Mortgage Confidential: closing an account can hurt your credit score
Filed under: Borrowing, Credit, Mortgage Confidential
The old adage, if 10 years ago makes for an adage, was to monitor your credit and close down any unused credit accounts. Before the advent of "instant" mortgage approvals and automated underwriting systems, loans were actually evaluated completely by a living, breathing human being: an underwriter.
When a borrower would make an application for a home loan, an underwriter would look at other credit accounts. Some that had a credit limit with a low or zero balance. If the potential borrower had any past history of running up his credit line to or beyond his credit limit, it would make an underwriter nervous. What if a borrower who was pushing his debt ratios to qualify for a home loan would suddenly go out and buy a boat, a new car and take a trip to Cozumel right after he closed on his mortgage loan? Suddenly that new homeowner might not have the ability to pay his brand new mortgage.
From another prudent point of view, having old, unused credit accounts simply should be canceled should anyone ever attempt to steal an identify or otherwise charge something on an old card. But that's old school. Here's the new school.
Lenders now rely on automated underwriting systems which also rely heavily on credit scores. Credit scoring is a secret science with algorithms designed by a company called Fair Isaac Corp., sometimes called FICO, a registered trademark of Fair Isaac. And I certainly don't have the secret formula. But FICO has made it known that the top five things of which a credit score is comprised include payment histories (35% of your score), amounts owed (30%), length of credit history (15%), new credit accounts (10%) and types of credit (10%). But notice the second item: amounts owed.
Amounts owed, which makes up nearly a third of your score, means the amount of money you owe on credit accounts compared to available credit. Certainly if you had a $10,000 balance and your credit limit was $8,000 then you would be over your limit and targeted as a person not currently responsible with your credit. Your scores would dive.
On the flip side, credit scores are nice to people who show the ability to buy things on credit and make regular payments. If you have an $8,000 limit and your balance was $2,500 then the "amounts owed" section of your credit score would be handsomely rewarded and your scores would rise. But you need to have a balance that you pay on each month which means you also need to have an open credit account.
Scores seems to favor accounts with balances at approximately one third of their available limit and not "zeroed" out. That makes sense if you think about it, a credit history can only be evaluated if you actually charge something and pay it off on a regular, monthly basis. This means two things: carry a small balance and whatever you do, don't cancel credit accounts with zero balances unless your total "amount owed" still equals somewhere around 1/3 of your available balance.
That means that if you have three credit cards that each have a credit line of $5,000 you would have a $15,000 cumulative credit line. Let's also say you transfer two of your credit card balances of $5,000 to just one card and cancel the other two; you would have one card with a $5,000 balance and a $5,000 limit. Your score could be hurt because now your "amounts owed" is at 100% of your available credit.
Closing unused credit accounts, while perhaps a prudent move, need to be examined more carefully because of the "amounts owed" category in credit scoring. Don't charge up as much as you can. And certainly don't close old accounts just because it used to be "the prudent thing to do." Because if you want to heighten your scores, it's a whole new school of thinking these days.
Real estate finance expert David Reed is president of CD REED Mortgage Bankers in Austin, TX and author of Mortgage Confidential: What You Need to Know That Your Lender Won't Tell You and Mortgages 101: Quick Answers to over 250 Critical Questions About Your Home Loan.
Reader Comments (Page 1 of 1)
7-22-2008 @ 7:06AM
Carl Camera said...
David, this all seems backwards. You're advocating that I adjust my lines of credit and credit balances to appease a flawed computer algorithm. No offense, but closing old unused zero-balance accounts is just plain good financial sense. I don't need that identity theft exposure thank you very much. If the FICO algorithm cannot figure out from my account history that I am acting in a financially responsible way, then the FICO algorithm needs adjustment. I'm still old-school on this topic and I refuse to let the tail wag the dog.
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7-23-2008 @ 11:52PM
Richard said...
Having worked at a bank I was told that those open credit cards still count towards a possible expense [as seen by the 3 credit bureaus]. In other words when we put in a client's numbers to see their credit report, if they could be approved, that first of all lowered their score by a few points [which would be not important if over 700-720, but could hurt them for 6 months or so if around the approval level of 650].
But we understood, and the bank was not clear on this itself [!???!], that an open account, a credit card or home equity line of credit [heloc], counts as "possible spending, like even tomorrow." So a heloc of $ 50,000, even if none was used for years, appeared as a [potential] 50k loan! Because it was, just not being fully used.
It was amazing how this department, selling heloc's mostly, was not expert in these matters and certainly didn't want us to educate the clients on too much [or they might not put in for or increase a heloc]. I also tried on my own to get more specfic information from the 3 credit bureau's and they were not very helpful either, with vague answers, implying that it was best for the rest of us to be in the dark about their methods.
We may not like some of it naturally. One client correctly said that because he moves around doing electrical work it lower's his scores; so he could be making good money but every time he reports a new address, probably to any significant account, it lower's his score as it is felt "those people are more credit risky."
I think we should appreciate that Congress years ago made the standards tougher and more fair, but we should call or write them to improve. The 3 firms also, having talked to thousands of people, have a bad rep for not responding well to questions about errors. Congress said they have to, BUT the co's can take their time and it can take quite an effort to correct. One man said he had a large bill from a hospital against his record, yet had never even visited it. The credit score companies tend to take corporate America more seriously than the average citizen.
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7-24-2008 @ 3:44PM
Carlos said...
David, here is what I did; my son is getting ready to start college.
So I added him as an authorized user to a Visa, and Amex cards, with credits of 25k; opened back in 1978. My son is only 19 years old and he went from a no credit score to 746.
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7-24-2008 @ 11:14AM
brad said...
what if he opens an account on his own and defalts will that come back on your credit or just his
7-24-2008 @ 2:00PM
Judy said...
Carlos I heard that the credit bureaus are going to not look at authorized users on credit reports. They are doing this because credit repair businesses are having their clients get on other people's accounts as authorized users to boost the person's credit score. Has anyone else heard this?
7-30-2008 @ 1:34AM
Northlander said...
I know credit card companies hate people like me, but does anyone know if it hurts my credit rating to pay off all my credit card debts every month to avoid paying interest? I do have one account I have been paying 1.99% on, but I've never paid late, and I have never used the card. I just made a balance transfer to that great deal.
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10-09-2008 @ 11:42AM
odessajohnson4 said...
I have a different situation; I've tried unsuccessfully to sell my small townhouse for over a year. In July, I learned that I could rent it out for 2 years (guaranteed rental), while purchasing a single family home with an additional much needed 1200 sq. ft of space. My loan (through Countrywide was approved); the permit was submitted. Yesterday, the loan officer called to say that effective October 1st a new FHA guideline had come into play so that it's likely I'll not be able to proceed with the construction of my home. He said that through the automated appraisal that my townhouse does not have the 25% equity that is now needed? Can you speak more to this, and, where does that leave the thousands of others (possibly like me)?
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