New credit cards often used to pay off old debt

A new study of credit card use in Ohio provides the best evidence to date that some consumers are involved in a risky pyramid scheme: getting new credit cards to pay off old cards.

The Ohio State study found that troubled credit-card owners -- those who had recently missed minimum payments -- had an average of 4.6 credit cards, compared to only 2.5 cards for consumers who paid off their balance each month, and 3.5 for those who kept a balance but had not missed a payment.

But even with these additional cards, the troubled credit-card holders had used almost twice as much of their total credit line as had other card holders.

By Jo McCulty

Graduate student TaeHyung Kim, left, conducted a credit card use study with Professor Lucia Dunn.

"In essence, these consumers seem to be involved in a strategic pyramid scheme where they obtain new credit cards to pay off old cards," said Lucia Dunn, co-author of the study and a professor of economics at Ohio State.

"By getting more credit cards, they get a little breathing space, avoid default, and are still able to keep charging their purchases."

About 11 percent of those surveyed had missed at least one minimum payment in the past six months. These troubled credit-card owners showed other signs suggestive of a pyramid-type scheme: They were about five times more likely than others to have cards charged to the limit, and carried an average balance more than $1,000 greater than did others.

And, surprisingly, high-income and highly educated people and homeowners were about as likely to miss payments as were other consumers, Dunn said.

Dunn conducted the study with TaeHyung Kim, a graduate student at Ohio State. They used data from a continuing monthly telephone survey of Ohio consumers conducted by the Survey Research Center at Ohio State. The survey involves 500 to 1,200 randomly selected Ohioans each month and asks a variety of questions involving financial status and credit card use. This study used data collected between February 1998 and May 1999.

The study examined those who had technically defaulted on their credit cards by missing one or more minimum payments in the past six months. These consumers were compared to credit card users who had not defaulted.

The statistic that best separated the defaulters from others was a comparison of their total minimum monthly credit card payments to monthly income, Dunn said. Those who defaulted had average minimum credit card payments that equaled about 5.5 percent of their monthly income -- compared to 3 percent for other credit card users.

Defaulters used an average of 32 percent of their total credit line on all their cards, compared to the 17 percent rate of others. Dunn said it was significant that credit card defaulters had more credit cards than others, but still used a greater percentage of their credit lines.

"This reflects a consumer's ability to avoid default by relying on further credit to pay off old debt," she said. "It's an interesting twist on traditional pyramid-scheme behavior."

The study found that defaulters averaged 0.72 cards charged to the credit limit, compared to 0.16 cards for other users -- one more indication that defaulters were getting new cards to pay off old debt, according to Dunn. Defaulters had an average credit card balance of $3,093, compared to $1,967 for others.

Another significant finding was that usual measures of credit worthiness -- such as education, income and homeownership -- were not related to whether a consumer had defaulted.

"The factors that banks have traditionally relied on to evaluate loan applicants don't seem to work for credit card users," Dunn said. "Credit card default is very democratic -- it cuts across all social classes."

Economists have also traditionally relied on one particular statistic -- the total debt-to-income ratio -- to determine when people are in danger of default. Dunn said that once the more detailed variables in this study were taken into account -- such as the minimum credit card payment-to-income ratio -- the debt-to-income ratio was not useful in determining who had defaulted.

"With credit cards, the minimum payment-to-income ratio is more relevant than total debt, because the minimum payment affects the consumer's immediate ability to avoid default," she said.

"Credit card debt is different than traditional kinds of debt like mortgages and car loans, and old methods of determining default aren't as effective," she said. "This new survey we used is the first to look at variables that really matter when we talk about credit card debt."

Dunn and Kim will present the findings of this research at an upcoming meeting of the American Statistical Association.

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