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Why canceling old credit cards can lower your credit score

by CreditScore.net Staff Writer on April 18, 2012

Yesterday, Hidden Credit Repair Secrets posted the above credit score advice on our Facebook page. He suggested that closing old credit accounts could negatively affect your credit score so you shouldn’t do it. While there’s nothing necessarily incorrect about this advice, like most things, it’s not quite that simple. And sometimes it’s advice like this leads to a misunderstandings about credit scores and results in irresponsible practices for what amounts to minimal gain.

Understanding what credit scores are looking for and how they are calculated (like length of debt history) can help you understand why and how much closing an older account can hurt you. It will also empower you to make more well informed decisions about your credit and can even help minimize any negative effects of otherwise harmless credit account decisions.

FICO score calculation:

35% Debt History
30% Debt level*
15% Length of Debt History*
10% New Debt
10% Type of Debt

*Can be effected when you cancel a credit account.

Credit limit vs. utilization

Let’s take on the second part of the advice first, because it’s a bit simpler to understand and can have a more direct impact on your credit score:

“If you close a 10 year credit card account with a nice limit…your overall available credit will decrease, which will also drop your score.”

It’s not the available credit that’s important, it’s the ratio of outstanding debt in relation to your overall available credit that credit scores use. It’s recommended to keep your credit utilization under 30% of your available credit with an optimal rate under 10%. The lower the better.

In other words, a person who keeps no outstanding balance on their credit cards has nothing to worry about. For others, suddenly losing a chunk of available credit can increase the ratio and hurt your score. Here’s an example:

Dave has 2 active credit card accounts, each with a limit of $10,000 ($20,000 total); one card has no balance, the other has a balance of $5,000. That means the current utilization is 25%, which is not bad. But if suddenly Dave cancels the first card, his utilization jumps to 50%, which is bad. But even if Dave pays off the debt, he now has less leeway for utilizing credit without hurting his score (about $3000).

If consolidating cards is the intention, getting the one account to increase your available credit for closing out the other is ideal (banks will do this). Adding another new card to regain more available credit would only lower your ‘new debt’ part of the score as well. If you do decide to close out a credit account and don’t get the adjusted credit offer, keep a lower balance of debt or your credit score may suffer.

Still the effect is minimal for those with good to excellent credit. This is much more of a concern for those who are trying to repair a poor credit history.

Length of debt history

Now for the first part of the advice, which is usually why it’s suggested to keep older credit accounts active: length of your debt history (15% of your FICO score).

“If you close a 10 year credit card account with a nice limit…your overall length of credit will decrease, which will drop your credit score…”

When you close a credit account, it stays on your credit reports. For some agencies, it stays longer than others. According to Experian:

A closed account with no negative information in its history will be deleted 10 years from the date it is closed. A closed account with late payments in its history will be deleted seven years from the original delinquency date of the account.

In other words, even if you closed your oldest account, you still have 10 years before it’s removed from your credit report. 10 years is a long time to continue to build credit. In fact, because you can have a nearly perfect credit score with 10 years of credit history, getting rid of an old account probably won’t hurt you much if you continue to build a positive credit history in that time.

Credit scores are more interested in your most recent activity. Activity older than 10 years isn’t of much use to creditors, so even with the length of debt history part of the score, such accounts will offer minimal gain (if any at all). And if there are blemishes on the account, it’s usually better to get it off your credit reports.

It’s not just your longest running account that’s taken into account, however. Average age, and how recent the activity is also part of the calculation. In other words, even if you hold on to an old credit card, if it’s never used, it isn’t helping much. Also, the more old accounts you have on your report, the more stable your average age will be if you remove one.

Other things to consider:

Why are you canceling the account?
It’s probably not worth a second thought about the minimal potential damages to your credit score 10 years down the road if, for example, your credit card suddenly charges you a monthly fee or you’re otherwise looking for a better offer. And even if you’re just trying to simplify your life by consolidating credit cards to a single account, you might never feel any negative effects, so it may not be worth keeping account(s) open just for the sake of keeping an account open.

