Why Being Good Can Be Bad for Your Credit
In the weird world of credit rating, prudence isn't always rewarded. These tips will help boost your grade.
(MONEY Magazine) – No fuss, no muss, very Zen. That's my credit-card life. I've got one card and only one card, which I pay in full and on time every month.
You may assume, as I did until recently, that such Girl Scout behavior automatically makes me a stellar credit risk. But as it turns out, practitioners of the dark and complex art of credit scoring don't necessarily give me--or anyone else who handles their credit simply but responsibly--too many props for prudence. Yes, good behavior generally boosts creditworthiness. But when you're trying to qualify for low-cost credit, there's a right way and a wrong way to be good.
The stakes in learning that right way are high since your credit score--an assessment of your creditworthiness based on your borrowing history and typically expressed as a number ranging from 300 to 850--is widely used by lenders to decide whether to grant you a loan and at what rate. The lower your score, the more you pay. Many insurers, employers and wireless-phone providers also use credit scores to help them decide how much to charge you for a policy and whether to hire you or sign you up for cell-phone service.
Fortunately, for those of us who prefer the minimalist approach to money, being good in the right way doesn't mean sacrificing simplicity altogether. The key is to understand the sometimes odd and counterintuitive rules of credit scoring and turn them to your advantage.
Less Isn't Always More
"Too few credit cards can hurt your credit score," said Evan Hendricks, author of Credit Scores & Credit Reports. That's because a thin credit profile doesn't provide as much evidence to lenders that you're capable of paying back your debts on time as the more extensive track record of someone who is responsibly managing several cards and loans.
To boost your score, consider opening another credit-card account or two; an installment loan, like a car loan, also looks good to scorers. But don't apply for more than, say, three cards in a short period. Every time you request a new card, the issuer checks your credit report, and the inquiry reduces your credit score by several points. Each individual inquiry is not a big deal, but the cumulative effect of several can be damaging.
Paying in Full May Not Work
One of the biggest factors in determining your score is the amount you've borrowed relative to your credit limit. Ideally, your balance shouldn't exceed 30% of the maximum you can charge. But even if you routinely pay your bill in full, it can sometimes look to creditors as if you're overstepping that threshold. That's because your score reflects what you owe when your card issuer sends its report to the credit bureaus, and timing is everything: If the report is sent in the small window after you've made a large purchase, but before your payment is received, you're out of luck.
This matters only if you're applying for a loan during that short time when your score takes a hit. The simple solution, says Rex Johnson, founder of Lending Solutions, a lender education firm in Elgin, Ill.: Don't charge big purchases for 60 days prior to applying for a loan.
Shifting Debt May Cost You
Consolidating debt onto a low-rate card and closing higher-rate accounts sounds like a smart strategy. But it can work against you. Say you owe $2,500 on each of two cards with a $10,000 limit. Your combined balance ($5,000) equals 25% of your total credit limit ($20,000). If you close the higher-rate card and transfer the balance to the lower-rate card, you'll reduce your total credit limit to $10,000, and your debt will amount to 50% of the maximum you can borrow. The net effect: a lower credit score.
To avoid that outcome, you could simply leave the second account open without a balance. Or, Johnson suggests, you might try to improve your score by paying off the $5,000 credit-card balance with an installment loan (for example, a personal loan from a bank or credit union) while keeping both card accounts open. That way you will retain your $20,000 credit-card limit while reducing your actual use of that credit to $0. In addition, you'll be converting revolving debt (as credit-card debt is known) to a bank loan. Lenders view this favorably because it shows that you can pay off a loan in regular installments over a set period of time rather than extend your borrowing indefinitely.
An installment loan only makes sense, though, if the rate rivals or beats the rate on your credit card. Although the average rate on a two-year loan is running around 14% vs. 13.6% for plastic, credit-card rates of 18% or higher, particularly on retail cards, are still common. And you can often get a better loan rate at a credit union, if you belong to one.
Nearly Perfect Doesn't Cut It
You're always on time with bills, but one month a family emergency messes up your routine. Your score will drop if your payment is 30 days or more past due, no matter how small the amount or how perfect your record had been until then.
Having other credit lines on which you always make timely payments will mitigate the impact of a missed payment, Hendricks says--yet another reason to carry more than one piece of plastic.
So what's the ideal mix if you want to maximize your creditworthiness yet still keep your finances relatively simple? The answer, says Johnson: Have two to four credit-card accounts, all older than six months, and preferably a bank loan too.
Hmm. I have been tempted to buy a new car. But first I think I'll find a friend for my lone credit card.