These Myths About Improving Your Credit Score Actually Hurt Your Credit
The credit scoring model used by nearly all banks, credit unions, and other financial institutions was a long-held secret in the financial world. For decades, the Fair Isaac Company, which created the credit scoring model, closely guarded the algorithm which calculates the score. Even today, the company only releases general information about the weights of each category making up the score.
As a result of this secrecy, much speculation and misinformation has been distributed by well-intentioned advisers trying to help people improve their scores. Before I worked as a Vice President at a financial institution, I was one of the people who believed a few of these myths. After being trained on the credit scoring model and talking with numerous banking executives as part of my role in the banking industry, I had my eyes opened to the realities of how to better manage my own score.
The Myths That Can Lower Your Score
Don’t fall into the credit score trap of believing these common myths. Understanding the realities will help you better manage your score and have more control over your credit.
Myth: Closing a credit card will improve your score
One of the most common myths circulating about credit scores is you can improve your score dramatically by cancelling credit cards. Some even say cancelling a card will raise your score by 60 points within a month. This is false. Cancelling or closing a credit card can have significant negative impacts on your score because it lowers your Capacity, one of the biggest factors of your credit score.
Your Capacity is how much of your available credit you have used. Said another way, how badly are you in debt relative to how bad it could be. Capacity makes up 30% of your overall credit score, slightly less than your Payment History (35%). Underestimating the importance of Capacity is a mistake, because it determines nearly a third of your score.
The inverse of Capacity, utilization, is often used because it’s easier to calculate. Adding up your capacity and your utilization will always equal 100%, so calculating utilization gives you your capacity. Your credit score goes up the higher your capacity and the lower your utilization. To calculate your utilization, divide your total balances by your total account limits.
As an example: assume you have three credit cards. The first has an account balance of $400 and a limit of $1,000; the second a balance of $550 and a limit of $1,500; and the third a balance of $1050 and a limit of $1,500. Adding the cards up, your total balance is $2,000 ($400 + $550 + $1,050) and your total limit of $4,000 ($1,000 + $1,500 + $1,500). Divide the total balances by the total limits ($2,000/$4,000) gets you a utilization of 50%. Not great but not too bad either.
The next month you work some overtime and pay off the first credit card. Paying off the balance will reduce your utilization to 40% ($1,600/$4,000), which increases your credit score. And your score increases a lot because of how important Capacity is to your score.
But if you also cancel the credit card when you pay it off, you actually hurt your score. You still owe the same $1,600 dollars, but your limits now add up to only $3,000 (the two remaining $1,500 cards). Divide $1,600 by $3,000 and you get a 53% utilization, worse than when you started. Paying off and cancelling the smallest card actually lowered your credit score.
The lesson isn’t, however, that paying off your debt will hurt your score. Paying off your credit card debt will always help your score, but you need to be strategic about closing cards.
Myth: Closing a credit card will hurt your score
This myth is often cited in articles and advice about the first myth. There are many articles about how closing a card hurts your Capacity and your score. Unfortunately, many of them give the impression you should never close a credit card.
As with most things in life, your credit score is far more nuanced. Although it is true closing a card will hurt your utilization or Capacity, it is also true you can actually improve your score by closing certain types of accounts. If you have a card with a finance company, closing the account will help your score.
The scoring model treats loans from different types of financial institutions very differently. An account with a ‘finance company’ will automatically hurt your score due to the the ‘Mix of Credit’ portion of your core.
Mix of Credit refers to how the score likes some loans and dislikes other. The presence of ‘helpful’ loans on your report, such as secured and installment loans, actually improves your score. The more ‘harmful’ loans you have, such as unsecured and revolving loans, the lower your score goes.
Loans with finance companies are harmful loans and will always lower your score. A finance company is a ‘lender of last resort,’ which is the type of lender one goes to when they can’t get loans through traditional sources such as banks and credit unions. Closing a finance company credit card will have a positive impact on your score.
