A reader sent me this heartbreaking story that I feel I need to share with you all.

I’m writing on behalf of a friend who just graduated from college two years ago and is trying to get on her financial feet. When she was young her mother used her identity several times to get loans and open credit cards. Her mother is a homeless nomad who has not taken responsibility for any of these accounts and has ruined my friend’s credit. She doesn’t even know how many loans and credit cards were obtained in her name, if any are paid of and to what degree, etc. She tries to run her credit report but can’t because she can’t answer the basic questions about her last address or last loan because it’s all her mother’s information.

Her mother has not used her identity for financial gain, that she knows of, in about three years. My friend is trying to be responsible. She has a good job, no debt of her own (just what her mother accrued!), and is trying to live more frugally. She’s been turned down several times for a credit card and obviously, can’t get any other sort of loan. Is there any way to get her mother’s mistakes off her report? It seems like identity theft to me, but I’m not sure how to advise her. Could a lawyer help her clear her report? It doesn’t sound like her mother will be able to pay for any outstanding charges, and I don’t know if suing her would do much good. Since many of these accounts were opened when my friend was under 18, I just can’t believe that she’d be held resposible for all of it. It’s just not fair, and I feel awful for her. Thanks in advance for your help.

Wow, that’s a mess.

First of all, reading stories like these really brings to light how lucky and blessed I was to have two incredibly wonderful parents. If you have a parent out there that loves you, even if your relationship is strained, read that story above one more time and think about giving your folks a phone call. I know I did - I just called my mother and had a good chat with her.

Now, how can this problem be addressed?

The first step I would take would be to contact each credit agency directly and ask them for suggested directions. Explain to them the whole situation, and work with them to work backwards through each of the creditors that have notes on the report.

This is going to be a long process and it will involve a lot of time on the phone. Be prepared for some serious time investment spread out over a long period. Expect to have to escalate this situation regularly, as the person on the phone when you first call probably won’t be equipped to handle this situation. Expect to get some rejections - keep trying and hammering away and escalating.

Second, get some form of credit monitoring service. Once the reports are straightened out, some sort of credit monitoring service needs to be put in place in case any of this happens again.

Third, consider changing your Social Security number. This can be done and is often warranted in cases of harassment - and I’ve got to think (though I don’t know for sure) that this constitutes harassment. Since the person in question is young, they have plenty of time to build up new credit.

Fourth, get involved with political movements pushing for individual credit reform. A big part of this problem comes from the fact that it’s actually quite easy to pretend to be someone else and get easy credit. There needs to be more evidence that credit is being granted to the actual person who the request appears to be coming from, not a paper entity. Identity theft is a real problem and it’s growing.

Finally, don’t give up hope. You didn’t do anything wrong, and anyone who studies your situation will be able to figure that out. Just be patient and realize that this is a sufficiently complex and knotty problem that will take some time to resolve - it won’t all be fixed in a day.

Good luck!

Do readers have further suggestions for this person?

On a fairly regular basis, I suggest to my readers that they cancel unused credit cards except for their oldest one. In fact, I often suggest that you reduce your credit cards to one or two that you use for regular purchases and your oldest one - cancel the rest. This advice is often criticized, so I thought it’d be fair to dig into the issue in some detail.

The “Facts”?

Many people who disagree with this advice point out that one of the elements of a person’s credit score is the debt-to-credit ratio. In other words, the more cards you have, the higher your total credit limit is, and thus your debt-to-credit ratio is better.

From that perspective alone, then it is a bad idea to cancel your cards. But that pulls just one fact out of a big handful of facts. Let’s look at some more.

No one knows for sure how FICO (or other credit scores) work. As I stated in an earlier writeup about credit reports, FICO’s exact formula is a trade secret. They reveal “tips” on how to improve your score and have offered this as general guidance on what makes up your score:

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

What do each of those mean? It’s not clear - the best we can do is try to interpret them.

The types of credit used is a factor. If you have a lot of credit cards, you have a lot of sources of revolving credit, the worst kind. That hurts the portion of your score that evaluates the types of credit you’re holding.

