The "Rule of 22"

If you have ever read any of my books or any other articles I have written you undoubtedly have heard me talk before about the importance of how you manage your credit card debt in the eyes of your FICO score.  Some of the concepts and principles I teach I understand can be a bit confusing at times, so in an attempt to help you improve your score, but also make it easier, I am going to focus on the number 22 with this article.  By the time you finish reading this, you will understand why “22” is a very important number that can have a significant impact on your score. The key now is to understand “why” it’s important and how you use it to your advantage! 

            Most people have heard before that there are 5 components to your FICO score. They are:  payment history, debt ratio, average age of credit, mix of credit and inquiries.  My favorite (yes I just said that I have a favorite component of the FICO score) is “debt ratio”.  The reason for this is because of the 5 it is the least understood, but represents the single fastest way that with a little bit of knowledge you can positively improve your score in the shortest amount of time.  That to me is exciting!  

            The largest part of this category that is being measured is the balance compared to the limit on your revolving accounts, most commonly your credit cards.  As a simple example, if I have one credit card that is open and the limit is $500 but my balance is $250 that means I am using 50% of my available credit.  It’s simple math but here are the areas where the confusion comes in.  First, people will tell you all kinds of magic numbers or thresholds that you should keep this number under to improve your score.  Usually everyone that tells you that information is wrong.  The best place to be to earn the most points you can in this area of your score is between 0 – 10%.  So keeping your balance under $50 in this example is ideal for your score.  Knowing that and having it reported on your credit report that way are two different things.  A lot of time people understand this, but are surprised when their credit is pulled and find out the balance on the credit report shows something much higher than what they believe it to be.  Since the FICO score is only based on what it see’s on the credit report at that moment in time this presents a problem.  Credit cards have two important dates associated with them. The first is the statement or cycle ending date and the second is the due date.  The statement or cycle ending date represents the day the previous billing cycle ends AND the balance of the card is then reported to the credit bureaus.  Then your paper statement is mailed to you and you have a 21 day grace period in which to make your payment.  This is important because if you know the proper way to manage your credit cards your score might still suffer just because you are not paying the balance down on the right date!  To help you with this I am giving you the “rule of 22”.  Look at your credit card statement and whatever the due date is get in the habit of paying it 22 days BEFORE the due date.  If you follow this approach not only will your balance on the credit report be a more accurate reflection, your FICO score will also improve.  There you have it….The Rule of 22!

The temptation was too much…now what do I do?

The holiday season is now over and for many comes the real downer of figuring out how much money they spent on credit cards and what they should do with the new retail credit cards they opened.  While I express to people all of the time to avoid that situation sometimes that advice is ignored because the temptation of the instant discount off your current purchase at the register is just too much for some.  Now that the dust is settled and you have this new card many are left thinking, “I will just close it right away and whatever damage I just did to my credit score will be fixed.”  To add to that, there are several “experts” out there that will tell you having a retail credit card is bad for your FICO score and the faster you close those cards the better.  What should you do? Let’s take a closer look at this scenario, but this time with accurate factual information.

First off, next year and moving forward if you are in doubt as to whether you should apply for the retail credit card or not, don’t! The reason they are giving you the immediate discount is because a lot of people will pay more in interest over time than the discount they are actually saving in the first place.  These companies are not dumb.   They understand the human spending habits as well as the fact that IF they can get a credit card in your pocket with their name on it, you are much more likely to buy things you can’t afford right now and then pay them extra interest over time on those purchases.  Retail cards are infamous for their subprime-style terms with interest rates well into the 20’s and credit limits as low as a few hundred dollars. Using and carrying a retail card balance will quickly add to the balance and with such low credit limits, modest purchases can result in highly leveraged cards, which lowers your credit score as a result.

But since we can’t go back in time and reverse the application for the new retail credit card you agreed to, let me give you three possible solutions with what to do with the account now:

Close the card immediately

Many people will close the card right away because they only opened it for the discount. That’s fine but you should be aware that closing it doesn’t do away with any damage you’ve already caused to your credit by opening it. The credit inquiry that was posted by the issuer (or issuers) when you applied will still be there and they can lower your score for the next 12 months. And, the newly opened account (or accounts) will be on your credit report likely for the next decade.

Close the Card… Eventually

I believe that if you don’t close the card immediately you shouldn’t close it ever. The unused credit limit, although a small one, is likely helping your credit scores because credit scoring systems like unused credit limits. By closing the card you will lose the value of the card’s unused credit limit. You will, however, still get the benefit of the age of the account, open or closed. There’s a pretty common myth that when you close a credit card you lose the benefit of the account’s age, which is not true. Also retail credit cards don’t charge monthly or annual fees (although that can certainly change), so the cost to simply hold on to the card is $0.

