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The Debt Conundrum

I hate debt, particularly credit card debt.  In fact my family and I have set a family goal of living totally debt-free (no mortgage, no car payment, nothing) in 6 years.  Debt is very deceiving.  It doesn’t seem like a big deal when credit is cheap - meaning very low interest rates but it will bite you in the butt when interest rates increase.  Debt, particularly lots of it, can really limit a family’s savings plans.  What is also very frustrating is that our economic system is set-up to encourage more debt!

This article from Bankrate.com is an example of my frustration with our economic system.  This article provides very practical tips about handling credit.  The one tip that is very practical but extremely frustrating is this one:

1. Close Credit Card Accounts

A quick way to guarantee that your credit score plummets faster than Lindsay Lohan’s career is to slice away your available credit by closing accounts.  You see, credit scores are not built around common sense. Doing away with unused lines of credit would make sense to most human beings, but not so much to a credit scoring model.  “Many of the things that can lower your credit score are kind of counterintuitive,” says Melinda Opperman, counselor and vice president of community outreach for Springboard, a consumer counseling organization.

When you close an account, it no longer adds to your total amount of available credit.

“There is a big chunk of your credit (score) that is factored on the amount owed—30 percent of your credit score. So one-third of your score measures the amount of debt against the credit limit,” Opperman says.

Without changing your level of debt, lowering the credit available to you throws the ratio of debt to available credit out of whack.

For consumers with very low balances, closing newer credit accounts, slowly, can make sense—especially if the cards sport high interest rates or charge annual fees.

But having too much credit will rarely be a problem.

“In years past there was kind of a myth that said if you have just way too much credit available, you have the risk of being potentially overextended because you could access that much credit right away,” Opperman says.

It’s still true that when consumers go to take out a home loan, some mortgage lenders may assess the amount of credit available to them and take that into consideration when evaluating their creditworthiness.

“If someone were planning to purchase a home and it was suggested that they close some accounts, the borrowers would want to do it well before applying for a loan and a few months apart—and make sure that the accounts that they closed did not have too high of a credit limit,” Opperman says. “But in general, having a robust credit file will not be an issue.”

Furthermore, only recently opened accounts should be considered for closing. Length of credit history is an important component of the credit score.

According to John Ulzheimer, president of consumer education at Credit.com and contributor to CNBC, the ideal credit customer is one with 20 years or more of credit experience—and you want that good history on your report. Closed accounts will drop off of your credit report.

“The sweet spot is someone who has 20, 30 or 40 years of credit experience and many, many accounts to look back on,” Ulzheimer says.

What kind of crap is that?  Closing credit card accounts may actually hurt your credit card score.  What a better way to encourage people to take on more debt is to say we, the credit bureaus and debt industry, will penalize you for closing accounts. 

The catch is that by closing credit card accounts we are lowering our total available credit.  Lowering our total available credit can throw-off a ratio that credit bureaus use when establishing our credit score.  The fix is in.

It gets better.  Here is another tip from the article:

2. Let Credit Cards Collect Dust

Consumers shouldn’t necessarily close their credit accounts, but burying cards in the backyard or hoarding them in a shoebox in case of an emergency also may backfire.

Creditors are loathe to let just anyone have vast sums of potential money at their fingertips. Lately lenders have taken a use it or lose it attitude—preferably lose it.

Consumers encounter two pitfalls if a creditor closes an account for nonuse: The available credit is pared down and that account no longer contributes to their credit history.

If an open account is unused for a long enough period of time, the company can stop reporting it to the credit bureaus. If the account goes unreported, that account is not contributing to your available credit, which affects your credit utilization ratio.

The FICO score isn’t an award or demerit system, but a predictive score that tells lenders what you might do in the future.

“The FICO score looks at how recently the information was reported, so, if say, a credit card trade line (credit card account) hasn’t been reported in X number of months, then we will not include that information for certain calculations, basically any calculations that look at dollars,” says Barry Paperno, consumer operations manager for Fair Isaac and head of myFICO.com’s consumer education and advocacy.

That includes the amount of debt you’re carrying relative to the amount of credit available.

Plus, the fact that the creditor took action to close the account is also noted on your credit report.

“Some folks feel that because there is the narrative there, it is less desirable for it to say closed by creditor rather than by the consumer. However, I wouldn’t have someone be overly concerned with that because the narrative isn’t picked up by the credit score,” Opperman says.

“But it would be better if consumers were not going to use an account to either close it themselves, or if they want to maintain that credit relationship, we suggest that people use their cards periodically,” she says.

Got that - it is not enough to cut-up the credit card and not use it because the credit card company may take away unused credit lines.  And if it shows up on our credit report that the credit card company closed the account that doesn’t look good despite paying off the balance and not using it.  Incredible. 

We have to be very strategic and careful when closing credit card accounts.  Unfortunately, it is can hurt us if we decide tomorrow that we are paying off all those credit cards and closing the accounts.  This is the system we are operating in and it is best we understand the implications of closing credit card accounts before doing so.  This is sad.

Good luck.