% pro-rated.
The final takeaway from this post is that assets are hard to track compared to income. The government depends on income to tax, but so far has been pretty nice on not taxing wealth over $5 million when you die (estate tax). You can be worth millions of dollars and still receive Obamacare subsidies if your income is below ~$45,000 per individual or $95,000 for a family of four for example. At the same time, you can have a million dollars in stocks and potentially get rejected by a credit card company because your income is too low compared to your mortgage debt.
The more credit card rejections there are, the better it is for the economy long term. Most of us have too many credit cards anyway!
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