Credit cards should be opened–and cancelled–sparingly

Dear Liz: I have paid off my credit card bills each month for years, and I am becoming increasingly frustrated with credit card requirements. I canceled an American Express card because a fee was about to be imposed.

Yet most articles on credit cards say that one should never cancel a card. In a recent column in my local paper, you wrote that applying for a new card could ding my credit. So now I can’t cancel a card or get a new one without harming my credit rating? Where is the logic in this? Should I just cancel all of my cards and go back to paying by debit card and checks?

Answer: Probably not, because another thing that can hurt your credit is not using credit. In order to judge your creditworthiness, the scoring formulas need to see how you’ve handled credit in the past. If you stop using credit entirely, eventually your credit reports will stop generating credit scores.

That doesn’t mean you have to carry credit card balances. Using cards as you have been, as a convenience only, is a great way to keep your credit scores in shape without paying unnecessary interest.

You need to keep in mind that credit scoring formulas were designed for lenders, not consumers. Credit scores’ primary purpose is to predict a borrower’s risk of default, and their logic is based on identifying the behaviors that increase that risk.

Because both opening and closing accounts are associated with a higher risk of default, both actions may hurt your scores.

That doesn’t mean you should never open or close an account, but you should do both sparingly and not when you’re in the market for a major loan.

Student loan settlement won’t be cheap

Dear Liz: I was disappointed with your answer to the person who wanted to settle student loan debt for less than what he owed, even though he had a windfall that would allow him to pay the balance in full. This person presumably benefited from the education that these loans provided and now could afford to pay them back. Why did you offer advice that would allow him to avoid that responsibility?

Answer: As you’ll recall, the writer originally borrowed $50,000 in federal student loans almost two decades previously but had received an annual forbearance ever since. Forbearance indicates the writer suffers some kind of ongoing, demonstrable hardship such as poor health, partial disability or inadequate income.

The unpaid balance had swelled to $155,000 because of interest and fees. Although the windfall would allow him to pay the debt in full, it wasn’t clear whether the problem that caused the need for the forbearance had disappeared. If not, then conserving some of the windfall might be a prudent option.

There are those who believe that paying the full balance of any debt is a sacred obligation, no matter how much damage such an action may do to a person’s financial future. Others would allow that there are shades of gray and that past and future obligations must be weighed against each other.

In any case, the writer isn’t going to be able to settle the debt for pennies on the dollar, as he might be able to do with other bills, such as credit card debt. Settling student loan debt is tough, because the Department of Education has many tools to force borrowers to pay.

As the previous column noted, what the department might be willing to do is forgive some of the accumulated interest and fees, according to student loan expert Mark Kantrowitz of FinAid (www.finaid.org).

Kantrowitz’s advice was to find out how much the department paid to acquire the loan when it was consolidated, offer to split the difference between that figure and the current balance, and then accept the department’s counteroffer.

New FICO formula not used by all lenders

Dear Liz: You recently stated that the latest FICO credit-scoring formula, FICO 08, excludes collections under $100. Not so. My 820 credit score was recently dinged by a $65 collection. It dropped my score over 100 points and took me a lot of time to get it removed.

Answer: Not every lender uses FICO 08. When a new version of the FICO formula is rolled out, some lenders adopt it immediately while others may take month or years, or may never do so at all.

The bureaus only started offering FICO 08 to lenders this year, so it’s rather likely that many lenders will still be using the older versions to calculate your scores.

Short sales trash credit scores, too

Dear Liz: We bought a house five years ago for $410,000 that is now worth $250,000. Meanwhile, our income in the last year has decreased by about $30,000 annually. We are trying to work with our lender to stay in our house, but things are tight and we don’t know how much longer we will be able to keep making payments on this house.

What would be the downside of doing a short sale, renting for a couple of years until we could buy again? It seems like we would be able to save up while we were renting, and I can’t see house prices doubling in the next two years. What do you think would be our best option?

Answer: You’re right that home prices won’t recover their lost value any time soon. But that alone isn’t good reason to bail on a mortgage, particularly given the fallout such a move can have on your finances.

The damage to your credit will be significant. Short sales — selling a home for less than what’s owed, with the lender’s consent — typically harm credit scores as much as foreclosures do.

And these days it’s harder to recover from a serious credit blow than it used to be. Fewer lenders are willing to take chances on those with subpar credit.

You may be able to qualify for a mortgage again within a couple of years, but you’ll probably pay higher rates for all your credit for several years.

If you can’t work something out with your lender and can no longer afford the payments, you may not have much of a choice. But given the stakes involved, you should explore all your options for saving the house before you turn in your keys.

Don’t let disputes go to collections

Dear Liz: Our FICO score is above 900. When we retired and moved to Oregon, our previous landlord in California imposed false charges against our security deposit that we refused to pay. The landlord has since turned the account over to a collection agency that indicates it will notify all three credit agencies of this outstanding amount. How will this affect our FICO score?

Answer: The top FICO score is actually 850. If the last score you saw was over 900, you probably were looking at a VantageScore, which isn’t used by as many lenders.

In any case, your scores probably will drop if the collection agency follows through on its threat. How much they’ll drop depends on the rest of your credit history, how much the collector says you owe and which version of the FICO formula a lender happens to use (the latest, FICO 08, excludes collections under $100).

Typically, though, collections are considered a serious negative that can easily knock your score out of the “prime” range.

This is why you don’t let disputes go to collections. You would have been better off paying the landlord under protest and then suing him or her in Small Claims Court.