Q&A: When paying debt hurts credit score

Dear Liz: You recently answered someone whose credit scores dropped more than 30 points after they paid off a mortgage. You mentioned that the big drop was probably because the mortgage was the person’s only installment loan. Credit scores like to see active use of both types of credit, installment loans and credit cards. Because this person’s scores were so high, they almost certainly were still actively using credit cards. But you should remind people that if they stop using credit, eventually they won’t have any credit scores at all.

Answer: Consider them reminded. There’s no need to carry balances; just using credit cards regularly is enough.

A few other readers wrote in suggesting the letter writer get a personal loan as a way of increasing their scores. Although personal loans can be a great help to people building credit, there’s really no point in increasing scores once they’re above about 760 on a 300-to-850 scale. Higher scores only get you bragging rights, and it would be a little silly to pay a lender unnecessary interest to get those.

Q&A: This is why credit scores are so confusing

Dear Liz: I am from Germany. I have had a bank account in America for over one year. Now I get my FICO score. After six months it was 738, half a year later, it was 771 and one month after that, 759. Why does it change in such a short time? Is it the real FICO score?

Answer: Welcome to the U.S. and its sometimes-baffling credit scoring systems. Even people who were born here often misunderstand how credit scores work.

You don’t have just one score; you have many, and they change all the time to reflect the changing information in your credit reports. Higher or lower balances on a credit card, a new credit application or the simple passage of time can make the numbers change.

The FICO scoring system is the most dominant, but lenders also use VantageScore, a FICO rival created by the three credit bureaus (Equifax, Experian and TransUnion), plus proprietary scores.

You also will see different numbers depending on which credit bureau report is used to create the score and which version of the score is used. Credit scoring formulas may be designed for certain industries and formulas are updated over time.

So your FICO Auto Score 6 from Experian likely won’t be the same as your FICO 4 from TransUnion, your FICO Bankcard Score 4 from Equifax or your VantageScore 3 from any of the bureaus, even if you get all the scores on the same day.

It can be hard to predict which score a lender will use, but the same behaviors tend to be rewarded by all of them. Those behaviors include paying bills on time, using only a small portion of your available credit, having different types of credit (installment loans and revolving accounts, such as credit cards) and applying for new credit sparingly.

If you’re using a score to monitor your credit, it’s important to use the same kind from the same bureau — otherwise you’re comparing apples and oranges, as we say in English.

Q&A: Take a look behind the credit-score numbers game

Dear Liz: I recently got an email from my credit card issuer stating my credit score had just dropped 21 points. Having a good credit score and not aware of any recent adverse actions, my first reaction was alarm.

Checking with the issuer online, I saw only advertisements for “protect your credit” services, so I phoned. I was informed the numbers came from Equifax credit bureau. I contacted Equifax as well as TransUnion and Experian, which resulted only in more offers of products to protect my credit. I downloaded my free credit reports from AnnualCreditReport.com and found nothing suspicious. I was finally directed to FICO, but an email sent more than a month ago remains unanswered.

Is it legal for these companies to market their products through presumably fictitious or even fraudulent means? What is the best way to find out my true credit score? Can my credit score suffer because I ask these questions in a public forum?

Answer: Knowing a little more about how credit scoring works may put your mind at ease.

There is no one “true” credit score. Lenders and other companies use many different kinds. FICO is the leading credit scoring company and the FICO 8 is the most commonly used score, but many companies use older versions or ones modified for their specific industry (such as the FICO Auto Score 5, for example). Plus, your FICO 8 from Experian may be different from your FICO 8 from TransUnion or Equifax because the scores are based on the information in your credit bureau files and the bureaus are separate, competing businesses that don’t always have the same information.

Then there’s the VantageScore, a rival to the FICO, which is used by some lenders and by many sites that offer people their credit scores for free. The VantageScore formula is different from the FICO formula, so your numbers could be different as well.

All these credit scores, however, are created solely using the information in your credit reports. Your income, gender, address, political opinions, computer operating system and online comments are not included in credit score calculations.

