The formula for building a good credit score is pretty simple — pay your bills on time, keep your balances low and don’t go crazy applying for new credit. Those are all smart rules but there are certain scenarios where going against the grain can work to your advantage. Here are four times where a short-term hit to your credit can pay off in the long run.
1. You need to increase your available credit
One of the things lenders look at when making credit decisions is your utilization ratio. This is the amount of your total credit line you’re using. Ideally, it shouldn’t be more than 30 percent and the higher the ratio is, the more it drags your score down.
Opening a new credit card account or two to increase your total credit line can even out your utilization ratio if you’re using a big chunk of your available credit. The only catch is that every application counts as a hard inquiry on your credit report. Inquiries make up 10 percent of your FICO score and every new one that shows up can knock five points off.
So why does it make sense to open multiple accounts if you’re trying to build credit? While inquiries can stay on your credit report for two years, they only impact your score in the first 12 months. Once you get past the initial dip, you should see your score start to increase as long as you’re maintaining a low utilization ratio. That means not running up huge balances on the new cards.
Tip: Choose a credit card that offers free access to your FICO score so you can see what kind of progress you’re making each month.
2. You want to diversify your credit mix
Another 10 percent of your credit score is based on the types of debt you’re using and they’re not all created equally. Loans carry a different weight than credit cards, which factor in more heavily than medical bills. The bottom line, however, is that lenders want to see that you’re able to handle multiple types of credit responsibly.
If the only debt you’ve got is student loans, for example, that’s not going to drive your score up, even if you’re making your payments faithfully each month. Opening a credit card on the other hand can balance things out when your score is on the low side. The trade-off is that the inquiry is going to show up on your credit report so you’re going to take a penalty for mixing things up.
3. You need to establish a payment history
At 35 percent, your payment history makes up the biggest part of your FICO score. Building good credit is an uphill climb when your score is low or close to zero because you’ve never had any credit before. That’s where a credit card comes in handy but it’s something of a catch-22.
To establish a payment history, you need to have something to pay off. That means running up a bill on your credit card, which in turn impacts your utilization ratio. If you’re doing the smart thing and paying it off in full each month then your ratio won’t really suffer but if you’re not, that can hinder the progress you’re making with improving your score.
Tip: Use an app like Mint to keep track of all your card balances.
4. You’re getting a terrible deal on one of your cards
Shutting down a credit card account hurts your score in a couple of different ways. First, it affects the overall age of your credit history. The longer you’ve been using credit, the more favorably lenders are going to look at you. If you close a card that you’ve had for several years, your average credit age drops. The other problem with closing a card is that it shrinks your available credit, which directly affects your utilization ratio.
Still, there are some instances when keeping a card just isn’t worth it anymore. For instance, if you’ve got a rewards card that carries a high annual fee, it can end up costing you money if you’re not earning enough points or miles to cancel it out. The same goes if you carry a balance from month-to-month and you’re being gouged by a high APR.
Transferring balances to a card with a lower rate is an easy work-around but there’s still the question of what to do with the old account. Closing it down is best if it’s got a high annual fee that the credit card company isn’t willing to waive. It also makes sense if the account is relatively new and you haven’t established a lengthy payment history.
Yes, your score will go down but it’s not a permanent reality. If you’re keeping the balances low on other accounts and practicing good payment habits you should have no trouble earning back the lost points.
Your credit score won’t magically improve on its own and if you’re not doing anything to help it along it’s guaranteed to go nowhere fast. Each of the steps we’ve described here require a little sacrifice up front but the end result is a higher score.
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