“Paid, Closed/Never Late” account status helps your credit standing
Having paid/closed accounts isn’t just good, it’s something that’s actually expected to show up for anyone who is responsible with debt and has been utilizing credit for some time. Sure, you need to have open accounts currently in use as well, but closing accounts doesn’t actually “hurt” your credit history for 10 years. Until then, it actually helps.

Old accounts can sometimes be a liability
Having multiple credit cards can be a pain to manage. Even if you don’t use the account, you need to be sure the terms don’t change or strange charges appear on your card. If you don’t manage these things and they happen, it can be a much larger problem for your credit rating than closing the account could ever be.

What’s your credit history like?
If you have little history or have a shaky credit past with a number of blemishes, it may (in fact) be wise to keep older accounts. Losing what little positive history you have can then be the difference between getting a loan and not. If you have a robust, diverse credit history with few negative marks, you have little to worry about and any negative effects on your credit score will likely be negligible.

Categories: Advice, Credit Cards, Credit Report, Credit Score

Paying down debt: Interest vs. Principal

by CreditScore.net Staff Writer on April 12, 2012

It certainly feels like this sometimes...

Last weekend, when visiting family for Easter, I overheard my younger cousin Kyle talking about a problem with his student loans. He complained that he’d been paying $200 per month for about 5 years and has only paid off $2000 from the original loan amount. “That can’t be right!”, he insisted. Unfortunately, it was.

What Kyle didn’t realize, is that most of his monthly payments have been going towards interest. In order to keep his monthly payment lower, he chose a payback schedules based on a 30-year loan. As a result, only a small fraction of each payment has gone towards paying down the principal. This is typical with longer payment plans. And after going over some numbers with my cousin, he now understands that by paying only a little more each month, he can pay off his debt quicker and cheaper.

Understanding the difference between Interest and Principal

It’s an important lesson for Kyle and anyone who ever considers taking out a loan. To fully understand what’s going on when you pay back a loan, it’s best to first understand the difference between interest, and principal:

Interest – is a fee you pay to a financial institution for borrowing money. Based on (usually) annual percentage rates (APR) of the principal balance.

Principal balance – is the remaining amount owed on a loan, not including interest.

Interest payment – is the amount of interest to be paid with each payment.

Principal payment – is the amount of each payment that goes towards paying down the principal balance of a loan.

Put more simply, your principal balance is how much money is still owed from the original loan, and interest is calculated as a percentage of that balance. Most payments plans have a component of both interest and principal with each installment. The interest portion decreases over time as the principal balance is paid down.

Calculating your interest payments

Knowing how much of your payments are going towards interest is the best way to illustrate what is going on when paying down debt. All you need is your principal balance and current interest rate on the loan. Let’s calculate the monthly interest payments for a $20,000 loan at 5% APR:

[Principal Balance * (annual interest rate/100)] / 12 months = Monthly interest payments

[$20,000 * (.05)] / 12 = $83.33

Using the above example, the monthly interest payment would be $83.33. So if the borrower was paying the loan back at $100 per month, less than $17 (per payment) would go towards paying down the principal balance. At first…

Paying down the principal balance

With each payment, even if you’re paying mostly interest for the beginning portion of a loan schedule, the principal balance starts to shrink. Faster and faster, too, as the more it shrinks, the less is owed each month in interest. This also means the more you pay each month, the faster your principal shrinks, the less you will pay overall in interest, and the faster you pay off your loan. It’s essentially reverse compounding interest.

Let’s start by continuing the example above with $100/month payments:

Payment: $100/month
Interest payment : $83.33/month
Principal payment: $16.67/mo. * 12 months = $200

After a year, about $19,800 of the principal is still left. So when you recalculate interest payments, they only shrink by about $.80:

[$19,800 * (.05)] / 12 = $82.50

Pay-off time: 36 years
Total interest paid: $23,091.39

However, if the person instead payed $150/month payments: after a year, about $800 of the principal balance will be paid off:

Payment: $150/month
Interest : $83.33/month
Principal: $66.67/mo. * 12 months = $800

And not only will this person be paying down the principal quicker in the first place, but interest payments shrink quicker as well:

[$19,200 * (.05)] / 12 = $80.00

Pay-off time: 16 years
Total interest paid: $9254.26

Over time, the savings compounds itself as more of each payment goes towards paying off the principal balance… quicker. Also, these examples only calculate interest once a year. If interest is calculated more often, this effect is magnified.

