Good Money Management Can Be Bad For Your Credit

The concept of good money management being bad for your credit is counterintuitive. Wouldn't people with the best money management habits have the best credit scores? Your credit score doesn't have to do with how much you have saved for emergencies or retirement. Rather, it has to do with how much debt you have, how long you've had it, what kind of debt it is, and how dependable you are about paying it off.

In other words, your credit score is about how good you are at making payments on your debts, whether you have a reasonable amount of credit based on your income, and how much of the credit available to you is in use on average. You can have a so-so credit score despite having a healthy emergency account, and there are good money management practices that can temporarily lower your credit score. Here's why.

Will Closing a Credit Account Hurt Your Score?

Sometimes closing a credit account hurts your credit score, but usually the hit is temporary. Credit scoring algorithms look at how much credit is available to you and how much of that credit you're using. The more of your available credit you're using, the more it can hurt your credit score. If you close a credit card with a $4,000 limit, you immediately cut your "available" credit, and if your other credit cards or credit accounts have balances, your utilization ratio shows you're using a higher percentage of your available credit. For minimal impact on your credit score, it's best not to close any credit cards until they're all paid off.

Should You Close Credit Cards You Never Use?

It only makes sense to want to close credit cards you never use. However, part of your credit score is determined by how long you have accounts in good standing. If you're going to close a credit card to rein in spending temptation, pay all your cards off, and close the credit card you've had for the shortest amount of time. If you close a credit account you've had in good standing for 15 years, and your other credit cards are relatively new, closing that old account brings down the average length of time you've maintained accounts in good standing and can hurt your score.

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Sometimes More Is Better

Balance transfer options can be tempting with new cards offering introductory 0% rates. However, consolidating all your credit card debt onto one card can hurt your credit rating. When you open a new credit card, a "hard" credit check is done, causing a temporary hit to your credit score. Also, putting multiple debts on one account causes a high utilization rate for that card, which can also hurt your score. Consolidating balances and closing other credit cards hurts your utilization rate more. Consolidating balances can hurt your credit score more than having low balances on several credit cards. Working steadily at reducing all your balances and avoiding using your cards more than you need to will ultimately help your credit score.

A Risk for Older Consumers

Older consumers may see a bigger hit to their credit scores by paying off debt. Consider an older person who has paid off his or her home and car and doesn't use credit cards. Credit card issuers sometimes close accounts that have remained inactive for too long. Eventually, an older person may find himself with little available credit, little credit history (due to closing out of accounts) and a lower credit score. It's better to charge a small amount regularly (like a Netflix subscription) onto existing cards and pay it off every month. You may be able to schedule automatic monthly payments so you won't forget.

What Credit Scores Incorporate

Your credit score is made up of several weighted factors:

•Payment history (35%)
•Total debt level (30%)
•Length of your credit accounts (15%)
•New debt (10%)
•Type of debt (10%)

A 2013 FICO study found that consumers who had the highest credit scores (greater than 785) used an average of 7% of their available credit on credit cards. That would be like having $70 charged to a credit card with a $1,000 limit. Or, for someone with several cards with a combined limit of $10,000, they would only have $700 charged in aggregate.

Good money management means something different to the rare person who eschews all debt and doesn't care about having a good credit score, and the typical person who uses debt with things like car loans and credit cards. For most people, keeping the utilization rate low and making consistent, on-time payments is the key to raising credit scores, and money management practices that may seem smart (like closing unused, long-held credit cards) can actually be harmful to credit scores.

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