CREDIT CARDS CAN EITHER MAKE OR BREAK YOUR CREDIT SCORES. THE TOP TEN THINGS YOU NEED TO KNOW ABOUT CREDIT CARDS AND HOW TO SUCCESSFULLY MANAGE YOUR CREDIT CARD PORTFOLIO TO HELP YOU MAXIMIZE YOUR CREDIT SCORES.
By: Shonnie Fischer
1- NEVER CLOSE YOUR CREDIT CARD ACCOUNTS
Thirty percent of your credit score is based upon your credit card portfolio. The technical term for this particular credit scoring component is known as the “Credit Card Utilization Ratio”. How the credit scoring model calculates your credit card usage into your score (like anything else related to credit scoring) is complicated, diverse and multi-faceted. Believe it or not, closing credit cards trumps missing payments and/or becoming delinquent when it comes to the potential of a negative effect on your credit score. Closing credit cards should never be used as a strategy to increase ones credit score. This happens to be a very common myth among consumers, and all too often wrongfully advised by industry professionals. There are two huge reasons why closing credit cards is never a good idea.
Reason #1: Your credit file as a whole is based upon the entire history and/or depth of the file. Therefore, let’s assume that you have had a Sears credit card that was opened back in 1990. Although you may not have used the card recently, the scoring model is scoring you based upon having a 20 year credit history. If you were to close that account, the length of your credit file “history” would revert to the next oldest tradeline in your file. Should that account happen to be a newer or less tenured account, you will lose points due to the decrease in the average age of your credit file.
The solution to this credit scoring predicament is simple. Keep your credit cards open and never ever close them. Even if they have low available credit limits and/or high interest rates, continue to use them periodically. Personally, I recommend using them at least once every three to six months. Simply stated, all you need to do is make a small purchase on your credit card such as a pack of gum, tank of gas, pair of socks, pizza delivery, etc. Then pay the balance off once you receive the statement. Just because you have a credit card does not mean you have to nor should you carry a balance on the account when possible.
Reason #2: Closing credit cards decreases your overall credit card utilization ratio. By definition, the revolving debt/credit card utilization ratio is the amount of your available credit limit on your credit cards vs. the amount that you owe on them. For example, if you have a Bank Of America credit card that has a $10,000 credit limit, and your current balance on the account is $5,000, you are at a 50% utilization ratio. The scoring models take into account individual credit card usage as well as an aggregate (total of all of your credit cards) calculation. Therefore, all of the available credit limits on your cards vs. what you owe on them is factored in to this particular piece of the credit scoring system.
By closing a credit card, you remove the amount of the available credit limit from the utilization category entirely. Let’s use the Bank Of America example above and tie in a Chase credit card that has a $20,000 limit and no balance. After combining the two cards, the available credit limit would be $30,000 with a $5,000 aggregate balance owed. Therefore, the combined total aggregate utilization ratio is 17%. If you were to close the Chase account, the $20,000 limit would be immediately removed from the total/overall available credit limit increasing you to a 50% utilization ratio. This would automatically cause a decrease to your credit score, which in this case, could be a pretty drastic drop.
In order to maximize your credit scores you always want to keep your balances on your credit cards as close to zero as possible. If you must carry a balance on any of your credit cards the most that you should carry without adverse affect to your credit scores is around 20%. Some experts say that 30% is the magic number but my personal experience leans more towards that 20% figure. Again, keep in mind the true magic number is $0 owed and 0% carry over. Just because you have a credit card does not mean that you have to carry a balance and/or use it on a daily or even monthly basis. You need to keep your cards active by using them, however use them sparingly and use common sense when making purchases with them.
2- MISSING AND/OR MAKING DELINQUENT PAYMENTS
This is an obvious event that is going to cause an adverse affect and decrease to your credit scores. The credit scoring software takes into account your payment history to see how you have managed your current and past credit obligations in order to calculate future risk.
