One of the things that drives people nuts about credit scores is how they react when you close an account.
A reader named Mike put it this way in an e-mail:
I'm not sure about "un-American," but it certainly can seem unreasonable or unfair until you understand a bit more about how credit scoring works.
Losing points for voluntarily closing accounts is just one of the unexpected ways you can hurt your credit scores, those three-digit numbers that lenders use to gauge your creditworthiness. You also can get dinged for:
- Opening accounts, both when you apply and for as long as a year afterward.
- Transferring credit card balances.
- Settling debts.
- Using "limitless" cards.
- Incurring library fines, parking tickets or other penalties seemingly unrelated to credit.
Here's what you need to know and what you can do to minimize unintentional damage to your scores.
Among all the bankrupts, you're the best!
If you have a bankruptcy on your report, for example, you'll be grouped on a score card with other bankrupts. Your credit habits may look pretty good compared with theirs, but if the bankruptcy were to disappear from your record, you'd be lumped in with people who have stronger histories. Your credit behavior might not look so good compared with this new group. Something similar apparently happened to Carmen Georgescu, who had $51,000 of credit card debt and a 710 FICO score. After paying off $17,000 of debt in a few months, her score rose to 726. A few weeks later, though, her score suddenly plunged to 686.
Such abrupt drops can often be traced to a negative item, like a delinquency or a bankruptcy, disappearing from a borrower's credit report. In this case, though, the change was even more subtle.
"Carmen had opened a new account (a year previously) which, at that time, put her in a different scoring group consisting of consumers who had newly opened accounts on their credit files. Then when this recently opened account had aged enough to take her out of this scoring group and put her into one with consumers who had not opened any accounts recently, her score dropped."
There's not much you can do about this quirk in the scoring formula, other than brace for the potential effect. The good news: Georgescu's score recovered within a few months, as Paperno had predicted. The key was continuing to pay down debt and holding off on opening any new accounts.
Don't transfer your problemsLower interest rates are generally better when you're trying to pay off debt, but taking advantage of a balance-transfer offer can wallop your credit scores in a number of ways.
Just opening a credit card account to take advantage of the offer can ding your scores by 5 points or so. Transferring your balance to a card with a lower limit can hurt your scores, as can consolidating debt.
That's because the FICO model is heavily influenced by your "credit utilization ratio," the portion of your available credit limit you're actually using. The formula likes to see a wide gap between your balances and your limits. Transferring a balance from a high-limit card to a lower-limit card makes it look like you're closer to maxing out that second card, and the scores can react negatively.
To put it simply: The FICO formula typically would rather see $1,000 balances on five cards than a $5,000 balance on one card.
You can compound the damage to your scores by closing the card from which you transferred the balance. Closing the old account trims the amount of available credit that's used in the credit-scoring formula.
If you're planning to take advantage of a balance-transfer offer, read the fine print and consider the following:
- Limiting the number of accounts you open. If you want to improve your credit scores, don't keep bouncing your balances from card to card.
- Paying down your debt. Use the lower rate as an opportunity to reduce your debt load. Paying off debt is good for your wallet and good for your credit scores.
Settling debtsFor years, a glitch in the FICO formula often penalized folks for paying old debts that had been charged off and sent to collection agencies. That glitch finally got fixed, as I wrote in "When paying bills can hurt your credit."
But you can still do substantial damage to your scores if you settle a current debt for less than you owe. If an account hasn't been charged off and you're dealing with the original creditor, Fair Isaac officials say, a settlement can be worse than leaving the account open and unpaid. Of course, leaving an account unpaid will eventually result in a charge-off and a referral to a collection agency, which isn't good for your scores either.
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