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!
