Escape from the Great American Debt Trap

Consumers are making remarkable progress in restoring their credit

Illustration by Topos Graphics; Hands: Corbis

By Steve Matthews

Michael Busick, a Charlotte (N.C.) math teacher, says his credit union “was shocked” to discover his credit score was 812 of a possible 850 when he applied for a $19,500 new-car loan. The loan officer told him he rarely saw scores so close to perfect, says Busick, 33, who added he pays bills on time and doesn’t overextend. He got the loan.

The average U.S. credit score—a predictor of the likelihood lenders will be paid back—rose to 696 in May, the highest in at least four years, according to credit reporting bureau Equifax. Delinquencies on consumer loans have dropped 30 percent in two years, according to Federal Reserve data.

Improving credit quality gives households the ability to spend more. A rebound in spending would belie Morgan Stanley economist Stephen Roach’s claim that consumers will be “zombies” for years because they are saddled with too much debt. “The financial situation of the household sector has improved far faster than everyone thought it would two years ago,” says James W. Paulsen, chief investment strategist for Wells Capital Management in Minneapolis. “People are still locked into the view that consumers are facing record burdens, and they are not.”

U.S. consumers have reduced debt by more than $1 trillion in the 10 quarters ended in March, according to the Federal Reserve Bank of New York. Households spent 16.4 percent of their earnings on debt payments in the first quarter, including lease and rental payments, homeowners’ insurance, and property taxes. That’s down from 18.9 percent in the third quarter of 2007, before the recession started.

Even consumers in trouble are in better shape, says Mark Cole, chief operating officer for Atlanta’s Cred Ability, a nonprofit provider of credit counseling. Clients have an average of $19,500 in unsecured debt this year, down 30 percent from 2009 and the lowest in at least six years, he says. “We really see credit quality increasing.”

Credit-card companies notice the rebound, too. Discover’s rate of 30-day delinquencies was 2.79 percent in the second quarter, the lowest in its 25-year history, company officials said in a June 23 conference call.

Jennifer Lahotski, 28, who has a marketing job in Los Angeles, says she’s been improving her credit since 2007, when it scored “absolutely below 660,” the minimum level needed to qualify for prime consumer loans, according to Equifax. The Penn State graduate had been late on some bills and even had an old charge of $5 from a gym. “I went through each expense, each delinquency, and sent them a check,” she says. “I turned myself into a hermit for six months, but I did it,” eliminating most restaurant meals and “random Target runs where you come out with $50” of merchandise. Lahotski, who has a Visa and an American Express card and $15,000 in student loans, says she is now saving “a few hundred a month,” with plans to buy a house when she can afford a down payment.

While household obligations are at a 17-year low because of increased savings and lower interest rates, Roach, the nonexecutive chairman of Morgan Stanley Asia, calculates that household debt still comes to 115 percent of income, compared with a 75 percent average from 1970 to 2000. “We need to encourage balance sheet repair and adjustment by overly indebted, savings-short consumers,” he says.