For what it’s worth, the credit score system makes a lot more sense when you realize it’s not about evaluating “this person’s ability to repay debt”, but rather “expected profit for lending this person money at interest”.
Someone who avoids carrying debt (e.g., paying interest) is not a good revenue source any more than someone who fails to pay entirely. The ideal lendee is someone who reliably and consistently makes payment with a maximal interest/principal ratio.
This is another one of those Hanson-esque “X is not about X-ing” things.
For what it’s worth, the credit score system makes a lot more sense when you realize it’s not about evaluating “this person’s ability to repay debt”, but rather “expected profit for lending this person money at interest”.
Expected profit explains much behavior of credit card companies, but I don’t think it helps at all with the behavior of the credit score system or mortgage lenders (Silas’s example!). Nancy’s answer looks much better to me (except her use of the word “also”).
I think there’s also some Conservation of Thought (1) involved—if you have a credit history to be looked at, there are Actual! Records!. If someone is just solvent and reliable and has a good job, then you have to evaluate that.
There may also be a weirdness factor if relatively few people have no debt history.
what looks like tyranny when you’re on the receiving end of it is motivated by the people in charge’s desire to simplify your behavior enough to keep track of you and control you.
Simplifying my behavior enough to keep track of me and control me is tyranny.
I think there’s also some Conservation of Thought (1) involved—if you have a credit history to be looked at, there are Actual! Records!. If someone is just solvent and reliable and has a good job, then you have to evaluate that.
Except that there are records (history of paying bills, rent), it’s just that the lenders won’t look at them.
There may also be a weirdness factor if relatively few people have no debt history.
Maybe financial gurus should think about that before they say “stay away from credit cards entirely”. It should be “You MUST get a credit card, but pay the balance.” (This is another case of addictive stuff that can’t addict me.)
(Please, don’t bother with advice, the problem has since been solved; credit unions are run by non-idiots, it seems, and don’t make the above lender errors.)
ETA: Sorry for the snarky tone; your points are valid, I just disagree about their applicability to this specific situation.
Except that there are records (history of paying bills, rent), it’s just that the lenders won’t look at them.
Well, is it really possible that lenders are so stupid that they’re missing profit opportunities because such straightforward ideas don’t occur to them? I would say that lacking insider information on the way they do business, the rational conclusion would be that, for whatever reasons, either they are not permitted to use these criteria, or these criteria would not be so good after all if applied on a large scale.
(See my above comment for an elaboration on this topic.)
(Please, don’t bother with advice, the problem has since been solved; credit unions are run by non-idiots, it seems, and don’t make the above lender errors.)
Or maybe the reason is that credit unions are operating under different legal constraints and, being smaller, they can afford to use less tightly formalized decision-making rules?
Well, is it really possible that lenders are so stupid that they’re missing profit opportunities because such straightforward ideas don’t occur to them? I would say that lacking insider information on the way they do business, the rational conclusion would be that, for whatever reasons, either they are not permitted to use such criteria, or such criteria would not be so good after all if applied on a large scale.
No, they do require that information to get the subprime loan; it’s just that they classified me as subprime based purely on the lack of credit history, irrespective of that non-loan history. Providing that information, though required, doesn’t get you back into prime territory.
Or maybe the reason is that credit unions are operating under different legal constraints and, being smaller, they can afford to use less tightly formalized decision-making rules?
Considering that in the recent financial industry crisis, the credit unions virtually never needed a bailout, while most of the large banks did, there is good support for the hypothesis of CU = non-idiot, larger banks/mortgage brokers = idiot.
(Of course, I do differ from the general subprime population in that if I see that I can only get bad terms on a mortgage, I don’t accept them.)
No, they do require that information to get the subprime loan; it’s just that they classified me as subprime based purely on the lack of credit history, irrespective of that non-loan history. Providing that information, though required, doesn’t get you back into prime territory.
This merely means that their formal criteria for sorting out loan applicants into officially recognized categories disallow the use of this information—which would be fully consistent with my propositions from the above comments.