The severity of your late payment(s) also plays a big part in your credit scores. Consumers who have missed payments by only a few weeks are far less of a risk than those who go 90 or more days delinquent. Scoring models are designed to predict if a consumer is likely to go 90 days or more delinquent in the next 24 months. Therefore, by its own calculations and measurements, the scoring system takes into account and places the heaviest concentration on a consumers past 24 month payment history. Late payments within a 24 month period will have a greater adverse scoring hit than a late payment made during years three through seven, with year seven being the max allowable timeframe a late payment can report on your credit and/or affect your credit scores respectively.
3- SETTLING ON PAST DUE ACCOUNT BALANCES WITH YOUR CREDIT CARD LENDERS
Anytime you do not or can not meet the terms of a financial agreement that you have entered into with a creditor, your account will go into some type of default status. If there is a deficiency balance owed to the lender, they can “charge off” the amount of money owed to them. Sometimes the creditor will attempt to collect on the debt internally, however in most cases they will sell and/or assign the deficiency balance to an outside collection agency.
It is very common once collection efforts begin, whether it is by the creditor directly or a third party collection agency, for them to offer the client a settlement for an amount less than contractually owed to them. Financially, this is a good idea. From a credit scoring perspective, this is a huge mistake. Anytime a debt is settled for less than the amount originally owed, a narrative stating just that is reported on your credit report. This particular narrative is as severe in nature as any other major derogatory posting that can report on your credit report. It will undoubtedly cause your credit score to plummet as it is considered a major derogatory event.
4- A DIVORCE DECREE WILL ABSOLVE YOU OF YOUR CREDIT RESPONSIBILITIES
Totally false!! Divorce proceedings typically require the parties to equitably and/or financially divide up debts incurred during the marriage. The judge will then review and order or decree that one or the other spouse will be responsible for making payments on car loans, mortgages, credit cards and other credit obligations. The judge’s order is a disposition made in a court of law. HOWEVER, the judge’s decree doesn’t override the contract that you signed with your creditors. Therefore, if you and your spouse both signed for financial liability and it stops being paid by the responsible party assigned by the judge, decree or no decree both of you will suffer. The lender will almost certainly report the late payments on both of your credit reports and if the account goes seriously delinquent, or even into the dreaded collection status, then your scores will suffer for years despite how the judge’s order reads. Additionally, if collection efforts begin they can and most likely will come after both parties. Again anyone who signed on the bottom line is eternally financially responsible until the debt is paid in full.
5- OVER UTILIZATION ON YOUR AVAILABLE CREDIT CARD LIMITS
We briefly touched on this topic in section one of this article. Maintaining high balances on your credit cards is a score killer. The mistake being made is called “over utilization”, which is the practice of maintaining balances close to your available credit limit. Anytime a consumer has a balance over 70% of their available credit limit, they are in big trouble score wise.
Another major issue in this category is going over and/or exceeding your available credit limit. By going over your credit limit you are adding an additional derogatory indicator to your score which could not be more detrimental to this credit scoring component. Best practices for credit cards is to use your cards sparingly, keep your balances as close to zero as possible, and do not use credit cards as a method to purchase large ticket items that you otherwise could not afford.
6- MAKE SURE YOUR CREDIT CARD COMPANIES ARE REPORTING YOUR AVAILABLE CREDIT LIMITS
As discussed in a couple of areas of this article, the credit card utilization ratio is a significant credit scoring factor accounting for 30% of your total credit score. One of the problems that consumers run into in this category is when the credit card companies do not report credit limits. Why is this so detrimental? The answer is that if there is no limit reporting on the credit report, the credit scoring model is set up to recognize any balance on that card to be one and the same as the credit limit, therefore putting you at a 100% utilization ratio. This will of course adversely affect and drop your credit scores, and in most cases significantly. For example, you could have an available credit limit of $100k on your Visa with a $10 balance, however if Visa does not report that you have the $100k limit the $10 is recognized as the card being fully maxed out and utilized.
