One of the most frequent questions that we get from our readers is about their credit scores and, more precisely, how to improve them. They wonder what, for example, having a short sale on their home will do to their credit score or closing the credit card accounts that they’re not using, among many other things. The problem is, that there are no hard, set rules that govern credit reports, credit reporting agencies and also the banks and other financial institutions that report to them.
With that in mind we put together a blog about different questions concerning credit reports and how the actions that you take financially affect it. We’re going to take actual questions that we’ve seen around the net and been asked by our readers and try to give our best real-world answer to all of them. Enjoy.
Many people talk about paying off a credit card and then closing the account completely. The problem with this is that closing your account will lower the amount of credit overall that you have. This will negatively affect your credit utilization ratio and will most likely lower your credit score at the same time. It would be better to pay off those cards and then, rather than closing the account, keep it open but use the card very sparingly. (The next paragraph talks about this also.)
Some people say that, once you have paid your credit card off, you should keep it but never use it. The problem here is that your credit card company can actually cancel your card in some instances if you haven’t used it in a specific period of time. Better to give yourself a reminder to use your credit cards for a couple of small, inconsequential purchases every 4 months and of course make sure that you pay them off immediately when you get them. In this way your account will stay active but, more importantly, your credit utilization ratio won’t be negatively affected.
Let’s look at an example. Let’s say that you have 4 credit cards and each of them have a $10,000 limit. That would mean that you have $40,000 worth of credit. If you had an outstanding $5000 worth of debt your credit utilization ratio would be 8%. (Which is pretty good.) If you were to close 3 of those accounts completely the amount of credit that you would have would drop down to $10,000. Doing this would mean that your credit utilization ratio would suddenly skyrocket to 50% and the effects on your credit report would be ugly, to say the least. The amount of debt that you have hasn’t changed of course but the amount of credit that you have access to has, something that credit agencies will look at acutely if and when you go to apply for credit in the future. That’s why keeping the accounts open but not using them is a better idea.
Many people are under the false assumption that, since they never agreed to make payments to a collection agency, they are not legally obligated to pay them. This is not only wrong but it is a bit dangerous. Collection agencies are legally allowed by the companies that hire them to go after consumers and do whatever they can to get back any debt that is owed. If the amount that they are trying to collect is valid they can, and often do, sue consumers to get it back. If this happens and a judge orders you to pay the collection agency you will have what they call a ‘judgment’ and it will appear on your credit report and cause even more damage than you already have.
When it comes to debt and paying off your debts many people use the advice of family and friends rather than professional financial advisors. This can be a very big mistake because, frankly, Aunt Bessie may not be the best person to ask for financial advice. Simply put, unless the person that you’re taking advice from is a professional financial advisor or has many years in the financial industry (or is very successful, debt-free and financially skilled) you should take their advice with a grain of salt. There’s no excuse not to do your own research today as well because the Internet makes it so easy. Remember that the credit score that will be affected is yours and yours alone.
Many people wonder why, when they finally finish paying off a specific collection agency, that there credit score doesn’t improve. The fact is, if you had a debt that went to collections it is at this point that you are credit score was affected. Paying off the debt won’t affect it negatively or positively. Of course, paying off any debt will keep your credit report from suffering any more damage by the possibility of getting sued and having a judgment filed against you.
The simple fact is that the best way to avoid debt problems is to not get yourself into them to begin with. For many this is akin to closing the barn doors after the horses have already gotten out, we realize. If you are just starting out financially the best advice that we can give you is to always be cautious and remember that, no matter how much money you make, it’s actually quite easy to get into debt over your head. So spend wisely, start saving for retirement as soon as possible and keep an eye on your credit reports regularly and you should do just fine. And come visit us regularly for more financial advice. (We’re experts, no worries.)