Mortgage lending, especially subprime lending, has been a highly politicized issue in the U.S. for many years, and this business presents an especially dense and dangerous legal minefield. Multifarious politicians, bureaucrats, courts, and prominent activists have a stake in that game, and they have all been using whatever means are at their disposal to influence the major lenders, whether by carrots or by sticks. All this has undoubtedly influenced the rules under which loans are handed out in practice, making the bureaucratic rules and procedures of large lenders seem even more nonsensical from the common person’s perspective than they would otherwise be.
(I won’t get into too many specifics in order to avoid raising controversial political topics, but I think my point should be clear at least in the abstract, even if we disagree about the concrete details.)
Considering that in the recent financial industry crisis, the credit unions virtually never needed a bailout, while most of the large banks did, which supports the CU = idiot, larger banks/mortgage brokers = non-idiot hypothesis.
Why do you assume that the bailouts are indicative of idiocy? You seem to be assuming that—roughly speaking—the major financiers have been engaged in more or less regular market-economy business and done a bad job due to stupidity and incompetence. That, however, is a highly inaccurate model of how the modern financial industry operates and its relationship with various branches of the government—inaccurate to the point of uselessness.
I actually agree with most of those points, and I’ve made many such criticisms myself. So perhaps larger banks are forced into a position where they rely too much on credit scores at one stage. Still, credit unions won, despite having much less political pull, while significantly larger banks toppled. Much as I disagree with the policies you’ve described, some of the banks’ errors (like assumptions about repayment rates) were bad, no matter what government policy is.
If lending had really been regulated to the point of (expected) unprofitability, they could have gotten out of the business entirely, perhaps spinning off mortgage divisions as credit unions to take advantage of those laws. Instead, they used their political power to “dance with the devil”, never adjusting for the resulting risks, either political or in real estate. There’s stupidity in that somewhere.
Still, credit unions won, despite having much less political pull, while significantly larger banks toppled.
In some cases this was an example of the principal–agent problem—the interests of bank employees were not necessarily aligned with the interests of the shareholders. Bank executives can ‘win’ even when their bank topples.
The principal-agent problem should always be on the list of candidates, but it can occasionally be eliminated as an explanation. I was listening to the This American Life episode “Return to the Giant Pool of Money”, and more than one of the agents in the chain had large amounts of their resources wiped out.
The question of whether an agent’s interests are aligned with the principal’s is largely orthogonal to the question of whether the agent achieves a positive return. The agent’s expected return is more relevant.
There were many agents involved in the recent financial unpleasantness whose harm was enabled by the principal-agent problem. My intended examples did not suffer that problem. I could have made that clearer.
Yes, that’s certainly true. In fact, what you say is very similar to one of the points I made in my first comment in this thread (see its second paragraph).
Except that there are records (history of paying bills, rent), it’s just that the lenders won’t look at them.
Fair point. This does replicate the Conservation of Thought theme. I think a good bit about business can be explained as not bothering because one’s competitors haven’t bothered either.
I’ve seen financial gurus recommend getting a credit card and paying the balance.
I’ve seen financial gurus recommend getting a credit card and paying the balance.
Ramit Sethi for example. I had the impression that this was actually pretty much the standard advice from personal finance experts. Most of them are not worth listening to anyway though.
This might be what they say in their books, where they give a detailed financial plan, though I doubt even that. What they advise is usually directed at the average mouthbreather who gets deep into credit card debt. They don’d need to advise such people to build a credit history by getting a credit card solely for that purpose—that ship has already said!
All I ever hear from them is “Stay away from credit cards entirely! Those are a trap!” I had never once heard a caveat about, “oh, but make sure to get one anyway so you don’t find yourself at 24 without a credit history, just pay the balance.” No, for most of what they say to make sense, you have to start from the assumption that the listener typically doesn’t pay the full balance, and is somehow enlightened by moving to such a policy.
Notice how the citation you give is from a chapter-length treatment from a less-known finance guru (than Ramsey, Orman, Howard, etc.), and it’s about “optimizing credit cards” a kind of complex, niche strategy. Not standard, general advice from a household name.