Anecdotally, manual underwriters for home loans do not like to see lots of credit cards. When I applied for my home loan, I had two open credit cards - my oldest one and a general use one. The manual underwriter flat-out told me that such a status was a good thing because it showed consumer willpower and less risk that I’d be opening a lot of lines of credit. We ended up getting a very good rate on our home loan.

The more open credit cards you have, the greater the chance of identity theft. Identity theft is a serious concern, and the more open credit card numbers you have floating around at banks, the more likely you are to get bitten by an accident at a bank or unethical use of business records. While this is a small risk, if it does happen, it can be devastating.

A lot of available credit is a psychological temptation. It becomes much easier to just push the plastic and buy something if you have $15,000 in available credit on your cards. If you find it very easy to put purchases on your credit card and worry about the bills later, this is a real concern.

What Does This All Mean?

In a nutshell, it means that there is no definitive and clear answer about what to do. Since the exact formula for credit scores isn’t known, we have to make some guesses about what to do to maximize our credit scores while, at the same time, balancing our other risks.

If your primary goal is to raise your credit score by a few points, you’re probably better off leaving your cards alone for the time being. It keeps your debt-to-credit ratio in a good place, for starters.

However, if you’re a compulsive spender or you’re looking at getting a manually underwritten home loan soon, you should get rid of the extra cards, as other aspects present a greater risk to you.

By default, the best thing you can do is to only have a few cards to begin with and, most importantly, don’t put a lot of money on the cards. That way, your credit-to-debt ratio is good and you don’t have a lot of sources of revolving credit and you don’t have a lot of credit numbers sitting out there, either. Because of that, when people begin paying off their cards and getting into good financial shape, I believe it makes sense to gradually cancel your unused cards.

Whenever you make a significant financial move today that requires financial assistance, it’s often accompanied by a check of your credit report and often a retrieval of your credit score. Lenders (and, quite frequently, other agencies like insurance companies) use this information to help determine a customized offer for you, so it’s quite useful to have an idea of your credit score and to make sure that your credit report is clean, particularly in terms of incorrect statements that can hurt you.

The problem is that there’s no obviously clear way to acquire this information. Credit reports are managed by three credit bureaus (Equifax, Experian, and TransUnion), and these companies make money by selling your credit report and your credit score to lenders. They also hope to make money by selling this information to you, too.

Even worse, there are sharks in the water out there. Programs like freecreditreport.com seek to trick you into signing up for subscriptions to stuff you likely will never use in exchange for your credit report.

Here are the best ways I’ve found to find out your credit report and credit score. Please, if you know of better sources than these, leave a note in the comments.

Getting Your Credit Report

Your credit report is just a listing of all of the accounts and debts that you have and whether you’ve been paying them on time. When you go to get a loan, lenders will use this to see whether or not you’re a reliable person who can be counted on to repay debts. The more reliable you look, the better the rates.

You can get your credit report for free, no questions asked, at annualcreditreport.com. This is a service offered by the FTC that allows you one free download of your credit report each year from each agency (Equifax, Experian, and TransUnion). Since most of the time the three reports are the same, you can effectively grab your credit report for free every four months.

Do not use other services to get your report - you’ll end up being forced to sign up for services and pay fees that you don’t have to pay. The worst offender here is the heavily advertised freecreditreport.com.

Once you have your report, you should read it very carefully to make sure it’s accurate. If you find something that isn’t, start calling. Get ahold of both the credit bureau and the organization that put the false info on your credit report. False information on your credit report does nothing but hurt you and you should seek to get rid of it as soon as possible.

Getting Your Credit Score

Unfortunately, a service like annualcreditreport.com doesn’t exist for one’s credit score. The exact method for calculating credit scores are actually considered to be a trade secret, held by the Fair Isaac Corporation. That’s why credit scores in the United States are often called FICO scores. Thus, you can find out all of the information that makes up your score, but you can’t find the score itself.

The cheapest option is to not find out your specific score. If you’ve checked your credit reports at annualcreditreport.com, you know what your credit report looks like. You can use that information, along with knowledge of your personal finances, and use a FICO score estimator to get a pretty strong estimate of your credit score. I tried this tool and found that it predicted a small range of potential scores - my real score was in fact within that range.

