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Starting Out
by Jeanne Sahadi
November 2005
Why Being Good Can Be Bad for
Your Credit
In the weird world of credit rating, prudence isn't
always rewarded. These tips will help boost your grade.
No fuss, no muss, very Zen. That's my credit-card life. I've
got one card and only one card, which I pay in full and on time
every month.
You may assume, as I did until recently, that such Girl Scout
behavior automatically makes me a stellar credit risk. But as
it turns out, practitioners of the dark and complex art of credit
scoring don't necessarily give me -- or anyone else who handles
their credit simply but responsibly -- too many props for prudence.
Yes, good behavior generally boosts creditworthiness. But when
you're trying to qualify for low-cost credit, there's a right
way and a wrong way to be good.
 The
stakes in learning that right way are high since your credit score
-- an assessment of your creditworthiness based on your borrowing
history and typically expressed as a number ranging from 300 to
850 -- is widely used by lenders to decide whether to grant you
a loan and at what rate. The lower your score, the more you pay.
Many insurers, employers and wireless-phone providers also use
credit scores to help them decide how much to charge you for a
policy and whether to hire you or sign you up for cell-phone service.
Fortunately, for those of us who prefer the minimalist approach
to money, being good in the right way doesn't mean sacrificing
simplicity altogether. The key is to understand the sometimes
odd and counterintuitive rules of credit scoring and turn them
to your advantage.
Less Isn't Always More
"Too few credit cards can hurt your credit score," said
Evan Hendricks, author of Credit Scores & Credit Reports.
That's because a thin credit profile doesn't provide as much evidence
to lenders that you're capable of paying back your debts on time
as the more extensive track record of someone who is responsibly
managing several cards and loans.
To boost your score, consider opening another credit-card account
or two; an installment loan, like a car loan, also looks good
to scorers. But don't apply for more than, say, three cards in
a short period. Every time you request a new card, the issuer
checks your credit report, and the inquiry reduces your credit
score by several points. Each individual inquiry is not a big
deal, but the cumulative effect of several can be damaging.
Paying
in Full May Not Work
One of the biggest factors in determining your score is the amount
you've borrowed relative to your credit limit. Ideally, your balance
shouldn't exceed 30% of the maximum you can charge. But even if
you routinely pay your bill in full, it can sometimes look to
creditors as if you're overstepping that threshold. That's because
your score reflects what you owe when your card issuer sends its
report to the credit bureaus, and timing is everything: If the
report is sent in the small window after you've made a large purchase,
but before your payment is received, you're out of luck.
This matters only if you're applying for a loan during that short
time when your score takes a hit. The simple solution, says Rex
Johnson, founder of Lending Solutions, a lender education firm
in Elgin, Ill.: Don't charge big purchases for 60 days prior to
applying for a loan.
Shifting
Debt May Cost You
 Consolidating
debt onto a low-rate card and closing higher-rate accounts sounds
like a smart strategy. But it can work against you. Say you owe
$2,500 on each of two cards with a $10,000 limit. Your combined
balance ($5,000) equals 25% of your total credit limit ($20,000).
If you close the higher-rate card and transfer the balance to
the lower-rate card, you'll reduce your total credit limit to
$10,000, and your debt will amount to 50% of the maximum you can
borrow. The net effect: a lower credit score.
To avoid that outcome, you could simply leave the second account
open without a balance. Or, Johnson suggests, you might try to
improve your score by paying off the $5,000 credit-card balance
with an installment loan (for example, a personal loan from a
bank or credit union) while keeping both card accounts open. That
way you will retain your $20,000 credit-card limit while reducing
your actual use of that credit to $0. In addition, you'll be converting
revolving debt (as credit-card debt is known) to a bank loan.
Lenders view this favorably because it shows that you can pay
off a loan in regular installments over a set period of time rather
than extend your borrowing indefinitely.
An installment loan only makes sense, though, if the rate rivals
or beats the rate on your credit card. Although the average rate
on a two-year loan is running around 14% vs. 13.6% for plastic,
credit-card rates of 18% or higher, particularly on retail cards,
are still common. And you can often get a better loan rate at
a credit union, if you belong to one.
Nearly
Perfect Doesn't Cut It
You're always on time with bills, but one month a family
emergency messes up your routine. Your score will drop if your
payment is 30 days or more past due, no matter how small the amount
or how perfect your record had been until then.
Having other credit lines on which you always make timely payments
will mitigate the impact of a missed payment, Hendricks says --
yet another reason to carry more than one piece of plastic.
So what's the ideal mix if you want to maximize your creditworthiness
yet still keep your finances relatively simple? The answer, says
Johnson: Have two to four credit-card accounts, all older than
six months, and preferably a bank loan too.
Hmm. I have been tempted to buy a new car. But first I think I'll
find a friend for my lone credit card.
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