“Two years ago I had terrible credit, and you were kind enough to steer me to a credit card company that would give me a card. Now I have three cards, and my credit has improved some, but not enough…how do I manage my cards to earn the highest possible credit score?”
Managing credit cards is more complicated than managing a mortgage or auto loan because you have multiple debts rather than just one. The number of cards can vary, balances can be increased or paid down, balances can be shifted between cards, new cards can be opened, and existing cards can be closed.
Any such change may affect your credit score. Whether it reduces or increases the score depends on whether the genie who scores credit believes that the change will increase or decrease the probability that you will default on future loans. The rules applied by the genie are as follows, in order of importance.
Payment History: Payments made on time raise the credit score, while delinquent payments reduce it. That is the most important rule by far.
Most cardholders understand this, but many also believe that the reduction in credit score caused by a delinquency is reversed when the card becomes current. This is not the case. Eliminating the delinquency merely prevents a further hit to the score. Delinquencies stay on your record for seven years, although their force will weaken over time as on-time payments come in.
Ratio of Card Balance to Maximum Balance: This is the second most important component of your credit score, and if your credit history is short, it can be the most important.
The genie compares the outstanding debt on each of your cards with the maximum amount of debt that the credit grantor has set on that card. For example, if the balance on a card is $2,000 and the maximum balance is $5,000, the utilization rate is 40 percent. The lower the utilization rate, the higher your credit score. The genie interprets high ratios to mean that the borrower is living closer to the edge.
Some experts advise that it is better to have about the same utilization ratio across all your cards, rather than have some high and some low. This would prevent borrowers from minimizing interest cost by concentrating balances in the card(s) with the lowest interest rates.
I don’t know whether the genie favors an even distribution of balances across cards or not. I suspect not, since the genie is logical and there is no logical reason why the distribution of balances across different cards should matter.
A cardholder can reduce his/her utilization ratio by reducing his/her balance, and also by increasing the maximum balance. If a borrower has had a good payment record, the maximum can often be increased simply by asking.
Make sure that your card issuer reports a maximum. If no maximum is reported, the genie assumes that the highest balance ever reached in that account is the maximum, when in fact it could be well below the maximum. This raises your utilization rate for no good reason.
If a card has no reported limit, you can either request that the limit be reported, or terminate the relationship. Alternatively, you can shift all your balances into this account temporarily so that the highest balance comes closer to the unreported maximum.
Age of Cards: The genie likes old credit cards much more than new ones. The card you have been using for 15 years is evidence of your financial stability, whereas the card you took out last week could mean you are in trouble. If you took out three cards last week, it could be big trouble.
To receive credit for old cards, they have to be active. If you don’t use a card for six months, it is classified as inactive and the genie ignores it.
Number of Cards: The scoring genie prefers that you have no more than four or five active cards, but if you have 12, don’t worry about it. If you reduce the number from 12 to 5, the genie will reward you for the reduction in numbers but might penalize you for the increase in utilization that goes with it.
Of course, there might be other reasons for reducing the number of your cards, such as simplifying your life. If you do it, retain the older cards and cancel the newer ones.
The writer is Professor of Finance Emeritus at the Wharton School of the University of Pennsylvania. Comments and questions can be left at www.mtgprofessor.com.
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