For some, though, an exact number is necessary, and you’ll likely have to pay for that. When I was in the process of shopping for my house loan, I looked at several services and finally used myFICO to get my credit score. They give you several options - the best one, for the long haul, is to get your FICO score from the credit bureau with the worst credit report (you checked them at annualcreditreport.com, right?) for a one time fee of $16. That’s the method I used to find my “worst” score - and it wasn’t bad at all.

There are other options (like getting your FICO score from all three bureaus at once at myFICO, or going to each credit bureau individually), but they’re more expensive. No matter what, though, you should definitely avoid any subscription services - credit monitoring is nice, but you can get the same effect for free by going to annualcreditreport.com regularly.

Now That I Have This Info…

Once you’ve downloaded your credit report, ensured that it’s clean, and figured out your credit score, you can use that information to get realistic assessments of the type of loans you can get. This tool provides a good estimate of the benefits of a strong credit score. With this information, you can make up your own mind about whether you can afford a big purchase right now - or if you need to focus on improving your credit right now.

Remember the biggest rule of thumb: don’t ever sign up for a recurring service unless you’re 100% sure you want it. For credit scores and credit reports, given the strong free and one-time services available, I don’t believe there’s any reason for the average person to sign up for credit monitoring subscriptions. Keep that cash in your pocket instead.

I often get notes from people who have a small mountain of credit cards. They’re trying to figure out which ones they should keep and which ones they should cancel for various reasons, and they’re (rightfully) concerned with their credit report when they do this.

Obviously, a wallet full of credit cards can be a problem: you have many more opportunities for identity theft and, often, with so many credit cards, your total line of credit may be high enough that it’s actually hurting your credit report. This doesn’t even cover the more aesthetic issues: extra paper management, an unreasonably fat wallet, etc.

So, if you have a mountain of cards, what should you do to trim them down? Here’s my recommendation for anyone dealing with a big pile of the cards.

First, identify one to be your primary spending card. There is no universal “best card” for everyone. You should look at your spending very carefully and choose one that best matches your habits. For us, we use the Citi Driver’s Edge card because we both commute for work and we earn a penny per mile driven in the form of a rebate on our next car purchase. It works well for us, but not necessarily as well for others. I actually have a second primary use card - we keep an Amazon card because we do a lot of our shopping there and it nets us 3% back on all purchases there, so we use the Amazon card exclusively for Amazon and the Driver’s Edge card for everything else.

Next, determine which card you’ve had for the longest period of time. Which is your oldest card? That card is the one that has the longest credit history, which is important for your credit report. For me, my oldest card is one that I got as a freshman in college. It has an atrocious “bonus” program associated to it (1/4% return in the form of “points”), but it was the first one I had and thus it’s been on my credit report for more than a decade, establishing that I’ve had positive credit for a long while.

Also, stop carrying this big, fat wallet full of cards with you. I only carry my two primary use cards with me. My oldest card is in my safe. All of the other cards I’ve ever had have been cancelled. This means my wallet is pretty thin, as I basically carry just a very small number of club and buyer rewards cards (library, Sam’s Club, Borders, Best Buy, etc.).

Then, start zero-balancing and cancelling all of your other cards over time. You can pretty safely cancel all of the rest of your cards that already have a zero balance. With the others, stop using them and start paying them off, making minimum payments on all of them and extra payments on whichever one charges the highest interest rate. When that one’s done, cancel it and start making extra payments on the next one and so on until they’re all gone, then cancel them.

What you’ll end up with is a much thinner wallet and a credit report in very healthy shape. The length of your credit history will remain unchanged and the ratio of your credit limit to your income will actually be in better shape than before.

In response to my two recent posts on building credit (getting credit without a credit card and building up credit), Konstantin writes in and says:

I am following your blog daily and I found two conflicting ideas you suggest that I have a hard time reconciling them:

“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.”

VS.

