Fiscal Cliff Diving: How Does It Impact Consumer Credit?

When I began writing this article, I thought there was a chance lawmakers would come to an agreement and avoid the so-called “fiscal cliff”, thus making any article written in advance immediately outdated.

However after thinking about the issue, it became clear that even if an agreement is (or has been) reached, some group of Americans is going to be impacted.

The size of the group is really the primary variable.

The General Impact

The general impact of falling off the cliff is very simple — many will be paying more in taxes, which means we’ll be bringing home less of our paycheck because tax rates will go up.

Those who make decent money will be paying Social Security taxes deeper into the year because more of their income is now subject to that particular tax.

And finally, the dreaded Alternative Minimum Tax (or “AMT”) will likely jump up and bite millions of Americans.

The Practical Impact

The practical impact to Joe Consumer is that his net will likely be smaller this year than it was last year.

And when consumers take home less pay, they tend to reshape their spending habits into their new income reality. I call this adjustment, “molding.”

Let’s face it: Those who make more tend to spend more. Those who make less tend to spend less, but really would like to spend more.

Their barrier to spending more is capacity, or lack thereof, not the lack of wanting to do so.

Maintaining Lifestyle Using Credit

When you sit and think about the impact of bringing home less of our paychecks, you have to consider how less than responsible consumers will react.

If they’ve become accustomed to a certain lifestyle, they’ll likely try to find ways to maintain that lifestyle.

The proper way of doing so would be to work more hours, take on a second job, or otherwise do something to increase your income to make up for the new smaller reality.

The improper way of maintaining a lifestyle is to supplement with credit cards. This is dangerous because credit card debt is likely to be the most expensive debt we’ll carry with average interest rates hovering around 15%.

Dipping Into Savings and Investments

You also have to assume some people will break into retirement nest eggs to maintain their lifestyles, which has its own set of problems.

Taking money from emergency funds leaves them depleted or short of their intended usage.

Taking money from brokerage accounts can create a taxable event and taking money from 401(K) accounts can lead to penalties.

And, all of these mean you’re taking money from “growth” accounts, which means it can’t grow any longer.

How Your Credit Scores Are Affected

The credit card income supplement also carries a credit score penalty because carrying balances that bounce too close to the card’s credit limit will lower your credit scores.

Here’s where the improper use can snowball.

When your credit score drops, even for only a few months, other credit card issuers with whom you do business can see the drop. This means your perceived credit risk has become elevated.

When your risk becomes elevated, credit card issuers start to panic. And when they panic, they play one of the many “risk mitigation” cards, which is to lower limits and increase rates.

What this means is your debt with credit card A can lead to higher interest rates and lower credit limits with credit cards B, C, D, etc.

The rates can’t be retroactively increased but they can apply them to future debt.

The True Impact of Fiscal Cliff Diving

The true impact of fiscal cliff diving won’t be known until consumers: A) realize their paychecks are smaller than they use to be, and B) decide how they will react with their wallets.

What is true: Regardless of an agreement, consumers of some level of income will feel the pinch.

If someone with $2,000,000 in taxable income has to now pay 39.6% in federal taxes instead of 35%, then they’ll not likely get a ton of sympathy from someone who makes $45,000 per year.

That is, unless they work for a small business owner who chooses to lay them off to offset their new increased tax liability.

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.