If your experience is anything like ours, you’ve found that some banking customers harbor strange ideas about credit scores. Here are several myths about FICO® Scores that we hear often.
Myth: To get a high score, run up high balances on your credit cards.
Contrary to what some believe, using a lot of credit is usually NOT good for one's credit risk score. Roughly 30 percent of a FICO® Score is determined by the person’s reported debt, with particular emphasis on revolving credit utilization (balance divided by credit limit). We find that high scorers typically keep their reported utilization under 25 percent on credit cards.
Myth: Paying your credit card bill down to zero every month will boost your score.
This is a great habit to get into and we strongly encourage it. It helps the consumer firmly control her credit card usage, encourages her to spend within her means, and helps avoid runaway debt. Because the information on credit reports is limited, however, this excellent habit doesn’t necessarily translate into a higher credit score.
Here’s why. The FICO® Score can’t see – and can’t deduce -- how much the borrower last paid the card issuer. On the credit report you’ll see the account balance last reported by the card issuer. But the previous month’s balance isn’t shown. Nor is the amount of the borrower’s last payment. And the way an account balance is reported, it rarely reflects the borrower’s most recent payment. That’s because many lenders report to the credit bureau the same outstanding balance that was last billed to the borrower. Other lenders report the balance as of a particular day in the month. So if a borrower habitually runs up a high card balance every month, his credit report will likely show those same high balances even though he routinely pays off his balance in full every month.
Myth: To raise your credit score quickly, open a new credit card or take out a loan.
The FICO® Score considers a wide variety of information about each reported account. In this case, opening a new account will likely have more negative effects than positive effects on the person’s score. On the plus side, it may improve the person’s credit utilization rate. It may also broaden the mix of credit types on the person’s credit report although this is a minor scoring factor. On the down side, the person will typically lose points in areas such as their length of credit history and the area we describe as “new credit,” or one’s propensity to seek new credit. Although the score will most likely drop from opening a new account, it should recover within a few months in response to responsible credit management. The best advice for consumers is to take on new credit sparingly and only when genuinely needed.
Myth: To raise your credit score quickly, close any unused credit cards.
If opening an account can lower your score, then closing an account must raise it, right? Actually this is rarely the case. Years ago lenders believed that having too much unused or available credit was a high-risk factor. In reality, having unused or available credit is often indicative of lower risk, and is viewed favorably by the FICO® Score. Closing a credit card typically removes available credit from the person’s credit report. That’s why closing a credit card doesn’t boost one's FICO Score, and in some situations may actually cause the person’s score to drop.
In a future post, I’ll discuss common misconceptions around closing credit card accounts and the impact on FICO® Scores.