“Keep the total amount of your credit cards’ available credit low”

So, if I cancel a card and/or if I have several cards - it’s bad BUT if I have several cards the combined credit limit reduces my debt ratio.

What’s the right way then?

These things are only in conflict if you carry a significant balance on your credit cards. Here’s what the game plan should be if you want to get your credit in good shape.

First, pay off all of your balances. Get those cards paid off, whatever it takes. Credit card debt is not healthy debt - the sooner you get rid of it, the better.

Once you’re on this level playing field, cancel some of your cards. I recommend keeping your oldest card and the one with the best bonus program and eliminating all of the rest, including the store-based cards. Why? A large total credit limit can be detrimental because it indicates to lenders that you have the potential to very quickly go deeply into credit card debt.

Once you’re there, use the bonus card, but try to keep the monthly balance under 20% of your total credit limit. For example, if the total limit on your remaining cards is $20,000, don’t carry more than $4,000 on the card if at all possible.

Doing this will keep the total amount of available credit low while not hurting you for eliminating lines of credit and altering your debt-to-credit ratio. The end result? A much better credit rating.

Mark writes in and asks:

I’m 18, and recently applied for a credit card at Citibank. They rejected me on the basis that I have no credit history. I’ve had a savings account at a local bank for nearly my whole life with all of my money in it, and I’ve started budgeting my money for when I go to college in September. So I know how to handle money, and I know all about interest rates and avoiding debt (partly thanks to your blog). Citibank has some of the best credit card deals I could find. But how am I supposed to build credit if I can’t get a credit card in the first place?

Mark actually has several options for building positive credit without his own unsecured credit card. Here are some ways that Mark can build credit in this situation.

Have his parents add his name to their card. They don’t even have to give him a card, just add his identity as an authorized user on their own card. This will make their card account appear on his credit report and thus he’ll get the benefit of their good management of their card.

Get a secured credit card. A secured credit card is one where you’ve already paid a certain amount before you get it - say, $250 or $500. Then, each time you use the card, it’s immediately paid out of that money and then you are billed for that amount to replenish the balance. This builds credit, and when you cancel the card, you get the money back.

Make a moderate purchase on a store payment plan. For example, you could purchase a piece of furniture at a furniture store or an electronic item at an electronics store. Sign up for their payment plan; it’s basically a form of credit. If you have a purchase you’re planning in the near future and already have the cash to pay for it, this is a route worth considering.

Get your student loans. If you’re 18 and planning on going to college, student loans are likely in your future. Your parents may have to cosign on them, but they’ll be in your name and be a very good source of credit.

All of these options will put you in good shape for the future. One tip: when you start to build credit, you will be inundated with all kinds of offers. Forget them and shred them. If someone sends you an offer in the mail, there’s likely a better one out there that isn’t wasting marketing money on direct mail campaigns.

James wrote in and asked the following question:

I just read your article: WHAT’S IN MY WALLET regarding credit cards. You mentioned that you pay your entire balance weekly. Would this work if you were trying to build credit also? How does building up credit work?

Good question. The technique of paying off your card every week certainly works for building up credit. Let’s start at the beginning, though.

The idea of building up credit refers generally to making a series of financial choices that results in positive growth of one’s credit score. So, in order to do that, one needs to understand the elements of the credit score. I discussed this in detail before, but here’s a refresher:

FICO scores are calculated based on your rating in five general categories: Components of the FICO score
Payment history - 35%
Amounts owed - 30%
Length of credit history - 15%
New credit - 10%
Types of credit used - 10%

So how can one build up credit? By looking for improvements in each area:

Payment history Make sure always that the minimum payment is paid before the due date on any bill. You can do this however you wish, but whenever you receive a bill with a minimum payment, make sure you pay that much before the bill is due.

Amounts owed The actual dollar amount isn’t as important as the percentage of your total credit limit that is used on your last set of statements; the lower the percentage, the better. The way to keep this part low is to simply avoid carrying large balances on a card.

Length of credit history Your credit history generally starts the first time you acquire a credit card (or other source of credit). This is why it’s generally a bad idea to cancel your oldest card.