Some people are understandably confused about that. Various start-ups and researchers have suggested that non-credit information — such as information gleaned from someone’s social media postings or online surveys — could replace credit information in loan decisions. But the U.S. has fair credit reporting laws that probably would make such alternatives unworkable. (It would be nice if start-ups checked to see what regulations apply to their industry before sending out press releases, but that doesn’t always happen.)

Given that you didn’t see anything obviously wrong on your credit reports, you don’t need to worry too much. The credit score drop you describe might be because you charged more on a credit card than usual, had a credit limit lowered or applied for a bunch of credit in a short period of time. It probably will reverse itself over time.

Alerting you to credit score changes isn’t an illegal practice, even if the company’s primary purpose in keeping you up to date is to market credit-monitoring services to you. (Credit protection is a misnomer because these services can’t prevent identity theft. They can only alert you if it’s already happened.)

You did exactly what you should have done when you were alerted to the point drop — you went to AnnualCreditReport.com and checked your credit reports. If you want to put your mind further at ease, consider freezing your credit, a process that could prevent identity thieves from opening new accounts in your name.

Q&A: Don’t believe this credit score myth

Dear Liz: Is it true that no credit is as bad as bad credit? I recently paid off my house and have no car loans. I use four credit cards every month, including one for automatic monthly bills. All are paid in full as soon as I get the bills. So practically speaking, I have zero debt. Am I making a credit history if I don’t have debt? I had excellent credit scores before I paid off my house.

Answer: You still do. You don’t have to carry debt to have good credit scores.

The myth that you do — that the only people with good credit are the ones in debt — is unfortunately a persistent one, typically spread by people who don’t understand how credit scores work. Rest assured that using your credit cards lightly but regularly, and paying the balances in full every month, is the right thing for both your scores and your finances in general.

Your paid-off mortgage should remain on your credit report for years to come, and it will continue to help your scores. Scoring formulas typically reward evidence that you can handle a variety of credit, including installment loans such as mortgages and revolving debt such as credit cards. Even after the mortgage disappears from your credit reports, however, your consistent and responsible use of your credit cards should keep your scores high.

Tuesday’s need-to-know money news

Credit report with score on a desk

Today’s top story: How your selfie could affect your life insurance. Also in the news: How to build credit in exactly 250 words, why you need to get to work on building your unemployment fund, and why the credit scoring system is about to get less awful.

How Your Selfie Could Affect Your Life Insurance
That brunch selfie could raise your life insurance rates.

How to Build Credit in (Exactly) 250 Words
Short, sweet, and effective.

Get to Work on Building Your Unemployment Fund
Don’t waste anymore time.

The Credit Scoring System Is About to Get Less Awful
Big changes are coming this fall.

Q&A: Effects of closing credit card accounts

Dear Liz: I would like to know how to close credit card accounts and not get a bad credit rating for doing so. We are trying to improve our credit after filing for bankruptcy seven years ago.

Answer: If you’re trying to improve your credit, then avoid closing credit accounts. Doing so can’t help your scores and may hurt them. Credit-scoring formulas are sensitive to how much of your available credit you’re using. The formulas like to see a wide gap between your credit limits and the amount you charge, both on individual cards and in the aggregate. When you close an account, you reduce your available credit, which narrows that gap and can ding your scores.

If you want to speed up your recovery from the bankruptcy, continue using the cards lightly but regularly and paying the balances in full every month. Make sure to pay all your bills on time so that a skipped payment doesn’t undo all the progress you’ve made. Review your credit reports and dispute any errors, including accounts that were included in the bankruptcy but are still showing up as active debts.

That doesn’t mean you can never close unwanted credit accounts. You just don’t want to do so now, or when you’re in the market for a major loan. You can close an account or two once your scores are in the high 700s on the 300-to-850 FICO scale and you don’t plan to apply for credit in the near future.

