CLEVELAND, Ohio – If you’ve been intentionally carrying a balance on your credit cards with hope of improving your credit score, you just may be making an expensive decision without getting any closer to your goal.
Count the balance-carry strategy as a giant myth, says Howard Dvorkin, chairman of the personal finance website debt.com.
“There are so many myths out there. And people invent new ones,” Dvorkin said during a recent telephone interview. “The No. 1 myth is the stupidest myth: ‘I should carry a balance on my credit cards so it shows activity.’ That is not going to help you. That is an expensive, expensive way to try to improve your credit. It just doesn’t have any impact on it.
“If you want to improve your credit, pay your credit cards on time and don’t carry a balance. … Pay your bills on time. Period. That’s 35% of your credit score according to FICO. Nothing else comes even close that.”
Though Dvorkin attributes secrecy behind the FICO logarithm to the spreading of myths about precise math behind creating the credit risk score commonly used by lenders, FICO does offer up some of the details.
1. Payment history (35%)
Pay your your bills on time and you’ll have a great number for this part of your overall credit score. FICO, through its consumer division known as myFICO, offers some words of relief for those who have had a handful of late payments: “A few late payments are not an automatic ‘score-killer.’ An overall good credit history can outweigh one or two instances of late credit card payments.”
But the fewer problems, the better: “Payment history is the biggest score factor, so it’s important to pay close attention to it and make sure your bills are paid on time.”
This is based on things like car loans, mortgages, student loans and credit cards. Also, bankruptcies can count against you for seven to 10 years.
If there’s a problem paying these bills, see if you can work out an affordable payment plan. Sometimes you might be able to negotiate a better interest rate. Financial advisers say to reach out to the companies you owe; some payment to them is often better than no payment at all.
2. Amounts owed (30%)
FICO with this metric is trying to determine whether you are overextended on debt. Less important than total debt is what percentage of your available credit is in use.
There are five factors: (1) Amount owed on all accounts; (2) amount owned on specific types such as credit cards or loans with regular payments; (3) how many accounts have balances; (4) are you close to maxing out revolving accounts such as credit cards; and (5) how much is still owed on installment loans.
Two notes on this. Even the balance on a credit card paid off in full will show up. FICO uses the last reported balance. But in some cases, a low “credit utilization ratio” can be better than not using any of your available credit, according to FICO.
Getting beyond these generalities that FICO shares, nailing down precisely what matters is difficult.
“I think the real reason there is so much confusion,” Dvorkin said “is that it’s a secret logarithm. They don’t like to talk about it.”
3. Length of credit history (15%)
FICO says it takes into account the age of the oldest and newest accounts, plus the average. Because of this averaging, if you recently paid off a credit card, you shouldn’t necessarily close it.
If you’re trying to build credit, FICO advises, “use your card, but keep the balances low and pay on time.”
But what if you have difficulty getting credit because you have a limited credit history, or perhaps a bankruptcy or other financial problems in your past?
“Try a secured credit card,” Dvorkin said, explaining that these cards require a deposit to act as security. For example, you may be asked to make a $200 deposit for a $200 credit limit.
“Every major credit card issuer has a secured program. Some are better than others. … Secure cards allow you at some point to flip over to a regular card. It could take months. It could take years. But at some point they typically allow you to change.”
The secure credit cards work like regular credit cards, with monthly payments. This is not to be confused with a debit card, which Dvorkin said does not help improve a credit rating because the withdrawals are automatic soon after purchase, almost like a check.
4. Credit mix (10%)
The thinking here is that someone showing an ability to manage different types of loans is a lower risk. This means creating a mix of revolving accounts such as store and bank credit cards in combination with installment loans such as those for a home, car or school.
At 10% of the total grade, this isn’t a big factor, but it can make a difference in achieving the very best scores.
5. New credit (10%)
Too much new credit is not a good thing. FICO believes opening several new accounts in a short period of time tends to signal a greater credit risk.
People with shorter credit histories run a risk of being penalized by this more than those with longer credit histories. Plus, remember, the average length of credit history also plays into the overall score; and a lot of new credit would drive the average down.
Why it matters
The better your credit the less loans usually will cost you.
“A 750 score or above, that’s a very good credit score. A score of 600 or 650, not so good,” Dvorkin said. “You’re typically going to pay a higher interest rate (with a lower credit score). It could cost someone thousands of dollars over the course of a car loan. Or on house loans, tens of thousands of dollars. A lender uses a bad credit rating as an excuse to charge you more.”
But, at the same time, Dvorkin pointed out that credit can be repaired, given time.
“Another myth is that once your credit is bad, it’s bad forever. That’s incorrect. It is easy to repair over time if people take the time to do it,” he said. Dvorkin’s checklist of advice includes:
* Sign up for a secured credit card, as noted earlier, if you can’t get approved for a regular credit card.
* Pay off your credit card balances each month.
* Don’t charge a lot. Remember, the last balance, even when paid off by the due date, will show up as an outstanding “loan.”
* Don’t max out your available credit.
* Don’t rush to close all old credit cards, though there’s no need to keep open everything you’re not using.
* Check your credit report for errors.
Free credit reports
You’re entitled to a free copy of your credit report each year, though during the pandemic you can actually get one every week, advises the Federal Trade Commission.
“Your credit score is derived from your credit reports, which contain just the raw data of how much you owe and how quickly you pay it all back,” Dvorkin explained. “Think of it like the difference between a basketball and a basketball player. The basketball is your credit report. It can’t score a basket on its own. But when a Cavalier throws it through the net, it suddenly becomes a score.”
The credit report details go far beyond the FICO score you may have seen reported on credit card statements or elsewhere. When I pulled my credit report recently, it was good to see it accurately reported that I had no bankruptcies, judgments or liens.
But in the pages upon pages of credit card and loan histories – current and old – I spotted one credit card listed as open that I thought was closed. That’s something I need to check on.
“People need to see what is on their credit report,” Dvorkin said. “Fifty percent of all credit reports have an inaccuracy. … Closed accounts. Late payments that you knew nothing about. Maxed out accounts.”
You can choose to get a copy of each of the available reports – from Equifax, Experian and TransUnion – or you may choose to get just one at a time. Instructions are included for how to request corrections.
Requests for the report can be made via the internet at annualcreditreport.com, by calling 1-877-322-8228, or by completing an Annual Credit Report Request Form and mailing it to: Annual Credit Report Request Service, P.O. Box 105281, Atlanta, Georgia, 30348-5281.
Rich Exner, data analysis editor, writes cleveland.com’s and The Plain Dealer’s personal finance column – That’s Rich! Follow on Twitter @RichExner.
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