Paying off debt doesn’t hurt FICOs

Dear Liz: In my younger days, I thought it was a smart practice to pay my bills late so I could keep my cash earning interest as long as possible. After having difficulty with a home purchase in the early 1990s because the late payments showed up on my credit report, I changed my perspective and built my credit score to 816 as of October 2008. At that time I had a home mortgage, an auto loan and three credit cards with limits totaling $35,000 and balances that were paid in full monthly.

Recently, I opened a new account to purchase a computer and I paid down my auto loan by $6,000. After these transactions, my credit score dropped 23 points to 793, even though my total debt has dropped and my credit limit has increased. It took 15 years to increase my score by 150 points and just days to drop it by 23 points. Where is the fairness in this system?

Answer: Let’s cut to the chase: If your FICO credit scores are over 760 or so, you really have nothing to worry about, since those scores will help you qualify for the best rates and terms.

But you do have some misconceptions about credit scores and how they work. For example, you don’t have one credit score, you have many, and they change all the time.

The FICO is the leading scoring formula used by most lenders. Each of the three major credit bureaus sells its version of the FICO to lenders. Experian has stopped selling FICO scores to consumers, but you can get your FICO scores for the other two bureaus at www.myfico.com.

Your FICO scores typically won’t drop if you pay down debt. In fact, they usually rise. What probably caused the drop in scores was an increase in the balance on one or more of your credit cards. Even though you pay your cards in full, the balance that’s used in calculating your credit score is typically the balance reported on your last credit card statement. If you ran up a big balance, you hurt your score.

As to your last question, FICO scores weren’t designed to be fair. They were designed to help lenders predict the risk that a borrower would default.

Don’t use 401(k) to pay credit cards

Dear Liz: I am wondering about withdrawing my 401(k) early to pay off debt. My husband is the primary breadwinner of our household and has just been laid off.

At the beginning of 2008 we had over $25,000 in debt, which we reduced to $19,000 over the last year. I fear that without his income we will be facing bankruptcy. We have considered refinancing our home, but our second mortgage has a prepayment penalty until September.

I realize that cashing out my retirement is possibly the worst option, but I am running out of ideas. If you have any advice I would appreciate it.

Answer: In most cases, you’ll want to conserve cash after a layoff. That means paying just the minimums on your debts while you look for ways to cut expenses and find cash (by selling stuff or taking part-time jobs, for example). Once you’ve got your expenses comfortably below your income you can begin to repay your debts out of that income.

Withdrawing money prematurely from a 401(k) is usually a bad idea, but that’s especially true if bankruptcy is a possibility, since retirement accounts are off-limits to creditors. In other words, you’d be taking money that would otherwise be protected and using it to pay debts that could be erased in a bankruptcy filing.

You would also be incurring unnecessary taxes and penalties that can eat up 25% to 50% of your withdrawal, and you’d lose all the future tax-deferred returns that money could have earned.

If your debt is primarily on credit cards, consider contacting a legitimate credit counselor affiliated with the National Foundation for Credit Counseling at www.nfcc.org to see whether you could benefit from a debt management plan. Also, make an appointment with an experienced bankruptcy attorney so you and your husband can explore other options.

Build savings or pay off debt?

Dear Liz: We have about $800 extra each month after paying bills, but we aren’t sure we’re doing the right thing with it. Should we pay down our adjustable-rate, maxed-out home equity line of credit? Or do we put it toward our savings, which has only $5,000 right now?
Answer: Before doing either, make sure you’re saving adequately for retirement. You may be tempted to cut back in this uncertain market, but the costs of retirement are so great that you need to start saving early and not stop if you want to have a sufficient nest egg. Your human resources department at work probably has tools to help you.
If you’re convinced you’re on track there and you don’t have any credit card debt, the next step normally would be paying down that home equity line. In today’s environment, however, you might find your lender lowering your limit as soon as you start to reduce your balance. Rather than freeing up credit that you could use again in an emergency, paying down your HELOC may actually reduce your overall financial flexibility.
This might not be an issue if you have tons of equity. If your current mortgage balance and your line of credit total less than 60% of your home’s current value, you may not need to worry about your lender reducing your credit limit.
If your loans total more than 60%, however, or if housing values are falling fast in your area, consider instead building up your savings.

Don’t cut yourself off from credit

Dear Liz: Like many in this economy, I overextended myself with credit card debt. Fortunately, most of the cards are now paid off, although some of my creditors have lowered my credit lines. (The card I use for my design business has had its limit lowered, for example.) You always tell consumers to keep cards open to protect their credit scores. Because I have so many cards, though, I would prefer to close the accounts that have the highest interest rates. I plan to use just my American Express cards because they must be paid in full every month.
Answer: Your best course is to wait until all your debt is paid off and your credit scores have recovered to decide about closing any accounts.
Because account closures can’t help your scores and may hurt them, you typically should put off closing cards until your FICO scores are above 750. Even then, you should avoid closing your oldest and highest-limit cards, because those help your scores the most.
In this economy, you also want to be wary about cutting yourself off from credit, particularly if you run a business. You may need to tap those funds in an emergency.
If you really can’t control your card use, of course, all these considerations are moot. Then closing accounts may be the only remedy. But the fact you’ve been able to pay off most of this debt indicates you have self control, so consider waiting before making any moves you may later regret.

Try to reopen a closed credit card

Dear Liz: I was traveling and forgot to pay my credit card bill last month. Instead of just charging a late fee, my issuer closed the account. I have high credit scores and had a high limit on this card. What can I do?

Answer: Write the issuer’s chief executive. Most credit card issuers are trying to reduce their risk, but slamming shut an account for a good customer with high credit scores is ridiculous. The decision was probably made by a computer, but you’ll need human intervention to get it reversed. Good luck.

P.S.: Consider setting up automatic bill payments so this doesn’t happen again.