Q&A: Helping a friend build credit

Dear Liz: I am selling my car to an old friend with no credit history. (The used car salesman wanted to charge her 6.5% interest.) Is there a way that I can report her timely payments to the credit reporting services to help her build her credit?

Answer: It’s not really practical for individuals to report payments, since subscribing to credit bureaus is expensive.

The rate your friend was quoted actually isn’t bad given her lack of credit history. If she kept the loan term relatively short (four years or less), she might be able to build up enough equity and credit history to refinance it to a lower rate in a year or two.

If she’d prefer not to take that route, you might suggest she explore credit builder loans. These loans, offered by credit unions, banks and some online lenders, are designed to help establish credit histories at the bureaus. The lenders typically put the borrowers monthly payments, minus a small interest charge, into a certificate of deposit that is the borrowers to keep after the final payment.

Secured credit cards are another good way to build credit scores. Borrowers make a refundable deposit with the issuing bank and get a credit line that’s typical equal to that deposit.

Q&A: Credit scores and new accounts

Dear Liz: My spouse signed up for a store credit card to receive a discount on a large purchase. As she has no strong interest in maintaining a line of credit there, is there a simple way of discontinuing this account without affecting our credit scores, given that we may apply for a mortgage in the near future?

If not, is it critical we maintain some frequency of use on this account?

Answer: First, let’s correct a popular misconception that marriage somehow combines your credit records. Assuming she applied for the card in her name alone, this account won’t show up on your credit report or affect your scores.

Should you apply for a mortgage together, however, her scores could affect the interest rate and terms you get. Opening and closing accounts can ding scores, so it’s best to avoid both when you’re in the market for a major loan.

Issuers vary in their policies on closing inactive accounts, so it’s hard to predict how much activity would prevent the card from being shut down. Typically, though, a small charge every two to three months is enough to keep an account open.

My FICO score is 846. And 796. And 878. And…

Zemanta Related Posts ThumbnailOne of the most persistent credit scoring myths is that you have one.

You don’t have one, you have many, and they change all the time.

The dominant model is the FICO, but even that comes in many flavors. You can get a taste for how many at MyFICO.

When I bought my scores there recently, my FICO 8 from Equifax was 846 on the 300-to-850 scale. But my FICO 5, the score Equifax most commonly sells to mortgage lenders, was 797.

There was even wider variation in my auto and credit card scores, are calculated on a 250-to-900 scale. My FICO Auto Score 8 was 867, while my FICO Auto Score 5 was 810. My FICO Bankcard Score 8 was 869 and my FICO Bankcard Score 5 was 797.

My scores from Experian ranged from 796 (FICO Score 3, used by some credit card issuers) to 878 (FICO Auto Score 8). The clutch of numbers from TransUnion ran from 806 (FICO Score 4, used by some mortgage lenders) to 874 (FICO Auto Score 8).

MyFICO used to serve up just one score per bureau. I like this wider view, since it better reflects the fact that lenders use different versions and generations of the formula.

TMI? Maybe. But I’ll take it over the days when credit scores were such a closely-guarded secret that you weren’t even supposed to know they existed.

Credit myths that need to die

YCS4 coverThe more you understand about how credit works, the more frustrated you get with how much misinformation is floating around out there. At least, that’s true for me and the three experts who joined me last week on a Google hangout to talk about “Credit myths that need to die.”

John Ulzheimer, who’s worked at Equifax and Fair Isaac, has unique insight into the credit reporting world. One thing that drives him around the bend is the persistent myth that employers use credit scores to evaluate applicants. Another myth he hates: the one about how closing accounts hurts your credit scores.

Gerri Detweiler, who writes for Credit.com and runs the DebtCollectionAnswers.com, discusses how medical debts affect your credits and debunks the myth that you need to carry balances to improve your credit scores.

Maxine Sweet heads consumer education at Experian and battles the myth that there’s just one credit score.

Take some time today to check out our discussion. You’ll come away from it a lot more informed about credit and how to make yours the best.