Credit

How the U.S. Credit Downgrade Could Hurt You

Well, it happened.  Late Friday afternoon Standard & Poor’s downgraded the credit rating of the United Stated of America from AAA to AA+. The reason they gave was a combination of political dysfunction when dealing with the debt ceiling issue and the fact that we’re going to continue to get deeper into debt and don’t have a responsible fiscal plan vis-à-vis debt reduction.

The talk of the U.S potentially defaulting on its debt had been the story de jour for almost five weeks. And regardless of your political affiliation we all have one thing in common…nobody really wanted to see the impact of a default. Defaulting on debt, regardless of the type, means one thing…elevated credit risk. And elevated credit risk always equates to higher interest rates.  And while we thankfully avoided default, all is not well.

One of the problems with the recent coverage of the debt ceiling issue is that it focused so much on the political players involved with the debate and not enough on the trickle down impact to Joe Six-Pack. Many of us were buried with terms like AAA rating, Treasury-bills, and Rating Agencies. But what does it all mean to you…and me?

Debt (not just Default) Equals Elevated Risk

While defaulting on a debt (of any size) is indicative of elevated credit risk, it certainly isn’t the only indicative characteristic. Simply carrying enormous debt is also indicative of elevated credit risk, and that’s not even up for debate. This is true for all types of debt including commercial, consumer and governmental. Secured debt is less risky than unsecured debt because the liable party doesn’t want to lose their home, car, 18-wheeler, or jet skis.  Unsecured debt is more risky, even at a fraction of the balance of large secured debts, because there’s simply nothing to repossess.

Too much attention has been paid to the implications of the U.S defaulting on its debts. Not nearly enough attention has been paid to the implications of simply HAVING $14 trillion in debt.  Point being; even though we didn’t default on our debts we are still very risky. In fact, some people believed it would have been irresponsible for the rating agencies to NOT downgrade our credit rating.

Our Rates Might Still Go Up?

Most experts believe the downgrade will lead to an increase in interest rates by as much as 5 percent. Ground zero for higher interest rates is going to be variable rate credit cards and HELOCs.  Why?  Because the issuers of these credit products still have the ability to modify the terms of our agreements almost on the fly.

Some people believe the CARD Act of 2009 protects them from interest rate hikes on credit cards, but they’re wrong.  Variable rate card issuers can increase their interest rates because they’re tied to a moving index, like the prime rate.  When the prime rate goes up, so does the rate of your variable rate credit card and your home equity line of credit.

The average credit card interest rate is 15 percent, which means a $5,000 balance will cost you a shade over $7,500 to finance the balance if you paid nothing but the minimum (in addition to paying back the $5,000 you borrowed). Add to that the fact that it would take you over 27 years to pay it back, if you paid nothing but the minimum, and it sounds pretty brutal.

That means the 15 percent you were paying to finance your credit card debt could become 20 percent.  And, the same $5,000 balance would cost you over $17,500 to finance, on top of paying back the original amount borrowed.  It would also tack on an additional 2.5 years to pay it back, bringing it to 30 years.

The HELOC balance that you’re currently carrying at roughly 3% would also skyrocket and push many consumers either into mortgage default or darn close to it. In fact, it’s possible that the payment due on your equity line might be more than the payment due on your first mortgage, especially if you don’t pay impounds (escrow for property taxes and insurance).

What Can I Do?

Now that we’re downgraded and rate increases could happen, there are some steps you can take to either fully avoid the impact or at least reduce your exposure. Here’s what you need to do:

1.  Inventory your credit cards, all of them.

2.  Call the issuers, all of them.

3.  Ask them if your card has a variable interest rate or a fixed interest rate. You’ll be surprised to learn that probably all of your cards have been converted to variable rate cards because of the CARD Act’s modest restrictions on increasing fixed interest rates.

4.  The cards that have variable rates…stop using them NOW. Those are the cards that will have higher interest rates as soon as the prime rate changes. That means any new charges financed under the new higher rate will be more expensive. Don’t worry about the existing balances; the rate cannot be increased due to restrictions on retroactive rate increases. Pay them down like you normally would.

5.  If you have a HELOC call your mortgage lender and ask them if a refinance is possible. The goal would be to combine your two loans (the first mortgage and the HELOC) into one loan with a fixed rate for 30 years.  At that point you’re locked in and no external rate increases can impact you. This is going to be a tough one because some 28 percent of us are upside down on our loans.

John Ulzheimer is the President of Consumer Education at SmartCredit.com, the credit blogger for Mint.com, and a contributor for the National Foundation for Credit Counseling.  He is an expert on credit reporting, credit scoring and identity theft. Formerly of FICO, Equifax and Credit.com, John is the only recognized credit expert who actually comes from the credit industry. The opinions expressed in his articles are his and not of Mint.com or Intuit. Follow John on Twitter.