This is why the borrower paying $100/month will take about 36 years to pay off the loan and pay an additional $23,091.39 in interest by the end. And the borrower who pays $150/month: 16 years and $9254.26 in interest.

Lump payments

It’s usually a wise investment to make lump payments to pay down your principal balance when you can. Because suddenly the principal balance is reduced, interest payments drop and even lower monthly payments can contribute a larger ratio of principal to interest.

Let’s say our example borrower, who can only afford $100/month loan payments is given $5,000 at graduation. What would their payment schedule look like if that money was used to pay down their $20,000 debt?

1^st year interest payments: [$15,000 * (.05)] / 12 = $62.50
Pay off time goes from 36 to 20 years
Total interest savings of $14,502.83

If you do this, just make sure your extra payment goes towards the principal balance or your lender may assume otherwise.

My advice for my cousin Kyle: find a way to pay more each month. Every additional dollar he can spare each month beyond the minimum payment plan (that he currently pays) will go towards paying down the principal balance of his loan. It will mean he’ll pay it off faster, and save money on interest in the long-run.

Some of the estimates on this page were made courtesy of: Asksasha.com’s loan calculator

Image credit: Flickr

Categories: Advice, Debt, Student Loans

Why is gas so expensive? Because you drive too much.

by CreditScore.net Staff Writer on April 3, 2012

Why is gas so expensive? Everyone wants someone to blame: Obama, the greedy oil companies, increased demand from India and China… Does it really matter? Gas is getting expensive and it’s likely to be more expensive tomorrow. There’s little that can be done about it. That’s really all you need to know. And if you want to escape the clutches of rising gas prices, the best way for you to do that is to learn how to use less.

cost of gas
Photo Credit – http://www.flickr.com/photos/ejcallow/3823944464/

Take the bus

Any mass transit will do. Even a park-and-ride closer to home will save you a bundle on gas. This doesn’t just go for your daily work/school commute, either. Gas prices have gotten to the point where taking the bus, train, or even flying can be much more cost effective than driving longer distances, especially if you’re traveling by yourself. Leave your car at home as much as you can. That’s the idea. There’s a nice

Carpool

Don’t be ashamed to ask a co-worker and/or friend to share a ride. In fact, it’s nice to have company especially during those longer commutes. For every person you add, you each practically cut your commute costs in half. Just make sure you’re schedules are consistent…

Work from home

Not everyone can do this, but even one day a week will pay you back over time. Another option for some might even be the 4-day work week. (4 10-hour shifts) Don’t be afraid to ask your boss if it’s possible. What’s the worst thing that can happen? Either they say no or you cut your commute costs up to 25% and even potentially have a 3-day weekend.

Move closer to work

Location, location, location. If you’re looking for a place or simply find yourself with an unnecessarily long commute, it’s a good time to think about living closer to work. If you drive to work 10 miles, both ways, 5 days a week, you’ll commute over 5200 miles per year. That’s the equivalent of driving from NYC to LA and back and still have enough left to drive down to Washington D.C. If you moved just 2 miles closer to work, you’d shave off over 1000 miles and save about $200 per year on gas.

Ride a bike

What can be better than saving money while getting a little exercise? Sure, you have to live relatively close to your work, with bike-friendly roads, contingent on weather and it certainly isn’t for everybody. But having done this when I have the chance during the warmer months, it’s actually something I started looking forward to around this time of year. I highly recommend it. Just be safe!

Shop locally

Support local shops and stores, also support locally grown/made foods and products. Not only is your drive usually shorter, but locally grown and made foods (and other products) tend to have more stable prices because transportation costs are minimal.

