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Financial Literacy - Credit scores
SPOTLIGHT
Craig Watts
This FICO expert offers tips for improving credit scores and clears up some common misconceptions.
Credit scoring, demystified

Interview: Craig Watts

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
Money moves that affect scores
Credit wreckers
Pay balance or not?
Balance transfers
What are some common ways that people hurt their credit scores?

The most obvious way is not paying bills on time. How you've paid your bills in the past is the biggest factor considered by FICO scores. Over half of consumers show no delinquencies at all on their credit reports. So for the majority of people, that's not really an issue.

The big surprise we hear most from consumers is when they think they should have a perfect score because they've never been late in repaying a creditor. But, in fact their score is not good at all because they have high balances on accounts as reported in the credit report.

When we recommend pay your bills on time, we mean pay all your bills on time.

Running up high balances or high debt-to-credit limit ratios is the second most important factor for FICO scores. Using most of your credit card limit on a consistent basis is likely going to hurt your score. We advise consumers to keep their credit card balances low as reported on their credit bureau reports the lower the better as far as their FICO score is concerned. We don't recommend a target percentage. Note that the balance that appears on your credit report is most likely the same balance that you were last billed by your credit card company. So keeping a low balance doesn't mean pay off each bill to zero, it means use that card sparingly so that your monthly bill is low.

Ignoring some bills. Another "aha" that people are realizing these days is you can't afford to ignore any business relationship you have. When we recommend pay your bills on time, we mean pay all your bills on time. Not just your bank bills or credit card bills, but the utility bills, cell phone bills. If you get a parking ticket, pay the ticket. If you get a library fine, pay the fine -- don't let these things wait. Larger metropolitan areas have begun reporting people who don't pay their parking tickets for a long time or those that don't pay library fines for a long time. Some cities have started reporting these outstanding accounts to collection agencies in an attempt to recapture some of that lost money.

Most collection agencies report their accounts to the credit bureaus whereas cities almost never have. In the past your credit rating was never affected by nonpayment of a library fine. Now you may find that it appears as a collection item on your credit report, which can hammer your credit score.

Does it matter whether you just pay the minimum monthly payment, some of the balance or if you pay off your balance every month?

The only thing the FICO score knows is the balance the lender reported to the credit bureaus most recently. If your balance is low but you're only paying the minimum anyway, then likely the reported balance to the bureaus is going to be low and your score is going to be fine.

If your balance is very high relative to your credit limit, and you're only paying the minimum, then you're going to maintain that high balance month over month. The high balance is what the lender is going to report, and that's what the FICO score is going to reflect. It will have a more negative effect on your score.

We certainly encourage people to pay down their credit card bills to zero every month, to the extent that they can. I think most personal finance experts would agree that's a good habit to get into. Spend within your means is really what that translates to. It doesn't directly affect the FICO score but that kind of a good credit habit will contribute to other good behavior that will in fact, improve your score.

When a consumer receives an attractive "preapproved" credit card offer, she might be tempted to transfer the balance from a card with less favorable terms and then cancel it. What can this do to a credit score?

That revolving of debt to a new card can lower a person's score. It depends on what else is on their credit report at the time, but it's unlikely to help a person's score. This is one of those cases where the FICO score has limited information to draw upon. It doesn't know why the person is closing one credit card account and opening another one at virtually the same time. The FICO score has no knowledge about interest rates, because that's not reported to the bureaus. What could be wonderfully smart behavior by the consumer to save on interest payments is invisible to the FICO score.

All it knows is one account closed, one account opened, balance remained the same overall because the balance on the old account got transferred to the new account. The closure of a credit card may have an impact on the person's score; it may lower the score some. The opening of a new account, just by itself, typically will lower the score a few points because every time you open a new account, you inherently add a little more risk to your overall profile as far as future lenders are concerned.

There's another myth involved in that. Consumers think that their credit score will improve because they are using more credit and that the whole idea is to use more credit. What they don't realize is that the purpose of the credit score is not to assess their revenue potential for creditors, but is to assess how likely they are to become seriously late in repaying any one of their creditors over the next two years. So, the more conservative the behavior by the consumer in managing their credit, the better their credit score typically will be.

If someone really wants to dump a bad card, is there a minimum amount of time a person should keep the account open?

Not really. If you have a credit card in your wallet that charges a membership fee every year, and you're tired of paying it and want to dump that card and go for one with no annual fees, you should do that. There may be consequences, short term, for your credit score in doing that, but you should handle your credit the way that you feel best about your money management. The time to close a card is not right before you apply for a big loan. That's the only caveat I'd apply.

-- Posted: June 18, 2007
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