All I ever hear from them is “Stay away from credit cards entirely! Those are a trap!”
That would be an insanely stupid thing for anyone to say. Credit cards are very useful if used properly. I agree with mattnewport that the standard advice given in financial books is to charge a small amount every month to build up a credit rating. Also, charge large purchases at the best interest rate you can find when you’ll use the purchases over time and you have a budget that will allow you to pay them off.
Well, then I don’t know what to tell you. I’d listened to financial advice shows on and off and had read Clark Howard’s book before applying for the mortgage back then, and never once did I hear or read that you should get a credit card merely to establish a credit history (and this is not why they issue them). I suspect it’s because their advice begins from the assumption that you’re in credit card debt, and you need to get out of that first, “you bozo”.
And your comment about the usefulness of credit cards for borrowing is a bit ivory-tower. In actual experience, based on all the expose reports and news stories I’ve seen, it’s pretty much impossible to do that kind of planning, since credit card companies reserve the right to make arbitrary changes to the terms—and use that right.
I remember one case where a bank issued a card that had a “guaranteed” 1.9% rate for ~6 months with a ~$5000 limit—but if you actually used anything approaching that limit, they would invoke the credit risk clauses of the agreement, deem you a high risk because of all the debt you’re carrying, and jack up your rate to over 20%. So, a 1.9% loan that they can immediately change to 20% if they feel like it—in what sense was it a 1.9% loan?
For that reason, I don’t even consider using a credit card for installment purchases.
Wow, they can jack up the rate like that? I would definitely consider that fraud and abuse. That’s not common, however, and Congress recently passed legislation to prevent that sort of abuse. Currently, I don’t have the option of not using a credit card; I would starve to death without it.
Wow, they can jack up the rate like that? I would definitely consider that fraud and abuse. That’s not common …
I thought so too, but then was overwhelmed with stories like that. Most credit cards agreements are written with a clause that says, “we can do whatever we want, and the most you can do to reject the new terms is pay off the entire debt in 15 days”. This is one of the few instances where courts will honor a contract that gives one party such open-ended power over the other.
If you haven’t been burned this way, it’s just a matter of time.
And if you google the topic, I’m sure you’ll find enough to satisfy your evidence threshold.
Currently, I don’t have the option of not using a credit card; I would starve to death without it.
Would you starve to death with it? If you can service the debts, let me loan you the money; at this point, most investors would sell out their mother to get a fraction of the interest rate on their savings that most credit cards charge. (Not that I would, but I’d turn down the offer without my trademark rudeness...)
For what that’s worth, when I quit smoking, I didn’t feel any withdrawal symptoms except being a bit nervous and irritable for a single day (and I’m not even sure if quitting was the cause, since it coincided with some stressful issues at work that could well have caused it regardless). That was after a few years of smoking something like two packs a week on average (and much more than that during holidays and other periods when I went out a lot).
From my experience, as well as what I observed from several people I know very well, most of what is nowadays widely believed about addiction is a myth.
Yes, I would think it would take around 5-10 cigarettes a day (or more) for at least a week to develop an addiction. While cigarettes (and heroin, and caffeine) are very physically addictive, it still takes sustained, moderately high use to develop a physical addiction. Most cigarette smokers describe their addictions in terms of “x packs per day”.
From what I can see before the paywall, it looks like I definitely didn’t meet the threshold under the best science, but I could probably cross it from 5 cigarettes per day. I’d only try that out if I were rewarded for doing it (but not for stopping as that would defeat the purpose of such an experience).
I read the article on paper before it was hidden in a paywall, so I can summarize some of the findings:
1) Rat brains are irrevocably changed by a single dose of nicotine.
2) Brains of rats that have never been exposed to nicotine (“non-smokers”), those that are currently given nicotine on a regular basis (“current smokers”), and those that used to be given nicotine on a regular basis but have been deprived of it for a long time (“former smokers”) are all distinguishable from each other.
3) The author notes that the primary effect of nicotine on addicted human smokers appears to be suppressing craving for itself.