Improve Gas mileage

Finally, if you simply must drive, it doesn’t mean you can improve on traveling and commuting costs. You simply need to think of ways to improve and optimize your gas mileage. There are a ton of great ways to improve gas mileage. Here are just a few of my favorites:

Get a more fuel efficient car…duh!
Keep your tires properly inflated
Proper maintenance
Avoid traffic/rush hour

Gas rewards programs

I love these. My local grocery store and a close gas station paired up to offer this and it’s a win-win. I saved $.40/gallon the last time I filled my tank, just for buying groceries I would normally buy anyways. In fact, the more I cook at home, the more I save on both food AND gas!

What other Gas saving tips do you have?

Categories: Advice

7 Dangerous habits of credit card users

by CreditScore.net Staff Writer on March 30, 2012

Credit cards, when used wisely, can be a beneficial way to pay for purchases and even a helpful way to manage your finances. But when they’re abused, they can become money pits. A hole of crippling debt of which escape becomes increasingly difficult the deeper you find yourself. But among some of the ways to properly use a credit card, there are a number of things that should be avoided. These are the 6 most dangerous habits of credit card users:

Paying the minimum balance

What makes this habit so dangerous (other than high interest charges) is how unfortunately common the practice is. Making purchases on your credit card you can’t afford (even in an emergency) leaves you with a balance you can’t pay off in one shot. So when the monthly bill comes, that “minimum payment” starts looking really tempting just so you can keep some cash on hand. But unfortunately, with interest rates sometimes as high as 40% or more, it becomes a trap.

What you should do instead: if you can’t pay off the balance in full each month (which is optimal), pay off as much as you can afford to. Don’t leave a balance on your credit card for too long or you’ll end up paying more in interest than the original purchase before long.

Late/Missing payments

Perhaps the only thing worse than paying the minimum balance is missing a payment or making the payment late. Charges of up to $50 for late payments aren’t unusual. Add that to the high interest rates of credit cards and you’re looking at an expensive mishap.

What you should do instead: Don’t be late. Pay the minimum balance if that’s truly all you can afford in order to be on time, but avoid paying late fees at all cost.

Balance transfers to pay your bill

Credit card companies try to steal your business from other banks by offering low or zero interest on balance transfers. Many times, it’s only a temporary “introductory rate” which increases after the grace period. Some novice credit card users think they can use these offers to “beat the system” and not pay interest through a chain of balance transfers. Not only will this fail to work out the way you think it does, but it can also do irreparable damage to your credit score.

What you should do instead: If you have a balance on your card and are looking for a way to reduce your interest rates temporarily, low rate balance transfer offers can be helpful, but do it sparingly. And also make sure the post-introductory rates are better (or similar) to your old card or you lose in the long-run.

Cash advances

Drawing cash from an ATM machine or during a credit card purchase from your credit account is another common credit card pitfall. Not only are there usually charges from ATM machines as well as your credit card company (commonly known as double-dipping), but the interest rates for cash advances are generally higher as well.

What you should do instead: Get cash elsewhere. Cash advances from credit card accounts should be an last resort for getting cash…next to a payday loan.

Maxing out your card(s)

Believe it or not, maintaining a balance of more than 10% of your available credit on your credit cards can lower your credit score. So maxing out your credit card (or cards, in some cases) can be incredibly damaging to your credit history. Use credit cards sparingly and if you can’t seem to stop your balance from increasing month to month, it’s time to stop using credit cards altogether.

What you should do instead: Try to keep a balance of no more than 10% of your available credit at any given time. If you can’t, perhaps you should cancel your cards until you have the financial responsibility to do so.

Keeping multiple credit card accounts

I know too many people who do this. They have one credit card for “regular purchases” and one for “emergency use only”. I don’t really understand the difference. It’s also common for shoppers to have store branded cards that they only use for stores. Avoid doing either of these if you can. Part of your credit score is calculated on how many active credit accounts you have. So even if you have open accounts for which you never have a balance it could hurt your credit standing. Worse yet, even though you don’t use a card, the terms can change, sometimes charging fees for non-use. Then, when you don’t pay that balance, you get hit with late fees, interest, and a stain on your credit report.

