An article in The Regional Economist noted that people who can’t pay their credit card bills have two options: delinquency (or informal default) or bankruptcy (or formal default). With both options, the credit score deteriorates dramatically, but there are other costs associated with these two options—costs that differ between the options.
Senior Economist Juan Sánchez noted that, during delinquency and depending on the state, debt collectors can garnish typically up to 25 percent of wages. Many states have limitations to stop lawsuits from collecting on a debt after some time, typically between three and six years. Bankruptcy stops wage garnishment immediately, but the household must have some resources to pay fees and sometimes hire a lawyer. Those costs typically exceed $1,000.1
Also, households that file for bankruptcy are able to write off their debts, but there is uncertainty about what happens to the debt of households in delinquency. Most credit card contracts have a penalty rate; so the debt of households in delinquency may increase according to that rate. But households are often able to renegotiate that debt with lenders. There is not much information about what happens in those situations.
Typically, after the debtor has been delinquent for some time, the bank must “charge off” the credit card debt to comply with federal banking regulations. That debt is sold to third-party collection agencies to be sold and resold to buyers of distressed debt. There is a large heterogeneity on what happens to those households that choose informal default. It’s unclear what happens to those households in the short run.
Sánchez noted that it is possible to tell what happens in the shorter run with debt in delinquency by using data from Equifax. He considered the variable “debt change,” defined as the change in debt among those who have all of their accounts delinquent for 90 days or more in the initial quarter. In particular, he looked at the change in debt from the first quarter of 2004 to the second quarter of 2004.
For about 40 percent of the households that were in delinquency, their debt change was negative. For many of them, it decreased significantly. For instance, for about 15 percent of individuals initially in delinquency, debt decreased more than 25 percent from one quarter to the next. Debt also increased for many individuals. For about 15 percent of individuals initially in delinquency, their debt increased more than 10 percent.
Sánchez concluded, “This heterogeneity is hard to reconcile with the idea that all of these individuals are charged the same penalty rate, since in that case there should be only one bar. In contrast, the findings here are more in line with the idea that households get a deal that is related to their repayment capacity.”
1 Hynes, Richard. “Broke but Not Bankrupt: Consumer Debt Collection in State Courts,” Florida Law Review, Vol. 60, No. 1, 2008.