Never Close the Card

If you never close the card, then you’ll always benefit from the card’s unused credit limit, assuming you don’t run up a large balance.  You’ll also always benefit from the account’s age because the credit bureaus won’t remove the account from your credit report, which they’ll likely do after the account has been closed for 10 years.  If you made the mistake and opened the new card don’t make it worse by making another poor choice.  Keep the card open!

How to Prepare Your Credit for a Mortgage Application

A lot of the people that come to hear me speak or contact me for a credit consultation have the same goal, to purchase a home or refinance the current mortgage loan they have.  Usually they contact me after they have discovered that their current FICO score is not high enough to accomplish that goal.  Since this is a common theme, I had the idea to write a few helpful tips for people in this situation.  Please feel free to share this with your friends or clients that might benefit from this.

Understand the score you checked

For clarity sake let us start by me telling you that the score you are probably using as the basis for determining whether or not your score is good enough or needs improvement is most likely not an accurate score.  All of these websites and services that sell you or allow you to view your credit score are not the same score your mortgage person will utilize.  Be careful putting too much emphasis on the value of these scores.  In my opinion if you want to get an idea of what your FICO score might be, two of the more accurate and free websites are CreditKarma.com and CreditSesame.com.  Again these are not true FICO scores (which is what your mortgage will be accessing, but they are usually two of the most accurate as a gauge).  Most of the other sites out there I never recommend to people because they typically are too far off in the range or model they use. 

Take Action 

One of the fastest and easiest things you can do to improve your score is to understand the importance of your credit cards on your credit report.  More specifically the balances that you are currently carrying on those cards.  A very important factor to your FICO score is the percentage of revolving credit you are utilizing at the time of the report.  A simple tip, the lower the balance on your credit cards the better when it comes to this.  If your goal is to improve your FICO score in the next few months start by making your main goal to pay off your credit cards. 

Stop using your credit cards

Now that you have paid off or paid down your credit cards you want to get the benefit of those lower balances on your credit report.  This can’t be accomplished if you keep charging on those cards every month.  All credit cards have cycles; there are different days where the credit card issuer reports the balances on your cards to the credit bureaus.  This date is not the same as the due date.  To get the score benefit of this action, after you pay the cards off, stop using them (do not close them) then wait 45 days before you apply for your mortgage.  This way you will actually get the score benefit of having these cards paid off!

You’re not done yet

Once you have been told that you are approved, that doesn’t mean it is time to start using the credit cards again or applying for new credit.  A lot of lenders pull a new credit report late in the process.  You do not want to jeopardize your loan because you decide that a new couch would look nice in the house that you don’t own yet.  Keep the balances at $0 and don’t apply for anything until after the loan is closed!

I understand that everyone’s situation and credit is different.  These are just a few simpletips that would benefit the large majority of people that I talk to.

Short Sale Changes

Recently I read an article about not only changes being made in the mortgage industry, but also how those potential changes might affect credit scores.  Since the article lists some credit “facts”, I feel obligated to address it further.  The article is short so I have listed it here and will follow up with a few opinions after:

Nondelinquent Borrowers Soon to Be Eligible for Short Sales

Daily Real Estate News | Wednesday, October 24, 2012 

Mortgage giants Fannie Mae and Freddie Mac have issued new rules, which will take effect Nov. 1 that will allow short sales for underwater borrowers who have never missed a mortgage payment. Previously, Fannie and Freddie allowed only home owners who had missed payments to qualify for a short sale.

Eligible borrowers under the new rules will need to show a hardship to qualify for a short sale, however. Hardships may include unemployment or a death of a spouse. 

Inman News points out one potential flaw to the new rule, however: The nondelinquent home owners who undergo a short sale will likely take just as big a hit to their credit score than if they had missed loan payments and gone into a foreclosure. 

“Under current national credit reporting practices, those nondelinquent borrowers are likely to be treated the same for credit scoring purposes as severely delinquent owners who go to foreclosure after months of nonpayment, or who simply toss back the house keys and walk away in strategic defaults,” writes Ken Harney for Inman News. 

Credit agencies use no special coding to indicate that a short sale was without delinquency. Therefore, home owners could see their credit scores drop 150 points or more after the short sale.

However, officials at the Federal Housing Finance Agency, which oversees Fannie and Freddie, told Inman News they are “in discussions with the credit industry” to explore ways to fix the credit score problem for those who haven’t missed a payment but undergo a short sale. 

The good news is that when the new rule change goes into effect, this will now give people an even greater incentive to take this course of action rather than just allowing the property to be foreclosed on. 

The bad news is a few of the credit facts listed in this article are wrong or at best misinterpreted.  With all due respect to Mr. Harney, who is a much esteemed writer, I believe the source of where some of his credit information came from was a little off, specifically paragraph 3 and his quote following that in paragraph 4.  

To completely understand the debate about short sales vs. foreclosures and more specifically the impact on the FICO score we need to understand a few things.  

First -what happens prior to the closing/sale date?

