[This post is written and copyrighted by FIRE Finance (http://firefinance.blogspot.com).]
Mrs. Micah has raised an interesting question as a comment to our post titled "Hot Credit Card Signup Bonuses" which we published last week. Here we quote her verbatim:
What is a credit score?
It is a three digit number which results as a product of a mathematical formula that evaluates the information in our credit report files. It is designed to give an idea about the likelihood of our ability to make payments on time and use credit responsibly.
Who checks our credit scores?
What is the most common type of credit score used?
One of the most commonly used credit scores is the FICO score. It was developed by Minnesota based Fair Isaac Corporation. It is a three-digit score that ranges 300 to 850.
Similarly some other credit scores used are those calculated by Experian, Transunion and Equifax (you can get a FREE credit report with these scores once a year from annualcreditreport.com). However the FICO credit risk score is the one used by most mortgage lenders and large financial institutions. FICO credit reports are not free and you have to purchase them.
Mrs Micah's Question:
Does closing unused credit cards with no balances affect our credit score?
This is an area around which myths exist and often people respond with a typically useless answer like "depends". However there is some useful information which lends light to this scenario.
Lender's View
Some lenders believe that the amount of credit available to an individual somewhat predicts future risk. How so?
Say a consumer is applying for a mortgage. Now the lender has found out that this applicant already has $100,000 of available credit through credit cards and other outstanding loans. Often this might be viewed as a risky proposition. Why?
Simply because of the fact that there is a lot of credit available to that person. Theoretically, this means that the applicant could some day use all that available credit all at once. And in that case there is a high chance that this consumer might not be able to pay back the lender's loan.
Viewpoint from FICO Score
The algorithm calculating a FICO score does not view our credit in the same way as a lender does. To the FICO score calculator, an individual's income, assets and money in the bank is invisible. However it does have information about the total credit available to a consumer and how much of it is being used. So the FICO score calculator looks at our "credit utilization rate," which is our total outstanding debt or revolving debt like credit cards, divided by their total credit limits.
Now when we close an unused credit card, the credit utilization rate is changed. In particular, if the card that we closed had no balance (i.e. debt) on it, then our total available credit is decreased. This will result in a higher credit utilization rate (since the denominator, which is the total available credit, has gone down and (assuming that) the revolving debt on the other cards is the same). Consequently our FICO score will be lowered.
Another typical scenario is when consumers do not pay down any of the outstanding debt. This results in a higher credit utilization rate. That will lower a person's FICO score. In this case, closing a credit card is never going to help improve a consumer's FICO score. And in some cases, it can in fact hurt your FICO score.
The bottom line is that simply closing a credit card will not help improve our FICO credit score. To improve it we have to pay off our debts and increase our total available credit limit.
Analysis
If we plan to take out a mortgage in near future, then according to the lender's perspective mentioned above, the lower our total credit limit the better is our credibility. In that case it might make sense to close our credit cards with no balance on them.
On the other hand if we have no plans to take out a mortgage in the next few years, then the higher our total credit limit (assuming our debt is same or decreasing every month) the lower will be our credit utilization rates. This will lead to better FICO scores.
Real Life Anamolies
Here is a story from our friend at The Sun's Financial Diary about how his FICO score has improved even though his credit utilization rate has jumped due to credit card arbitrage. His theory is that "no late payments" are more important than total credit utilization rates. Well this might provide an interesting case study to test the theories of typically acclaimed methods to improve our credit scores.
Our Two cents
If we were planning to take out a mortgage we would decrease our total annual credit limit (by closing cards with zero balance) and paying off our debts as fast as possible. The goal would have been to strike a balance between a good FICO score and an acceptable (to the lenders) total credit line which would help us procure low interest rates on our mortgage.
On the other hand if we had no plans to get a mortgage for the next few years, we would earn as much free money as possible through credit card sign-up bonuses and maintain a zero balance on the cards we are not using frequently. Doing so, would not only increase our total annual credit limits but also bring down our credit utilization rates. Consequently our FICO scores would be higher i.e. a better credit score!
We hope that this information will help answer Mrs. Micah's question to a certain extent. We would be delighted to know your personal experience in this regard. Please free to share it for the benefit of all. We are looking forward towards learning more about this topic from real life scenarios such as yours.
Our esteemed readers can send their questions (if any) by emailing us at firegetters@gmail.com. We will try our best to research and address them.
And if our site interests you, please kindly extend your support by subscribing to our feed. This will help us to deliver our stories to your feed reader where you can read it with pleasure in your own sweet leisure.
Image Source(s): iStockPhoto
Her question set us on the road to research. We wanted to find out for sure about what really hurts our credit scores and how we can improve it. First we shall discuss some background information of a credit score before addressing Mrs. Micah's query."I'd do this except for one reason--well, I'd do it in the future, right now we're trying to straighten out our finances and I wouldn't want anything new to deal with--I'm not sure how it would effect my credit.
Specifically, I know that having older cards is good. And I know that having lots of available credit (open cards with no balances...which is what I'd have) can be bad when one is looking for a mortgage.