New credit Whenever you first apply for a source of credit, it provides a negative for your card. This is why it’s a bad idea to apply for several cards at once - your better solution is to apply for just one. Never apply for a credit card on a whim.

Types of credit Basically, if you have a lot of revolving credit out there (say, more than 30% of your annual salary), it will hurt your credit report. Keep the total amount of your credit cards’ available credit low - the best way to do this is, again, stick with just one or two cards. Credit comapnies like to keep lifting your credit limit if you carry a balance on the card but pay it off faithfully, so if you have several cards, the limits could skyrocket and end up hurting you.

Here’s a recipe for building credit that works in all respects:

Apply for just one credit card. Spend the time to research a number of them by visiting the sites of various credit card companies (Citi, Chase, Bank of America, etc.). Find one card with a rate and a bonus program that seems to fit you and apply for it. Don’t worry about a low credit limit - that’s good.

Use it for only small purchases for a year. Each month, buy two or three small things on it that you could have otherwise paid in cash. Don’t use it to finance things you can’t afford.

Pay off the balance in full by the time the next payment is due. You can do this in pieces online if you wish, or all at once by check. Just avoid carrying a balance from month to month.

After six months, request a credit limit increase, but don’t go above 20% of your gross salary. If you’ve used the card and paid it back, they’ll usually be glad to bump it up.

If you follow those steps and avoid carrying a balance on your card, your credit will start to steadily improve. Stick with making small purchases (try to keep your balance at any time less than 20% of your credit limit) and keep paying them off. You’ll end up having pretty solid credit when you go to apply for things.

Good luck!

For the last week, there have been numerous reports of individuals who have opened Electric Orange checking accounts and after sixty days have had a credit check run on them. Here’s a typical example of such a report at Consumerism Commentary. In some cases, apparently, after this credit check, the Electric Orange account is closed. To me, at least, this is rather ominous behavior as initial descriptions of the account indicated that there would be no credit checks, so I began investigating.

First of all, from their FAQ:

Do you pull my credit if I apply for Electric Orange and the Overdraft Line of Credit?
Yes. As part of your application, ING DIRECT will obtain information about you from a consumer credit reporting agency (a “hard pull”) to confirm that you are eligible for Electric Orange.

So, indeed, the standard practice for people who sign up for an Electric Orange account is that they check your credit report with a hard pull. A “hard pull” generally means about a -5 on your credit score that lasts for about six months, then goes away. MyMoneyBlog has an extensive explanation of hard pulls versus soft pulls.

So where did the idea that ING did not pull one’s credit come from? The story that I have been able to piece together is that when ING first sent out press releases for the account, their official policy was to give everyone a $1,000 line of credit without a credit check. Most of this initial information was sent out in January 2007 and was posted on various banking sites that post press releases and such.

Sometime shortly thereafter, ING changed their policy for new accounts. I spoke to a customer service representative at ING who basically said that this change happened a few months ago, implying that it was likely in February or March 2007. The change stated that ING did have the option to run a credit check at their discretion. Now, the policy is as stated above.

Why did they make this change? I have read many, many reports of people signing up for Electric Orange, immediately “overdrafting” their checking account, and using the overdraft protection as another credit card, which was not the purpose of the account at all - it was intended as an occasional protection against overdrafts. I would strongly speculate that this behavior warranted the change in policy from ING.

What can we learn from this? First of all, know what you’re signing up for, no matter what. If you read a four month old press release on a product, sign up for it without reading the documentation, and find out that things have changed, you’ve made a bad move. Don’t rely on second-hand information ever - investigate for yourself. Blogs like these are meant to get you thinking and point you in the right direction, but you have to do the investigation yourself.

Second, you need to ask yourself if a credit check like this is an issue for you. The credit protection offered by this account is exactly what I want. I’ve overdrafted once in my life and it was due to a mathematical error - but it ended up costing me almost $100 to deal with. With Electric Orange, it wouldn’t cost me a thing other than a few cents in interest. Plus, the account balance itself earns a 4.00% APY. My credit is stellar, so I’m not bothered by the credit check, but if your credit is poor or you’re sweating every single point on your score, this could be an issue for you.