The average middle-class American household carries between $6000 and $11000 in credit card debt, depending upon who you choose to believe.
Each household also had an average of 5.4 credit cards. In 2006, 173 million Americans were credit cardholders and that number is expected to increase to 181 million by 2010.
As you know, your FICO (Fair Isaac & Company) score is a used as a prime indicator of your credit worthiness and plays a crucial role in your ability to obtain credit. This includes anything from credit cards to auto loans and home mortgages. As potential lenders view it, the higher your FICO score the better risk you are when it coming to extending credit. A higher score indicates a higher likelihood of repayment while a lower score indicates a lower likelihood. With so many Americans holding so many cards and carrying such large balances, it is important to understand exactly how credit card usage, or misuse as the case may be, may affect your FICO score. Here are a few things you should know.
Make Your Payments on Time
This may seem like stating the obvious but the importance of making your payments on time cannot be overstated. Your payment history is the single largest factor used (about 35%) to determine your credit score. Payments made 30 days or more late can be and usually are reported to the 3 major credit reporting agencies (Equifax, Experian and Transunion) and have a negative effect on your FICO score.
As of April 2009, 15% of Americans or about 34 million people had made late payments in the previous 12 month period. A full 8% or 15 million people had missed a payment entirely. With the economy in its current state and unemployment on the rise it is not likely these statistics will improve anytime soon. So if you find yourself in this situation, you can take a little comfort in knowing you are not alone.
So, always do your best to make your payment on time. You should leave yourself a pad of several business days to insure your payment has time to clear before the due date. Many lenders have a zero tolerance policy and being late by even one day can result in substantial interest rate increases and late fees.
Always try to make more than the minimum payment. By paying the minimum only, you are greatly extending your repayment period and the amount that you will be paying in finance charges. Current credit standards require minimum payments equal to 1% of the outstanding balance plus interest charges. Assuming a 20% interest rate that means the debt will double in 5 years. Making the minimum payment only will require over 8 years to pay off and you will have paid 160% of the original amount in interest!
Also, making minimum payments raises a red flag with the credit card company. It signals that you may be in credit trouble which puts you at greater risk of being unable to repay your debt. As a result, the credit card companies may raise your interest rates.
If you are having trouble making your payments, contact the credit card company immediately. It may be a little humbling but you will usually find they are willing to work with you in developing a repayment plan you can afford. It is usually in their best interest to keep you as a customer whenever they can. Ignoring them will only cause matters to worsen. When my wife was laid off, I contacted VISA and they cut my monthly payment in half and lowered my interest rate from 18.9% to 7.9%.
Carefully Manage Your Balances
The second most important factor in determining your FICO score is the total amount of outstanding debt you have. Even If you make more than minimum payments in a timely manner, carrying large amounts of credit card debt makes you less likely to repay and can result in a ding to your FICO score. Make a point of not acquiring any new debt and paying down what you do owe.
Also, make sure you do not owe more than 50% of your credit limit to any one card and not more than 33% of your limit on all cards combined. Historically, this has accounted for around 30% of your FICO score but it has been receiving increased emphasis since 2009. It may even replace your payment history as the largest single factor.
To Close Accounts or Not
This gets back to the last point in the previous section. If you have paid off a credit card, do you close the account or not? The answer will vary from person to person. If you have the requisite self-control to not charge that card up again, I would say keep the account open. If not, then it would be wise to close it.
Here is the reasoning. Assume that you have 5 cards with $2000 limits for $10000 total available credit. Say all 5 cards have balances of $1500. Your outstanding balance on all cards is $7500 and your credit utilization is 75% ($7500/$10000 x 100 = 75%). No too good, right?
Now you come into some money and and wisely choose to pay off 1 of the cards. Now your outstanding balance on all cards is $6000 and your credit utilization is 60% ($6000/$10000 x 100 = 60%). Better, huh? Choose to leave this account open and you should see a nice little bump in your FICO score.
But if you choose to close that account, your total available credit is now $8000. You still owe $6000 on the other 4 cards but now your credit utilization is still 75% ($6000/$8000 x 100 = 75%). So you have less credit available ($8000) and that is 75% utilized. Choose this option and you may well see a negative effect on your FICO score even though you paid a card off!
Length of Your Credit History
Another 15% or so of your credit score is determined by the length of your credit history. People with high credit scores tend to have 3 or more credit cards with low balances that have been maintained over a period of 7 years or more. Constantly doing balances from one card to another is a red flag to credit card companies. If you leave accounts open with a little activity that is paid off each month, you demonstrate to credit card companies that you know how to properly use credit.
If you are looking to acquire an additional credit card, be selective and don’t apply all over the place. Many applications result in multiple inquiries on your credit record. Each one of the inquiries can potentially ding your FICO score a few points. Credit inquiries and new debt comprise about 10% of your FICO score.
This is less of a concern if you are shopping for a mortgage or auto loan. All mortgage inquiries occurring within 30 days of each other are grouped together as if they were one inquiry. For auto loans, the same occurs but the limit is 14 days.
Credit Card Tips
- New credit card rules recently took effect this year. You should become familiar with these changes and your new rights and privileges to maximize your FICO score.
- Having too many credit card accounts, even with zero balances, can also lower your FICO score.
- Credit card debt is revolving debt as opposed to a car loan which is installment debt. Revolving debt is looked upon less favorably than installment debt.
- Your credit rating affects more than just your ability to get a loan. Potential employers, landlords, cell phone companies and more may check your credit record as a judge of your financial stability and even character.
- You should check your credit report frequently. You can obtain your credit report free from the 3 major credit reporting agencies once per year. If you see errors or signs of identity theft, contest them and have them corrected quickly.
- Open you credit card statements immediately and check them for unauthorized use or billing errors. Report any questionable charges in writing to your credit card company to preserve your rights.
- Report any lost or stolen credit cards to the issuer immediately! Do not wait! Most companies have 24 hour phone service for reporting stolen cards. You can find the number on your statement or the company website. If you report the loss before the card is used, you are not liable for any charges. If it is used before you report it, your liability is limited to the first $50 per card.