Unfortunately there is not a lot a consumer can do in this category as credit card companies are not required to report credit limits on the credit report. If you do have a credit card that does not report the credit limit, really the only thing that you can do to avoid credit scoring problems is by paying the card off monthly. You can always try calling the credit card company to request that they report the information. But if they do not report it is not being done in error, it is because it is their policy not to report that information.
The other solution to this problem is to go credit card shopping. This is a last resort and only applies if you need to carry a balance from month to month, and you are not in the middle of a home purchase. Additional inquiries can and most likely will hurt your scores even further. This option needs to be carefully considered as it is not advisable in most circumstances.
7 - MYTH: CHECK CARDS WILL HELP YOUR CREDIT SCORES
This is a common credit myth that has no bearing or weight on your credit score. Check cards and/or Debit Cards are nothing more than plastic access to your checking account. Since checking accounts are not recognized as an extension of credit they do get reported to the credit agencies nor do they affect your credit scores.
8 - NOT HAVING ANY CREDIT CARDS AT ALL HURTS YOUR CREDIT SCORES
Contrary to popular belief, not having credit cards dramatically hurts your credit scores. Again, the credit card scoring component accounts for 30% of your overall credit score. Therefore, if you do not have credit cards or if you are a consumer who does not believe in credit cards, you are losing out on one-third of the points possible in the credit scoring system.
If you are a non-believer in credit cards, or if you are a consumer who has had credit cards in the past that got you in financial trouble, you may want to rethink your position. If you want to maximize your credit score you will have to have credit card accounts open and reporting on your credit report. It is recommended for a consumer to have three to five open credit card accounts to maximize their credit scoring potential. Remember, just because you have a credit card does not mean that you have to use it on a consistent basis or carry a balance.
9 - CONDUCT A SEMI-ANNUAL REVIEW WITH YOUR CREDIT CARD COMPANIES
I recommend that every six months you contact each one of your credit card companies and conduct an account review with them. You will want to ask them if you are receiving the lowest rate they are currently offering. You will want to inquire about getting a credit limit increase - remember, you are not spending the money!! Getting a credit limit increase is going to leverage and increase your available credit limits, thus lowering your utilization ratios. Finally, make sure you are benefiting fully from any additional perks or point systems they may be offering. You could very well be throwing money away by not taking advantage of reward programs credit card companies offer and/or lower interest rates that unless you ask will not be automatically assigned to your account.
10 - TAKE EXTREME CAUTION WHEN CO-SIGNING FOR CREDIT CARD DEBT
This is an across the board credit warning for all types of credit, not just credit cards. However, as of February 22, 2010 the CARD Act went into effect requiring people between the ages of 18-21 to have a parent co-sign for a credit card unless they can demonstrate an ability to repay the loan via a steady and consistent income stream. Translation- 9 times out of 10, we as parents are going to have to put our name on the bottom line in order for our 18-21 year olds to get a credit card. A couple of caveats need to be noted here when co-signing for your child or anyone else for that matter:
1- Make sure that you are monitoring the credit card statements monthly to ensure the payment is being made on time. There is no distinction between signer and co-signer when it comes to reporting late payments. Therefore, their late payments are your late payments and will drop your score accordingly.
2- Their credit utilization ratio becomes and/or ties into your credit utilization ratio. Thus, if they max out their card it will in turn increase your ratios possibly causing your scores to drop.
It is not a bad idea to co-sign for your child, nor is this section intended to scare you away from doing so. This is simply a new law that went into effect, so as a precaution we as parents will need to ensure that our credit ratings are not being adversely affected. This is again new to us all and we simply need to incorporate monitoring practices to avert any future problems that could damage our credit ratings.
Thank you for reading this month’s publication and as always if you have any questions on this or any other credit related matter, please don’t hesitate to contact me directly anytime.
