#18: Credit Scores

25 Rules to Grow Rich By

This is part of a series in which we re-evaluate Money Magazine’s “25 Rules To Grow Rich By”. One “rule” will be re-evaluated each weekday until the series concludes; you can keep tabs on the action at the 25 Rules index.

Rule #18: The best way to improve your credit score is to pay bills on time and to borrow no more than 30% of your available credit.

In the United States, the most common type of credit score is the FICO score (or Fair Isaac Corporation score). From the Wikipedia credit score entry:

Although the exact formulae for calculating credit scores are closely guarded secrets, Fair Isaac has disclosed the following components and the approximate weighted contribution of each:

* 35% punctuality of payment in the past (only includes payments later than 30 days past due)
* 30% the amount of debt, expressed as the ratio of current revolving debt (credit card balances, etc.) to total available revolving credit (credit limits)
* 15% length of credit history
* 10% types of credit used (installment, revolving, consumer finance)
* 10% recent search for credit and/or amount of credit obtained recently

Money’s rule seems to directly address the first two: pay your bills on time to reduce late payments, and reduce your credit card debt to improve your debt ratio. But where does that 30% number come from?

The fact of the matter is that there is no specific number that qualifies as a “good” ratio, just that lower is always better. Different reporting agencies use different formulas to calculate a “good” and a “bad” debt ratio and don’t disclose the actual contents of the formula, leaving you to guess what is best.

In short, you shouldn’t necessarily feel good if your credit ratio is below 30%. You should feel good if your credit ratio is lower now than it was six months ago, as every time you decrease your ratio, you help your credit score.

Another tip is that by canceling credit cards, you’re actually hurting yourself in two ways. First, you’re reducing the total available revolving credit that you have without reducing the amount of current debt you have, thus raising your credit ratio. Second, by eliminating lines of credit, you’re shortening your credit history. Simply put, if you’ve already got a credit card and paid it off, don’t cancel it; put it away somewhere safe.

Let’s rewrite that rule.

Rewritten Rule #18: The best ways to improve your credit score is to pay bills on time, to reduce the balance on your credit cards, and to not cancel old cards when you’ve paid off their balance.

You can jump ahead to rule #19 or jump back to rule #17.

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  1. Nathan says:

    I was told by my bank that having open lines of credit is a bad thing if they are not being used.

    I understand the debt/credit ratio and couldn’t agree more, however wouldn’t it be better to keep the lines of credit open that you can use and pay off completely each month.

  2. Fuller says:

    I was told something similar about leaving open lines of credit that you are not using. Many times when a bank looks at your financial situation they don’t just analyze your credit score, they create a Bankruptcy score as well. This is something that is calculated by: 1)your credit score 2) your salary 3) your potential for becoming further in debt than you already are.
    Essentially by having several open lines of credit (by keeping open cards you no longer use), you have the potential to run up thousands of dollars in debt on a single day though the use of the cards. So when a bank sees that you have access to 30K in loans, and you are asking for a 30K car loan, it thinks twice before extending you any more credit than you already have.

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