4) The author hypothesizes that the brain has a craving-generating system and a separate craving-suppression system. (These systems apply to appetites in general, such as the desire to eat food.) He further goes on to speculate that the primary action of nicotine is to suppress craving. This has the effect of throwing the two systems out of equilibrium, so the brain’s craving-generation system “works harder” to counter the effects of nicotine. When the effects of nicotine wear off (which can take much longer than the time it takes for the nicotine to leave the body), the equilibrium is once again thrown out of balance, resulting in cravings. (The effects of smoking on weight are mentioned as support for this hypothesis.)
For what it’s worth, the credit score system makes a lot more sense when you realize it’s not about evaluating “this person’s ability to repay debt”, but rather “expected profit for lending this person money at interest”.
Someone who avoids carrying debt (e.g., paying interest) is not a good revenue source any more than someone who fails to pay entirely. The ideal lendee is someone who reliably and consistently makes payment with a maximal interest/principal ratio.
This is another one of those Hanson-esque “X is not about X-ing” things.
Expected profit explains much behavior of credit card companies, but I don’t think it helps at all with the behavior of the credit score system or mortgage lenders (Silas’s example!). Nancy’s answer looks much better to me (except her use of the word “also”).
I think there’s also some Conservation of Thought (1) involved—if you have a credit history to be looked at, there are Actual! Records!. If someone is just solvent and reliable and has a good job, then you have to evaluate that.
There may also be a weirdness factor if relatively few people have no debt history.
(1) Seeing Like a State: How Certain Schemes to Improve the Human Condition Have Failed is partly about how a lot of what looks like tyranny when you’re on the receiving end of it is motivated by the people in charge’s desire to simplify your behavior enough to keep track of you and control you.
Simplifying my behavior enough to keep track of me and control me is tyranny.
Except that there are records (history of paying bills, rent), it’s just that the lenders won’t look at them.
Maybe financial gurus should think about that before they say “stay away from credit cards entirely”. It should be “You MUST get a credit card, but pay the balance.” (This is another case of addictive stuff that can’t addict me.)
(Please, don’t bother with advice, the problem has since been solved; credit unions are run by non-idiots, it seems, and don’t make the above lender errors.)
ETA: Sorry for the snarky tone; your points are valid, I just disagree about their applicability to this specific situation.
SilasBarta:
Well, is it really possible that lenders are so stupid that they’re missing profit opportunities because such straightforward ideas don’t occur to them? I would say that lacking insider information on the way they do business, the rational conclusion would be that, for whatever reasons, either they are not permitted to use these criteria, or these criteria would not be so good after all if applied on a large scale.
(See my above comment for an elaboration on this topic.)
Or maybe the reason is that credit unions are operating under different legal constraints and, being smaller, they can afford to use less tightly formalized decision-making rules?
No, they do require that information to get the subprime loan; it’s just that they classified me as subprime based purely on the lack of credit history, irrespective of that non-loan history. Providing that information, though required, doesn’t get you back into prime territory.
Considering that in the recent financial industry crisis, the credit unions virtually never needed a bailout, while most of the large banks did, there is good support for the hypothesis of CU = non-idiot, larger banks/mortgage brokers = idiot.
(Of course, I do differ from the general subprime population in that if I see that I can only get bad terms on a mortgage, I don’t accept them.)
SilasBarta:
This merely means that their formal criteria for sorting out loan applicants into officially recognized categories disallow the use of this information—which would be fully consistent with my propositions from the above comments.
Mortgage lending, especially subprime lending, has been a highly politicized issue in the U.S. for many years, and this business presents an especially dense and dangerous legal minefield. Multifarious politicians, bureaucrats, courts, and prominent activists have a stake in that game, and they have all been using whatever means are at their disposal to influence the major lenders, whether by carrots or by sticks. All this has undoubtedly influenced the rules under which loans are handed out in practice, making the bureaucratic rules and procedures of large lenders seem even more nonsensical from the common person’s perspective than they would otherwise be.
