Understand your Credit. Don't Fear It!

Another great post from the Dr. today, all about credit scores. Also, can you see how tan my legs were in the picture below?? Oh, to live near the sea again.

Probably the best return on my time & energy for free travel has come about from signing up for and at some future time closing new credit cards. But, I think some people have fears about that and its effect on your credit score.

Sometimes our choices related to credit are done out of fear.

A Story

I was getting my hair did at a stylist last week. She does a great job. Like, I won't go anywhere else in the area anymore. We always chat about travel in the chair and she mentioned that on a recent US Airways flight they advertised a credit card over the PA system. I know which one, cause I have it. I've been there before too—US Air does all this lame advertising to their captive audience during flights. But oh well they're cheap.

Back to the story. She said she was thinking of signing up and didn’t. Just then, someone else took a pamphlet and signed up. She just kept telling me how they shouldn’t do that kind of thing and ruin their credit.  Since she took a strong stance, so I didn’t respond to her comment, but I think this is how people think.

Now I’m not saying that people SHOULD sign up. You probably shouldn’t if you overspend, can’t responsibly pay the bill on time, just applied for other cards, want to simplify life, or any number of reasons—it’s a matter of being honest with yourself. But, I am saying that if your only concern is how it will affect your credit score, then maybe you should read on.

Your Credit Score

Your FICO credit scores are generated only from information in your credit report. Credit reports come from the 3 credit reporting agencies: Experian, TransUnion, and Equifax. Most creditors don’t pull all 3 reports when you request credit, but some do (notably CapitalOne cards do). FICO is a company with a complex, proprietary scoring algorithm. Since it’s popular, I’m sure they make lots of $ on their algorithm. Scores range from 300-850.

Here’s a breakdown of how different aspects of your Credit Report factor into your FICO score.

Image from MyFICO.com

Percentage	What	Description
35	Payment History	Shows responsibility for paying accounts on time
30	Amounts Owed	Total statement balances divide by Total of credit limits
15	Length of History	Average age of accounts. Good to keep old accounts open
10	Types of Credit	Real Estate, Installment Loans, Credit Cards. Good to mix
10	New Credit	Inquiries impact for 1 year. Lower impact after 1-3 mo.

From www.experian.com

What happens when you apply for a credit card?

When you fill out an application online or at a bank or online, the bank does a hard pull on your credit file. This is called an “inquiry.” I have been able to confirm what several other points bloggers have noted this type of inquiry does reduce your credit score by less than 10 points (blog 1: 2-8 pts, blog 2: 3-11 pts). Technically inquiries fall off your credit report (and hence affect your score) for only up to 1 year. However, from my own history, it appears that the lifespan of the credit “hit” is really 1-3 months.

If the application is approved, then other changes will show up in your credit score. First, you have a new card that is 0 months old. This new card will now be factored into the average age of credit lines. This is another potential place where a credit score could be reduced especially if you’re just starting to use your credit.

Second, your credit score will be increased because you have a new amount added to your total credit limit, while there is no balance on that line yet. The result is a lower credit utilization rate. In my experience, this usually ends up increasing my credit score.

Another Story

Several years ago (probably 2006) I opened a bank account with Key Bank because they offered a free iPod nano for opening a new checking account and a credit card with Lock Bank (name changed to protect the innocent). This is when iPods were the coolest possible thing. I read the offer and it basically said I had to have $100 in the account for 6 months. So I opened the account and met the requirements. Then, I fought to get my iPod, since they later argued that they never had such a promotion. I ended up with the iPod. Finally, I called their service desk to close my account. Their “retention” department told me to be careful and read me a thing about closing accounts and warned me that it could affect my credit. 

The fear built up inside of me. “Oh no! I might ruin my credit. And I’m so young! I might never get a home.”

With a portion of truth, it was a lie. It was a lie to get me to keep my account open.

Like most people I didn't actually know how credit files worked. First of all, bank accounts that are not credit accounts are not reported to credit reporting agencies. So having a debit card with a visa sticker on a checking account will not do anything to your credit. Secondly, although opening and closing accounts does have an effect, the effect is very limited and most importantly, it can be understood before closing

What happens when you close an account?

When you close a credit card it will only impact the last two factors—Credit utilization and average age of accounts. Here’s how to avoid dropping your credit score when you close an account:

Don't close your oldest accounts. If you're not using an account, you don't necessarily need to close that account. If you're just starting out using credit, open “no annual fee” cards so that when you keep your oldest card open forever it won't cost you anything. Remember, the average age is the only thing that matters here.

Credit utilization will go up when you close an account because your total of all credit limits will go down. One thing you can do when you close an account is to call your card company. If you have multiple credit lines with that bank, consider moving most of the credit line to one of your other accounts—like a no-fee card. That way your credit utilization rate and score won’t move.

That’s it. There is no more mystery. Now you don’t have to be afraid of opening and closing accounts.

The Rest of the Story

So I need to finish my story…

Even though I was initially afraid of what the phone rep told me, my B.S. detector was going strong. I closed my account with the Lock Bank. I had an iPod nano and it was awesome. Now it’s in a box somewhere. Want it?

How my FICO score has varied

So everyone’s experience will be a bit different. But I can speak from experience. Here’s a snapshot of my credit score over time. (This is via creditsesame.com)

I don’t have a problem sharing this with you. Part of the reason why we fear this credit-related items is because it’s taboo to talk about. It is not a competition. When no one communicates, knowledge isn’t transferred and the banks win. 

What I'd point out is that all of the stronger dips are months where I applied for 1 or 2 cards this year. The result was minor impacts on my score and a rebound within a couple months. In December, I closed an account and opened 2. The January score reflects that.

Note: Credit Sesame doesn't use exact FICO scoring—it’s their best guess pseudo-score and it shows trends just fine. I think it tends to give me too high of a score compared to real FICO scores. No matter. The point is to see the trends.

For reference here are my current FICO scores (they come free with some credit cards)

TransUnion FICO Score from Barclays Bank

Equifax FICO Score from CitiBank

Thanks for another great post, Thomas! If you have any questions please leave them in the comments below and I'll have the Dr. answer them.