So, do you know if one can open cards, keep them for a while, then just close them down without hurting one's score? We wouldn't close our oldest (and currently only) card.
It's not too hard to be without credit, we can still use debit if we have the cash in the bank, which is what we're doing right now. Some advocate carrying only cash, but I prefer paying "cash" via debit."
What is a credit score?
It is a three digit number which results as a product of a mathematical formula that evaluates the information in our credit report files. It is designed to give an idea about the likelihood of our ability to make payments on time and use credit responsibly.Who checks our credit scores?
Lenders (including mortgage companies) check it to determine whether they will approve our loan and calculate the subsequent interest rates to be charged. Credit scores help them to achieve a better balance of the credit risks they take into their overall loan portfolios.- Auto insurance companies use it to decide if they will insure us and at what rate.
- Cell phone companies use it to approve an application for a new account.
- Landlords use it to decide if they will rent an apartment to a prospective tenant.
- Employers often use it in their background checks before hiring somebody.
What is the most common type of credit score used?
One of the most commonly used credit scores is the FICO score. It was developed by Minnesota based Fair Isaac Corporation. It is a three-digit score that ranges 300 to 850.Similarly some other credit scores used are those calculated by Experian, Transunion and Equifax (you can get a FREE credit report with these scores once a year from annualcreditreport.com). However the FICO credit risk score is the one used by most mortgage lenders and large financial institutions. FICO credit reports are not free and you have to purchase them.
Mrs Micah's Question:
Does closing unused credit cards with no balances affect our credit score?
This is an area around which myths exist and often people respond with a typically useless answer like "depends". However there is some useful information which lends light to this scenario.Lender's View
Some lenders believe that the amount of credit available to an individual somewhat predicts future risk. How so?Say a consumer is applying for a mortgage. Now the lender has found out that this applicant already has $100,000 of available credit through credit cards and other outstanding loans. Often this might be viewed as a risky proposition. Why?
Simply because of the fact that there is a lot of credit available to that person. Theoretically, this means that the applicant could some day use all that available credit all at once. And in that case there is a high chance that this consumer might not be able to pay back the lender's loan.
Viewpoint from FICO Score
The algorithm calculating a FICO score does not view our credit in the same way as a lender does. To the FICO score calculator, an individual's income, assets and money in the bank is invisible. However it does have information about the total credit available to a consumer and how much of it is being used. So the FICO score calculator looks at our "credit utilization rate," which is our total outstanding debt or revolving debt like credit cards, divided by their total credit limits.Now when we close an unused credit card, the credit utilization rate is changed. In particular, if the card that we closed had no balance (i.e. debt) on it, then our total available credit is decreased. This will result in a higher credit utilization rate (since the denominator, which is the total available credit, has gone down and (assuming that) the revolving debt on the other cards is the same). Consequently our FICO score will be lowered.
Another typical scenario is when consumers do not pay down any of the outstanding debt. This results in a higher credit utilization rate. That will lower a person's FICO score. In this case, closing a credit card is never going to help improve a consumer's FICO score. And in some cases, it can in fact hurt your FICO score.
The bottom line is that simply closing a credit card will not help improve our FICO credit score. To improve it we have to pay off our debts and increase our total available credit limit.
Analysis
If we plan to take out a mortgage in near future, then according to the lender's perspective mentioned above, the lower our total credit limit the better is our credibility. In that case it might make sense to close our credit cards with no balance on them.On the other hand if we have no plans to take out a mortgage in the next few years, then the higher our total credit limit (assuming our debt is same or decreasing every month) the lower will be our credit utilization rates. This will lead to better FICO scores.
Real Life Anamolies
Here is a story from our friend at The Sun's Financial Diary about how his FICO score has improved even though his credit utilization rate has jumped due to credit card arbitrage. His theory is that "no late payments" are more important than total credit utilization rates. Well this might provide an interesting case study to test the theories of typically acclaimed methods to improve our credit scores.Our Two cents
If we were planning to take out a mortgage we would decrease our total annual credit limit (by closing cards with zero balance) and paying off our debts as fast as possible. The goal would have been to strike a balance between a good FICO score and an acceptable (to the lenders) total credit line which would help us procure low interest rates on our mortgage.On the other hand if we had no plans to get a mortgage for the next few years, we would earn as much free money as possible through credit card sign-up bonuses and maintain a zero balance on the cards we are not using frequently. Doing so, would not only increase our total annual credit limits but also bring down our credit utilization rates. Consequently our FICO scores would be higher i.e. a better credit score!
We hope that this information will help answer Mrs. Micah's question to a certain extent. We would be delighted to know your personal experience in this regard. Please free to share it for the benefit of all. We are looking forward towards learning more about this topic from real life scenarios such as yours.Our esteemed readers can send their questions (if any) by emailing us at firegetters@gmail.com. We will try our best to research and address them.
And if our site interests you, please kindly extend your support by subscribing to our feed. This will help us to deliver our stories to your feed reader where you can read it with pleasure in your own sweet leisure.
Image Source(s): iStockPhoto
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