It's easy to become confused about credit scores. Myths abound about to improve a credit score, what goes into a credit score and which credit scores warrant attention.
To put certain misconceptions to rest, we caught up with Fair Isaac's public affairs manager, Craig Watts, whose company invented the FICO score -- the score that most lenders use to assess their applicants' credit risk.
Inside story on credit scores
Credit counseling & income
Other credit scores
Is it a good idea for a consumer to close unused credit cards?
There are several myths about credit scores and how to improve a credit score. You've certainly tagged one of them.
The FICO score looks at credit card closures a little bit differently than lenders might. For example, some lenders believe that the amount of credit available to an individual is by itself predictive of future risk. So, if a consumer applying for a mortgage has $100,000 of available credit through credit cards and other outstanding loans, the lender might view that as a risky proposition, simply because there's a lot of credit available to that person and theoretically, the person could some day use all that available credit all at once and then find that the consumer is unable to pay it all back.
The FICO score doesn't view credit in the same way. An individual's income, assets and money in the bank is invisible to the FICO score. It considers available credit only in the context of how much of that credit the consumer currently has in play, how much are they currently using. When we calculate the FICO score, we're looking at the person's "credit utilization rate," which is their total outstanding debt on revolving debt like credit cards, divided by their total credit limits.
So, when a consumer closes an unused credit card, they change their credit utilization rate. One of the consequences is there is less available credit on the person's credit report.
Unfortunately, what we see more typically are consumers who have not paid down any of the outstanding debt, which results in a higher credit utilization rate. That will lower a person's FICO score.
But, closing credit cards is never going to help your FICO score. And in some cases, can in fact hurt your FICO score. If you want to close credit cards for other reasons, that's perfectly acceptable and you should do whatever you need to do in order to manage your credit well, but just don't expect the closing of credit card accounts to improve your credit score.
What are some other credit scoring myths?
Credit counseling automatically hurts credit score. Until the late '90s, that was in fact true for FICO scores. When a lender would report an account to the credit bureaus as being associated with credit counseling, the FICO score would detract a few points from the person's score because we found that association with credit counseling was predictive of future risk. We changed the model in the late '90s to remove that factor from the calculation of the score because we found more consumers were seeking credit counseling and that, as an isolated factor, was having less value in predicting future risk. The end result is a win for consumers.
scores take a person's income or assets into account.
This is a widely-held misunderstanding for a couple of reasons. When consumers apply for credit, typically a lender is going to try to ascertain how much money they make. They're trying to get a handle on capacity to repay before they make that yes-or-no decision on the credit application. The FICO score can't look at that information because it has no access to that kind of asset information or income information. It is not reported to the credit bureaus, or if it is reported, it's not consistent, and oftentimes it's not accurate. Some lenders will pass stated-income information on to the credit bureaus but that comes from credit applications, which isn't always reliable. Unfortunately, consumers don't always tell the truth when they're applying for credit. So, the FICO score ignores income and assets.
Some consumers might be surprised to learn they have more than one credit score. What's the story here?
That's another great myth, that people only have one score, and so they all come out of the same barrel. There are literally dozens of risk scores used by businesses. In some ways, it's almost a misnomer.
The FICO score is unique in that it's the only risk score widely used by businesses that is also shared with consumers. It has many imitators. There are other credit scores sold to consumers that imitate the FICO score but in fact, not only are they not FICO scores, they have no connection with the FICO score. And, they aren't widely used by lenders -- in fact, most of them aren't used by lenders at all.
In the realm of credit risk scores, the FICO score is the real deal. So if a consumer is interested in knowing what cards the lender is holding when applying for credit, they need to know their FICO scores. Other scores may be useful as guides or to help educate people about how these credit scores work in general, but they're not necessarily indicative of the person's scores that lenders see.