2 Truths, 1 Lie – Credit Scores

There are a lot of myths and misconceptions about credit scores. Formulas created by information companies turn our lives into a three-digit number and understanding how credit scores work can be difficult. Using the format of the icebreaker game, “2 Truths and a Lie,” here is a quick lesson about credit utilization.
Below are three statements, and your goal is to figure out which one is the lie. Good luck!

A. Having credit cards and never using them hurts your credit score.
B. Quickly opening a new accounts raises your available credit and improves your credit score.
C. Closing a credit card account hurts your credit score.

Brief Overview of Credit Scores and Utilization

The most well-known credit score is created by the company, FICO. Although there are other credit scores, FICO is at the top of everyone’s mind. The five broad categories that FICO uses to calculate your credit score are payment history, the amount owed, new credit, credit mix, and length of credit history. However, there is a lesser-known term to consider called credit utilization.

Credit utilization is the ratio of how much credit card debt you have compared to your credit limits. For example, Jackie has five credit cards with a limit of $2,000 on each card. She owes a little bit on each card for a total debt of $1,000. Since Jackie owes $1,000 with a total credit limit of $10,000, her credit utilization is 10%.

A. Having credit cards and never using them hurts your credit score.

This statement is surprisingly true. Maxing out your credit cards forces your credit utilization closer to 100%. This is bad because if you lose your job or run into trouble, it’s harder for you to handle extra expenses. Since it is also harder to pay off your debts, a high credit utilization hurts your credit score.

Having a credit utilization of 0% can also hurt your credit score. A credit utilization of 0% means you have the ability to borrow money but never do. CreditKarma and FICO both suggest to have a credit utilization above 0%, and you can do this without carrying a balance and paying interest. Using a credit card and paying it off each month will push your credit utilization above 0%. The charges on your credit card are debt even if they are quickly paid off.

FICO doesn’t give away their entire formula, so it’s difficult to say exactly why those that have credit and never use it have lower scores. I compare a credit utilization of 0% to buying a car with a manual transmission and never learning to drive it. It’s nice to have the car in case you need it, but knowing how to drive a stick shift is another story.

Another explanation comes from Barry Paperno from CreditCards.com, “Going back to the idea that the percentage ranges are based on research into the behavior of millions of consumers, it turns out that the risk of default has actually been found to be a little higher at 0 percent utilization than at slightly higher-than-0 percentages.” As they say, it is what it is.

B. Quickly opening new accounts raises your available credit and improves your credit score.

This statement is the lie because you should consider your credit utilization, your length of credit history, and new credit information.

In the short term, it looks bad when someone opens several new credit cards at one time. History has shown that such a person is either irresponsible or is expecting a major emergency. For example, if you are about to lose your job, opening a handful of credit cards is a lot faster than building an emergency fund. Also, your average length of credit would drop causing your credit score to go down.

In the long run, having multiple accounts should raise your credit limit and could improve your credit utilization. As time goes on and your average length of credit history goes up, it should help your credit score.

C. Closing a credit card account hurts your credit score.

This statement is true by considering credit utilization and the average length of credit history. When FICO compares how much you owe to how much you can borrow, less debt and higher credit limits make you look good. It’s a great feeling to pay off a credit card, but closing the account will drop your credit limit and can lower your score.

When considering your average length of credit history, the worst thing to do is to close your oldest credit card account. Closing a fairly new account may not hurt your score as much.

A Final Note

Credit scores are complicated, and it can be a time-consuming hobby to try and maximize your credit score. These examples mention what can hurt or help your credit score, but I have no idea how many points might be added or subtracted.

I signed up for a free account on CreditKarma and used their Credit Score Simulator. Closing my oldest credit card would most likely drop my score by nine points. Opening one more new credit card would probably drop my score by only four points. There are actions that can hurt or help your score, but the severity changes quickly.

The largest factors that affect your credit score are payment history and amount owed. For FICO, those two factors account for 65% of your credit score. Based on this information alone, a good strategy to earn a high credit score is to pay down your debts and pay on time.

To learn more, check out myFICO.com and CreditKarma.com for their wonderfully written articles and guides.