With a foreclosure we know that the person will have multiple late payments listed on the credit report for that account.  With a short sale (especially with this new rule) there doesn’t have to be any late payments. This is great news because the absence of 30, 60, 90+ day late payments on an account is better for your FICO score than if those were present on the account history.  One of the biggest arguments that people used to have is that it was basically impossible to get a short sale negotiated without being delinquent first.  Now with this new change that issue should be eliminated.

 For this reason, if a person does not become delinquent on the mortgage prior to the short sale being completed this action would be better for the FICO score than a foreclosure.

Advantage- short sale

Second- what happens after the closing?

When there’s a foreclosure the account will be listed as such or it will say “charged off account.” Any derivative of this is bad and will hurt the FICO score.  With a short sale the article is correct; there is no special way that a lender can mark the account as a short sale.  Since that is not an option the lenders have the choice of how they report it.  Most commonly lenders report it as “settled for less than full” which in the eyes of your FICO score all means the same… it is bad! With that being said, since a short sale is not an option for credit reporting, the one wild card that can come into play is if the lender just simply marks the account as “paid”.  If this were to happen it would be much better than being reported as a foreclosure.

Advantage- short sale

The last part of this debate hasn’t been covered. Not only is the FICO score measuring how delinquent someone’s account is, it’s also measuring the time since that incident.  Meaning the older that negative is, the less it hurts your score.  With a short sale you can help to speed up the process, which will help an individual’s FICO score recover quicker.  

Overall if this new rule does in fact come into play it is a positive thing for struggling homeowners that need to get out from under a property they can no longer afford.  Keep in mind homeowners also want to do everything they can to lessen the credit score damages that will become associated with any of these actions. 

Spending to improve your FICO score?

Have you ever heard or been told that when trying to rebuild or improve a credit score “it is a good idea to charge up your credit card, leave the balance on the card for a few months then pay it off?” Followed by, “repeat this cycle a few times because it will show that you are a responsible consumer and manage your credit well,” and by doing this overcomplicated system the end result would net in a better FICO score?  If you haven’t, you just haven’t been listening to enough people that are always quick to explain how you can improve your credit score.  After almost 5 years of being a Certified Credit Scoring Expert and reviewing thousands and thousands of credit reports it is one of the most common tips that people share with me that someone else gave them prior to them talking with me about how to improve their score.  Since it is such a popular piece of advice I have decided to address it for everyone.

                This advice stems from a category of your FICO score that is most commonly referred to as your debt ratio.  In simple terms it measures the percentage of debt that you currently have (balance) in proportion to the limits available on revolving accounts or the opening balance on installment debt, with the highest weight being placed on the revolving accounts.  Revolving accounts and more importantly how you use those accounts have been found to be a highly predictive factor to the FICO score, thus the reason they are so important.  The more predictive something is, the more important it should be to us as consumers if our goal is to improve or maintain a good FICO score. 

                With that as our basis, this is where the common advice takes a turn from being “helpful” to flat out wrong and destructive information.  The measurement that is calculated is the percent of revolving credit being used at any given time compared to the limit.  So here is a simple math exercise; if I have one credit card and the limit is $1,000 but I currently have a balance of $500 then I am using 50% of my available credit on that card, which means my revolving debt ratio is 50%.  The first thing to understand as a rule of thumb is the lower your revolving debt ratio the better.  In fact the best percentage you can have to maximize this piece of your score is between 1 and 2%. 

                If we understand the mechanics of how this number is calculated, we just need to then understand a few basics of how credit reporting works.  Credit scores and credit reports are two different things.  Credit reports are just complied by a bunch of data that exists about us.  Credit scores happen when that data from the credit report is evaluated and analyzed to give some type of score or rank.  The FICO score is measuring the statistical chance of a consumer being 90 days late or more in the next two years. 

Credit scores are real time information based on non-real time data.  The area where this presents the largest issue happens to be in credit card balances.  The reason this can be such a problem happens to be one of the reasons why the advice being discussed here is total garbage.  The due date on your credit card is not the day your balance is reported to the credit bureaus.  The date your balance is reported is a day most commonly referred to as the cycle ending date or statement ending date.  If I had one credit card with a $500 limit and every month I charge it up to the max, then wait for the bill to come and pay it off in full my score would be suffering all because of the timing of when I pay my bill!  Credit card balances do not get updated daily, this is further proof that credit reports are full of out dated information.  Also credit scores are evaluating my credit report at that moment in time; they do not look back over the history of our credit card balances.  It is all about what is owed compared to the limit at that moment in time in which a score is requested. 

Following this very popular and bad advice not only will help you be successful at lowering your FICO score, you will be in credit card debt plus it will cost you money as you will be paying interest charges on that revolving balance!

Here is a better approach to improving your credit; have a credit card and on a monthly basis charge 10% or less of the limit, wait for the bill to come and pay it off.  Sometimes the simple approach will not only result in better results, it will save you money, time and frustration!