(I won’t get into too many specifics in order to avoid raising controversial political topics, but I think my point should be clear at least in the abstract, even if we disagree about the concrete details.)
Why do you assume that the bailouts are indicative of idiocy? You seem to be assuming that—roughly speaking—the major financiers have been engaged in more or less regular market-economy business and done a bad job due to stupidity and incompetence. That, however, is a highly inaccurate model of how the modern financial industry operates and its relationship with various branches of the government—inaccurate to the point of uselessness.
I actually agree with most of those points, and I’ve made many such criticisms myself. So perhaps larger banks are forced into a position where they rely too much on credit scores at one stage. Still, credit unions won, despite having much less political pull, while significantly larger banks toppled. Much as I disagree with the policies you’ve described, some of the banks’ errors (like assumptions about repayment rates) were bad, no matter what government policy is.
If lending had really been regulated to the point of (expected) unprofitability, they could have gotten out of the business entirely, perhaps spinning off mortgage divisions as credit unions to take advantage of those laws. Instead, they used their political power to “dance with the devil”, never adjusting for the resulting risks, either political or in real estate. There’s stupidity in that somewhere.
In some cases this was an example of the principal–agent problem—the interests of bank employees were not necessarily aligned with the interests of the shareholders. Bank executives can ‘win’ even when their bank topples.
The principal-agent problem should always be on the list of candidates, but it can occasionally be eliminated as an explanation. I was listening to the This American Life episode “Return to the Giant Pool of Money”, and more than one of the agents in the chain had large amounts of their resources wiped out.
The question of whether an agent’s interests are aligned with the principal’s is largely orthogonal to the question of whether the agent achieves a positive return. The agent’s expected return is more relevant.
There were many agents involved in the recent financial unpleasantness whose harm was enabled by the principal-agent problem. My intended examples did not suffer that problem. I could have made that clearer.
These are not such different answers. Working on a large scale tends to require hiring (potentially) stupid people and giving them little flexibility.
Yes, that’s certainly true. In fact, what you say is very similar to one of the points I made in my first comment in this thread (see its second paragraph).
Fair point. This does replicate the Conservation of Thought theme. I think a good bit about business can be explained as not bothering because one’s competitors haven’t bothered either.
I’ve seen financial gurus recommend getting a credit card and paying the balance.
And thanks for the ETA.
Ramit Sethi for example. I had the impression that this was actually pretty much the standard advice from personal finance experts. Most of them are not worth listening to anyway though.
This might be what they say in their books, where they give a detailed financial plan, though I doubt even that. What they advise is usually directed at the average mouthbreather who gets deep into credit card debt. They don’d need to advise such people to build a credit history by getting a credit card solely for that purpose—that ship has already said!
All I ever hear from them is “Stay away from credit cards entirely! Those are a trap!” I had never once heard a caveat about, “oh, but make sure to get one anyway so you don’t find yourself at 24 without a credit history, just pay the balance.” No, for most of what they say to make sense, you have to start from the assumption that the listener typically doesn’t pay the full balance, and is somehow enlightened by moving to such a policy.
Notice how the citation you give is from a chapter-length treatment from a less-known finance guru (than Ramsey, Orman, Howard, etc.), and it’s about “optimizing credit cards” a kind of complex, niche strategy. Not standard, general advice from a household name.
That would be an insanely stupid thing for anyone to say. Credit cards are very useful if used properly. I agree with mattnewport that the standard advice given in financial books is to charge a small amount every month to build up a credit rating. Also, charge large purchases at the best interest rate you can find when you’ll use the purchases over time and you have a budget that will allow you to pay them off.
Well, then I don’t know what to tell you. I’d listened to financial advice shows on and off and had read Clark Howard’s book before applying for the mortgage back then, and never once did I hear or read that you should get a credit card merely to establish a credit history (and this is not why they issue them). I suspect it’s because their advice begins from the assumption that you’re in credit card debt, and you need to get out of that first, “you bozo”.