What you should do instead: Consolidate your credit cards to a single account. Keep the card that suits you best: lowest interest rate, highest available balance, best rewards, etc. If you must insist on having multiple cards, manage them diligently even if they aren’t being used regularly.

Poor budgeting

Using a credit card wisely means knowing what you can and can’t afford. So perhaps the biggest pitfall for credit card users is those who aren’t managing their purchases closely enough. Spending more money than they have. This is the easiest way to end up in a crippling debt situation where you start to consider some of the above poor habits like maxing out a card, paying minimum payments, or balance transfers.

What you should do instead: Watch your purchases closely. Understand the costs of interest and fees associated with maintaining a balance and avoid it all you can. Don’t use your credit card to purchase items you can’t afford and you’ll be just fine.

Categories: Advice, Credit Cards

15 Blog Posts with Tips to Avoid Wasting Money

by CreditScore.net Staff Writer on March 28, 2012

Money is tough to hold on to for many people, especially when you have extra cash and see something that you want but really do not need. Money tends to burn a hole in your pocket if you keep cash on you all of the time. One of the best ways to cut down on unnecessary spending is to put your extra money away in a savings account so you don’t spend it. This will leave you with less money in your pocket on a daily basis and can help a bit to end splurge spending. It is easier said than done, especially with so many cool gadgets and toys available all over the place. These 15 blog posts offer some great advice on saving your money rather than wasting it.

20 tips to keep from spending money – It’s hard to say no to yourself when the urge to spend strikes, especially when you have money in your pocket. Here are 20 tips to help stop spending.
Stop Spending Tips & tools to help you fight yourself – here are more great tips from different people including some money saving experts, there is a lot on this page to read and following through with the advice can make a huge difference in your spending habits.
Top Ten Money Saving Tips From Stop Wasting Money – Here are some more excellent tips to help you stop wasting money, these are all great ways to achieve the goal you are working towards and can help you also get some extra money put away towards savings.
Money tips and financial advice to help you stop wasting money – Money is tight for many people these days due to the struggling economy, here are tips to help you save and recession proof your money.
9 Big Time Money Wasters and How to Avoid Them – This post discusses 9 things that can waste a lot of money and gives advice on how to avoid these things so you can save more money.
Stop Wasting Your Money on These 25 Things – There are many ways that people overspend on a regular basis. They include costs that could easily be avoided, or reduced, by customers willing to do some market research, shop around, or plan ahead.
Ten Ways To Avoid Financially Irresponsible Buying – In this modern era, we are surrounded by almost infinite opportunities to spend money – and an almost infinite number of enticements to take up those opportunities. Advertisements trick us into thinking our lives will be better if we just buy this one item.
The Upside of Being Cheap – Some great ways to save money while also helping out with other things such as energy consumption and more.
Stop Wasting Money: Seven Ways to Cut the Fat from Your Budget – Even more wonderful tips that can help you cut back on spending money on things you do not need.
Time is Money – So Stop Wasting It with These Helpful Tips! – Do you sometimes wonder where all the time went? Or wonder where the money in your bank account went at the end of the month? It may not seem obvious, but time and money go hand in hand, and not just for fancy jobs that make a lot of money. Time is money for all of us.
Find Out Where Your Money Goes to Avoid Wasting More Of It – Most of us are not aware that the little amounts of cash we spend each day are actually huge when we total it each week or month. This makes us wonder where all our money goes, once we find that we’ve run out of cash even before the next payday arrives.
Stop Wasting Money Today – “Most people aren’t aware when they’re wasting money,” says Jeanna Bridges, Market President with BMO Harris Bank. “So the first step is becoming conscious of how much you’re spending and what you’re spending it on.”
25 Ways You Are Wasting Your Money – Getting out of debt is NOT hard. True, it does take time, patience, and discipline, but it’s not really that hard. Usually, all that is required is just changing your spending habits.
Stop Wasting Money – Another post with tips and tricks to help you stop wasting your hard earned money.
Stop Wasting Money Page on FB – This is a great Facebook page that is always updated with advice and tips on saving your money instead of wasting it, well worth a like if you are on FB.