I, like many of you, receive these balance transfer offers from my credit card company. I don’t normally take advantage of these offers because I don’t have other credit card balances to pay off, but I received one offer that seemed pretty good. I could get 0% interest for one year, with a 5% balance transfer fee. So, my effective interest rate would be just over 5%. I thought that if I took this money, I could invest it in something that would earn me more than 5% for the year, then cash out the investment, pay back the credit card advance, and be left with a profit. Or alternatively use my earnings to pay of the advance over the next year and keep the investment. It seemed like a good idea.
I took a $40,000 advance on my credit card. The very first month that my credit card company reported the advance to Experian, my credit score dropped about 40 points from around 815 down to 775. Six or seven months went by, and I decided I would take advantage of the low mortgage rates and refinance by house. So, I cashed in some investments and paid off the credit card hoping it would improve my credit score. The good news is that while the money cost me 5% (on an annualized basis) my estimate was that I had earned about 20% (on an annualized basis).
The first time my credit card company reported that I had paid off the credit card, my credit score just back up about 40 points to 817. That’s great because when I refinance my home to get a better interest rate (and maybe even take out some money) I will have a great credit score. But then I got to thinking. What changed about me personally that would cause my credit score to drop 40 points, or more than 5%, just by taking one credit card advance or to move back up by that amount, just by paying off a credit card?
Well, I started to look at my personal finances. My income did not change, and it may have increased a little between the time I took the credit card advance, and when I paid it off. My assets increased because I have real estate investments and I still save a significant portion of my earnings into savings. Nothing about me changed when I took that credit card advance other than my debt went up by $40,000 and my assets went up by $40,000.
Now I know someone from Experian, or Transunion or Equifax would have some statistical analysis that correlates the amount of credit card debt any consumer has with potential defaults on credit cards or other debts. But that analysis must completely ignore other factors such as what the person does with the credit card debt, the consumer’s assets, the consumer’s income, the consumer’s savings habits and the consumer’s historical track record. The conclusion must be the credit score system is extremely flawed.
Yet this flawed system is what banks, credit card companies, finance companies, mortgage companies and other lenders use to assess the credit risk of borrowers. So, was I 40 points less credit worthy the day after I took the credit card advance, as opposed to the day prior? Further, the companies that market low interest credit card advances must know that anyone taking them up on their offers is going to take a hit to their respective credit scores. Is it a plan on the part of banks to on the one hand reduce credit scores by offering these offers so on the other hand they can charge more interest on car loans and mortgages?
I accept that we need some sort of system to assess the credit worthiness of borrowers. But certainly, in this age of modern technology where computers can analyze huge data sets in seconds, it would seem the credit score companies, each of which is worth billions of dollars, could figure out a better way to assess the credit risk of consumers. Or is the system set up the way it is because it helps financial institutions squeeze ever more money from every day, hardworking Americans? The cynic in me suggests the latter might very well be the case.