Myth: Late payments stay on your credit for 7 years
This myth comes from federal law, which states a credit reporting agency must delete information after seven years. But there is nothing in the law mandating the reporting agencies to keep the late payment for 7 years. Late payments obviously affect the Payment History portion of your credit score, which is the most important at 35%.
You can determine how many years a late payment will stay on your record by pulling your credit report and counting the number of payment history boxes the report has. Your Payment History is looking backward at the most recent payments you have made. If the credit agency only has 60 boxes (60 months) on their credit report for Payment History, after 5 years new on-time payments will have filled in all the boxes. The late payment you made 61 months ago will no longer be on your credit history because there is no box to put it in.
Even if the credit bureau keeps your payment history for 7 years, the credit score doesn’t really care about things which happened over half a decade ago. Under the FICO credit scoring model, the past three years of Payment History account for 90% of your ‘Payment History’ factor. If you are trying to rebuild your score, within a just three years of on-time payments you’ll have nearly a perfect Payment History score.
Myth: It’s better to stop paying on some accounts so you can keep a few accounts current
This is a strategy suggested by many as a way to preserve some of your credit when you have financial difficulties; and it is dangerous. An example often given is if you have five accounts, but don’t have enough money to pay them all, choose two of them to continue paying on time, and stop paying the rest.
The idea is having a few accounts which are paid perfectly will ‘make up’ for the delinquent accounts. Although this may be a necessity from a budgeting standpoint, it will definitely not help your score.
The Payment History factor in your credit score is a nuanced and complex formula. The credit score doesn’t just add up a bunch of numbers. It weighs late payments more the longer you go without paying them. The score punishes you far more for having one 90-day late account than it would for having three (or more) 30-day late accounts.
A better strategy would be to start by paying some of the bills this month, then catching up on the others in the next month. This will keep your report from showing anything more than 30-days late, but you can’t stop there. Next, contact your creditors to explain the situation and ask if you can work out a payment plan. Finally, review your budget to see what can be cut out (like cable TV) so you can begin making all your payments on time.
Myth: You Can Hire a Consultant or Company to Quickly Improve Your Credit
This is probably the most dangerous myth out there. Consultants or companies which advertise they can immediately improve your score often make claims they can’t support. And many are straight up scams.
Under the law, there is nothing a consultant or a company can do which you couldn’t do yourself. Most of what these consultants do is filing disputes with the credit reporting agencies, which you can do yourself directly from the credit bureau website.
Another common ‘strategy’ consultants use is to suggest you not pay your bills while they are working with your creditors. They do this because if you stop making any payments, the banks will think you will never pay them again, which gives the consultant a little more negotiating power. Unfortunately, while they are building their ‘negotiating’ power, your credit score is being decimated; your balances are rising; and you’re racking up interest charges, late fees, and other costs.
If you owe the money, never follow advice to stop making payments to build negotiating power. This might benefit the consultant, but if it doesn’t work they get to walk away and you’re left with all the negatives. The most important thing to a bank is getting the loan paid back. If you can show the bank you won’t be able to make payments in the future, they have all the incentive they need to work with you.
Myth: A financial adviser or financial coach can’t help you improve your score
Just because there are bad companies out there which make unfounded promises about improving your score, doesn’t mean you can’t get help. A good financial adviser or financial coach can provide you with a variety of services and support to help you improve both your score and your overall finances.
A good adviser will help you build a plan and a budget for how to improve your finances in general, which will also help your score. If the company is talking only about your score, walk away. Having a high score should not be the goal of financial planning. Your planning should focus on improving your overall finances; and your score should then simply reflect your stronger financial position.
Joshua Escalante Troesh is a tenured professor of Business at El Camino College and the founder of Purposeful Finance. His career provides him with a unique insight on personal financial, having been a VP at a financial institution leading up to 2008, and involved with technology and internet stock research leading up to 2000. He can be reached for comment at firstname.lastname@example.org