|
18 July 2005
"Two years ago I had terrible credit, and you were
kind enough to steer me to a credit card company that would give me a card. Now
I have three cards, and my credit has improved some, but not enough�how do I
manage my cards to earn the highest possible credit score?"
Managing credit cards is more complicated than managing
a mortgage or auto loan, because you have multiple debts rather than just one.
The number of cards can vary, balances can be increased or paid down, balances
can be shifted between cards, new cards can be opened, and existing cards can be
closed.
Any such change may affect your credit score. Whether
it reduces or increases the score depends on whether the genie who scores credit
believes that the change will increase or decrease the probability that you will
default on future loans. The rules applied by the genie are as follows, in order
of importance.
Payment History
Payments made on time raise the credit score, while
delinquent payments reduce it. That is the most important rule by far.
Most card-holders understand this, but many also
believe that the reduction in credit score caused by a delinquency is reversed
when the card becomes current. This is not the case. Eliminating the delinquency
merely prevents a further hit to the score. Delinquencies stay on your record
for 7 years, although their force will weaken over time as on-time payments come
in.
Ratio of Card Balance to
Maximum Balance
This is the second most important component of
your credit score, and if your credit history is short, it can be the most
important.
The genie compares the outstanding debt on each of your
cards with the maximum amount of debt that the credit grantor has set on that
card. For example, if the balance on a card is $2,000 and the maximum balance is
$5,000, the utilization rate is 40%. The lower the utilization rate, the higher
your credit score. The genie interprets high ratios to mean that the borrower is
living closer to the edge.
Some experts advise that it is better to have about the
same utilization ratio across all your cards, rather than have some high and
some low. This would prevent borrowers from minimizing interest cost by
concentrating balances in the card(s) with the lowest interest rates.
I don�t know whether the genie favors an even
distribution of balances across cards or not. I suspect not, since the genie is
logical and there is no logical reason why the distribution of balances across
different cards should matter.
A card holder can reduce his utilization ratio by
reducing his balance, and also by increasing the maximum balance. If a borrower
has had a good payment record, the maximum can often be increased simply by
asking.
Make sure that your card issuer reports a maximum. If
no maximum is reported, the genie assumes that the highest balance ever reached
in that account is the maximum, when in fact it could be well below the maximum.
This raises your utilization rate for no good reason.
If a card has no reported limit, you can either request
that the limit be reported, or terminate the relationship. Alternatively, you
can shift all your balances into this account temporarily so that the highest
balance comes closer to the unreported maximum.
Age of Cards
The genie likes old credit cards much more than new
ones. The card you have been using for 15 years is evidence of your financial
stability, whereas the card you took out last week could mean you are in
trouble. If you took out 3 cards last week, it could be big trouble.
To receive credit for old cards, they have to be
active. If you don�t use a card for 6 months, it is classified as inactive and
the genie ignores it.
Number of Cards
The scoring genie prefers that you have no more than 4
or 5 active cards, but if you have 12, don�t worry about it. If you reduce the
number from 12 to 5, the genie will reward you for the reduction in numbers but
might penalize you for the increase in utilization that goes with it.
Of course, there might be other reasons for reducing
the number of your cards, such as simplifying your life. If you do it, retain
the older cards and cancel the newer ones.
Copyright Jack Guttentag 2005
| 