And your comment about the usefulness of credit cards for borrowing is a bit ivory-tower. In actual experience, based on all the expose reports and news stories I’ve seen, it’s pretty much impossible to do that kind of planning, since credit card companies reserve the right to make arbitrary changes to the terms—and use that right.
I remember one case where a bank issued a card that had a “guaranteed” 1.9% rate for ~6 months with a ~$5000 limit—but if you actually used anything approaching that limit, they would invoke the credit risk clauses of the agreement, deem you a high risk because of all the debt you’re carrying, and jack up your rate to over 20%. So, a 1.9% loan that they can immediately change to 20% if they feel like it—in what sense was it a 1.9% loan?
For that reason, I don’t even consider using a credit card for installment purchases.
Wow, they can jack up the rate like that? I would definitely consider that fraud and abuse. That’s not common, however, and Congress recently passed legislation to prevent that sort of abuse. Currently, I don’t have the option of not using a credit card; I would starve to death without it.
I thought so too, but then was overwhelmed with stories like that. Most credit cards agreements are written with a clause that says, “we can do whatever we want, and the most you can do to reject the new terms is pay off the entire debt in 15 days”. This is one of the few instances where courts will honor a contract that gives one party such open-ended power over the other.
If you haven’t been burned this way, it’s just a matter of time.
And if you google the topic, I’m sure you’ll find enough to satisfy your evidence threshold.
Would you starve to death with it? If you can service the debts, let me loan you the money; at this point, most investors would sell out their mother to get a fraction of the interest rate on their savings that most credit cards charge. (Not that I would, but I’d turn down the offer without my trademark rudeness...)
::followed link::
Did you ever experience nicotine withdrawal symptoms? In people who aren’t long-time smokers, they can take up to a week to appear.
For what that’s worth, when I quit smoking, I didn’t feel any withdrawal symptoms except being a bit nervous and irritable for a single day (and I’m not even sure if quitting was the cause, since it coincided with some stressful issues at work that could well have caused it regardless). That was after a few years of smoking something like two packs a week on average (and much more than that during holidays and other periods when I went out a lot).
From my experience, as well as what I observed from several people I know very well, most of what is nowadays widely believed about addiction is a myth.
No, never did. My best guess is that I didn’t smoke heavily enough to get a real addiction, though I smoked enough to get the psychoactive effects.
Yes, I would think it would take around 5-10 cigarettes a day (or more) for at least a week to develop an addiction. While cigarettes (and heroin, and caffeine) are very physically addictive, it still takes sustained, moderately high use to develop a physical addiction. Most cigarette smokers describe their addictions in terms of “x packs per day”.
Okay, then I guess my case isn’t informative … I’d use the pack/year metric instead instead of the pack/day.
I wish I could direct you to this Scientific American article so I could ask how it compares to your experiences, but it’s behind a paywall.
From what I can see before the paywall, it looks like I definitely didn’t meet the threshold under the best science, but I could probably cross it from 5 cigarettes per day. I’d only try that out if I were rewarded for doing it (but not for stopping as that would defeat the purpose of such an experience).
I read the article on paper before it was hidden in a paywall, so I can summarize some of the findings:
1) Rat brains are irrevocably changed by a single dose of nicotine.
2) Brains of rats that have never been exposed to nicotine (“non-smokers”), those that are currently given nicotine on a regular basis (“current smokers”), and those that used to be given nicotine on a regular basis but have been deprived of it for a long time (“former smokers”) are all distinguishable from each other.
3) The author notes that the primary effect of nicotine on addicted human smokers appears to be suppressing craving for itself.
4) The author hypothesizes that the brain has a craving-generating system and a separate craving-suppression system. (These systems apply to appetites in general, such as the desire to eat food.) He further goes on to speculate that the primary action of nicotine is to suppress craving. This has the effect of throwing the two systems out of equilibrium, so the brain’s craving-generation system “works harder” to counter the effects of nicotine. When the effects of nicotine wear off (which can take much longer than the time it takes for the nicotine to leave the body), the equilibrium is once again thrown out of balance, resulting in cravings. (The effects of smoking on weight are mentioned as support for this hypothesis.)