CREDIT CENTER: Industry Secrets

Need a Loan? No Problem

Need a loan? No problemo. No matter what your financial standing, lenders have a line of credit with your name on it. And that's just the problem.

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By Dayana Yochim

There was a time when just the gilded gentry qualified for a line of credit. In their 11-piece suits, these hopeful borrowers would engage their well-heeled banker in some social patter and high tea, then get down to the business of arranging a very gentlemanly installment loan.

How quaint. These days it seems like anyone can dial, click, or lick a stamp to get approved for a line of credit. (Heck, you don't even need a pulse or to be potty trained to qualify.)

The state of borrowing in the U.S. is at an all-time high. The amount that Americans owe on loans for houses, cars, credit cards, and other purchases adds up to nearly 100% of their annual income after taxes, according to a BusinessWeek report. That's up from 75% in 1992, after the last recession ended. Today's average credit line is around $3,500, compared to $1,800 just 10 years ago.

There's plenty more credit to be had, says the Consumer Federation of America. Credit card issuers have more than $3 trillion of unused credit lines up for grabs. That's about $30,000 per family. If you have a decent history of managing credit, then you can easily tap into that line of credit at an interest rate of 5% or less over the current prime rate. (Your decent borrowing status also qualifies you for cards that do not charge an annual fee, or one that offers rewards for your spending.) If you like to flash your wallet, you can easily get approval for a Gold or Platinum card. Don't let it go to your head, though -- about half of cards in circulation are Gold cards, which require just $10,000 in annual income for you to qualify.

Given the available pool of money earmarked for borrowing, the average consumer's restraint is impressive. According to Fair, Isaac and Co. (FICO), the typical consumer has access to $12,190 on all credit cards combined. It says more than half of all people with credit cards are using less than 30% of their total credit card limit. As of mid-year 2002, according to CardWeb.com (one of the best followers of the lending industry's goings-on), total unused credit lines for bank credit cards was $1.8 trillion.

Based on the state of borrowing in the U.S., lines of credit are wending their way into households faster than kudzu weeds. It's just a matter of time before our nation's Pledge of Allegiance closes with the words, "...with liberty, justice, and a line of credit for all."

All kinds of credit cards for all kinds of borrowers

Are you a student? There's a credit card designed just for you! A small business owner? Gotcha covered. Filthy rich? Don't have a bank account? No problem. Yup, there's a credit card -- actually several -- for every conceivable type of borrower. We even offer a card for Fools.

Still, not everyone is showing such self-discipline with the deck of cards in their wallet. A little more than one in eight credit card holders uses 80% or more of their credit card limit, according to FICO. And about 10% of cardholders carry total balances in excess of $10,000. CardWeb estimates that about 20% of credit cards used in the U.S. are maxed out.

Don't write these borrowers off. Lenders sure haven't.

The industry divides potential customers into the "prime" and "subprime" markets, referring to the prime interest rate set by banks as a benchmark for other loans. The top tier of borrowers (as determined by their credit score) can get a line of credit on a Platinum card at an interest rate around 12%. A Gold card carries an average interest rate of 15%, and a standard credit card charges rates around 17%.

Then there's the subprime market. As with most labels in life, having the prefix of "sub" attached to your status indicates a less-than-stellar standing (unless you are subliminal, in which case you can just will your lender to give you free money).

Bottom fishing lenders

Leave it to the number crunchers to find a way to include -- and profit from -- these most needy of borrowers. In the 1990s, the subprime category emerged. It gave access to a line of credit to consumers with credit scores in the 500s, little or no credit history, those emerging from bankruptcy and anyone with a recent spotty history of managing credit.

Unlike "secured" credit cards (discussed below), cards offered to subprime borrowers require no security deposit. Credit limits start out low -- initially in the $100 to $500 range. Fees can be hundreds of dollars and interest rates can easily soar to 30% or more.

High-risk borrowers have been a boon to subprime lenders. According to CardWeb, about 20% of credit card accounts (about 70 million) are considered subprime. The lure of unsecured credit blinds customers to high fees and exorbitant interest rates lenders charge. They're willing to fork over big bucks to become a credit card-carrying member of society, even though there are other less costly options.

If the subprime lending business sounds cut throat, well, it is. It smacks of the 1930s banking scandals, when TIME magazine coined a new term for shifty banking executives -- "banksters."

Rest assured, these modern-day banksters are getting their due. With a rocky economy, subprime issuers are writing off losses in the 15% to 17% range, versus the average industry loss rate of 6.5%, according to CardWeb. Delinquency rates among subprime card issuers average about 10% while those for the rest of the lending industry average just 5%. Even Washington has taken notice of the way these lenders do business.

As their customers' finances tumble, so have the banks who built their business models off the high fees they charged. Buh-bye, NextCard. So long, Providian. Sayonara, Metris.

Still, their suffering means little to the record 1.3 million cardholders who filed for bankruptcy last year. Too bad the irony was lost on Capitol Hill. At the same time banks lobbied for tighter bankruptcy laws, they were increasing promotions (including those to subprime targets) to a record 5 billion solicitations -- about 50 per household -- compared to 3.5 billion the year before, according to the Consumer Federation of America.

So where does that leave customers who don't qualify for Platinum, Gold, or even standard credit cards?

You naughty borrower

Have no history of credit? Or were you a bad boy about borrowing money in the past? If your credit score clocks in at 500 or less, you're considered a credit risk. Like brothers-in-laws and ex-anyones, lenders are wary of loaning you money, no matter how much you claim you've mended your ways.

The industry created a class of "secured" credit cards to offer less-credit-worthy customers. Like their unsecured cousins, secured cards are bank credit cards in that they say Visa, MasterCard, Discover, and even American Express on them, so the store clerk will be none the wiser. But there is one major difference: Borrowers are required to pay an up-front security deposit to serve as collateral in case they decide to skip town on the loan.

Despite the pre-payment requirement, a secured credit card remains the best way for someone building (or re-building) their credit to access and use a line of credit. Most secured credit cards charge an annual fee and require a minimum deposit (from $99 up to $5,000, in our research) for you to set up an account. (For more information on what to look for in a secured credit card, check out "Finding The One.")

Don't have the means to make a security deposit? Want to skirt the stigma (however non-existent) of carrying a secured card? To avoid the fees and the up-front collateral of a secured credit card and the loan-shark rates demanded by, well, the loan sharks, a debit card issued by your bank is the best way to go.

A debit card, which is emblazoned with either Visa or MasterCard, takes money directly out of the cardholder's checking account. It acts just like a credit card in that you can make charges with it at a cash register, over the telephone, and via the Internet.

But a debit card has one key difference from any other product invented by the credit card business: When you run out of money, you run out of charging power. What a novel idea for a spending card, eh?