FICO Algorithm says “Don’t Consolidate!”
ARDELL on 06 28, 2007
I found this great chart over at Christine’s Active Rain Blog. 30% of your credit score requires you to have 70% or more of available credit on your credit cards! WOW! That’s important to know! In other words, credit limit $9,000? Then available credit should be $6,300 or more.
Coming from a poor family, we learned about credit issues from my really smart Mom. She said, if we don’t have enough money to pay ALL the bills, then pay the mortgage first, and then pay the car payment and pay the phone last. Back then, phone bills and utilities didn’t show on a credit report. Today we need to know different things, but the same concept that our choices affect how lenders view us, is still just as important, and this graph gives a great visual we can learn from.
[photopress:fico.gif,full,alignright]
Today most things DO show on a credit report, but still, we all make choices that can affect our credit. Like consolidating three credit cards and thinking one at full credit limit is better…it is NOT!!! I actually didn’t realize how heavily this section was weighted until I saw this pie chart, so I ran over here to post it after I stole it from Christine 
This is VERY important to know!
High balance. - “Johnson estimates that you lose 1 point for every percent of your credit limit that you use. So if you have a total credit limit of $10,000 and have an outstanding balance of $4,000 (40%), your score would be 40 points lower than if you had a $0 balance. Ideally, credit experts say, you never want your balance to exceed 30 percent of your credit limit.” (MSN.Com)
I don’t like the idea that it is better to have $1,000 on three cards with a credit limit of $5,000 each, than it is to have one card with $3,000 and a credit limit of $5,000. In fact it’s pretty sad that you have to have more than 3X the available credit you need in order to keep your credit score high. It is particularly sad that you need to make three minimum payments, instead of one consolidated payment, in order to be viewed favorably by an algorithm. But good to know that is how we’re expected to handle our finances to please the almighty FICO algorithm.
Technology impacts our lives, and whether some of these changes make good sense or not, they are a fact of life. Those who fight these changes and wish they would just go away, are only hurting themselves. Since your score can affect your interest rate, and cost you many thousands of dollars over the life of your mortgage, better to grin and bear it and handle your finances “as expected” by the algorithm.
When it comes to managing your credit score, you have to ”see the forest for the trees” That graph is a fabulous “aerial view” of the credit score “forest”.
We all wish for the good old days when paying our bills on time meant good credit. But now that paying your bills on time is only 35% of what matters, we need to pay closer attention to the algorithm that SO impacts us when buying a house. So let’s all shake our fists up to the sky and complain that 30% of our score is impacted if we consolidate. Then we need to resolve ourselves to the fact that we must buckle under and spread out the debt, so that no credit card has less than 70% of available credit. It sucks…but whatcha gonna do…
About the Author: Ardell DellaLoggia
- Author's website: http://www.realtown.com/ardell/blog
- More posts by ARDELL
- email the author
16 Responses to “FICO Algorithm says “Don’t Consolidate!””
Leave a Reply
Live Comment Preview
Popular Posts
Recent Posts
Recent Comments
- Jerry Gropp Architect AIA: That's not so good.
- Jerry Gropp Architect AIA: As to "you must be s
- Rhonda Porter: Some of the fine tun
- Rhonda Porter: you must be so excit
- Jerry Gropp Architect AIA: Hi Rhonda- Good to s
Ardell, this is why consumers should meet with their Mortgage Planner once a year to review their credit. It’s ideal if they can meet with a Mortgage Planner at least 6 months before buying a home. Then if credit needs to be “shifted” to obtain a below 30% use of their credit limit, they can work on that. Sometimes borrowers are better off paying down a certain account than paying off one, when in comes to improving credit scores. 50% is the next level where scores are dinged…so if you have cards just over 50%, you may want to consider that.
Credit scoring is one my big beefs with this industry.
Ardell, this is such a great article, and it stuff most consumers and even a lot of people in our industry don’t know. I knew the credit agencies didn’t like to see a bunch of maxed out cards, so I always tell people the best thing you can do is pay on time, and pay down on your cards. But I think for a lot of people who have too much debt, that is a really daunting prospect. Giving them the percentage of balance to limit that will benefit them the most might make it seem more doable.
This one sentence was SO ENORMOUS! it bears repeating here:
“you lose 1 point for every percent of your credit limit that you use. So if you have a total credit limit of $10,000 and have an outstanding balance of $4,000 (40%), your score would be 40 points lower than if you had a $0 balance.”
It totally sucks that having a $4,000 balance on a $10,000 limit card can impact you to that extent. I mean REALLY?!?! But like it or not…it’s important to know. That’s for sure.
[...] Check out Ardell’s blog on this for the full story. http://www.raincityguide.com/2007/06/28/fico-algorithm-says-dont-consolidate/ [...]
One thing to remember is that a FICO score is not a measure of a borrowers fiscal health. It’s measure of their ability to pay their debts on time.
I always make sure my customer knows the difference before advising them on boosting their ranking.
I wish that were true Todd. But when only 35% of the score is paying on time…I don’t think your statement is correct. Unless you are saying the pie chart is incorrect. In which case…please elaborate.
I believe what Todd is saying is that there can be a difference between being in a good place financially and having a high FICO score.
If you make $30,000 per year and have three credit cards with $4,000 balances and $15,000 credit limits each that have all been open for a long time with the minimums paid on time each month, plus a car loan at $500/mo for 6 years you are consistently making payments on, you will likely well have a high FICO score. Your FICO score meaures your ability to pay your debts, and you are doing so well.
However, your fiscal health is quite poor. You owe $12,000 + the car loan on a $30,000 income. Your debts are a staggering amount compared to your income and, unless the credit card debt was incurred buying appreciating assets, are fully related to things that depreciate. You may have a high FICO score, but I wouldn’t want to lend you money – you really need to better learn to live within your means and spend less.
Having multiple lines of available credit means that a borrower can better handle being unemployed for a short period of time, paying for a blown engine in their car, or robbing Peter to pay Paul in making their credit credit card and mortgage payments on time.
Credit companies don’t care if using that credit will diminish the borrowers overall fiscal health, just that it means they will still be able to pay on time. They also know that the borrower earned those limits by being a good customer in the past.
Example: If all else was equal, a borrower with $500 in debt on a credit card with $750 limit would have a lower credit core than a borrower with $5000 in credit card debt on $10,000 in open lines of credit. Borrower #1 could be an excellent saver, who pays cash for everything, and has a nice fat 401K. It doesn’t matter, because he hasn’t proven he can pay his bills on time. Borrow B could be buying his groceries on his card, living paycheck to paycheck. All the credit company cares about is that he’s proven in the past that he can handle a large amount of debt.
hmmm, interesting answer Todd. I like that there appears to be a reason for wanting people to have three cards with lots of available credit.
BUT what if someone has $100,000 in the bank and one really good low rate credit card that is at 80% of limit? Using credit to get by if you lose your job is not as good as having savings for that, seems to me.
Seattllite,
But isn’t it still better to consolidate debt, keep your required payments low by having one instead of three to pay, and have one card with a really good interest rate than three cards? I’m not getting that part. Why should FICO penalize someone for not spreading out their debt to different cards?
Exactly, using credit cards to get by is not good fiscal advice! That is why I caution people when they ask how to raise their credit score.
Credit companies have no way of knowing how much money you have saved. They can only go on your credit history to make a decision. That’s why credit scores are only part of the equation on bigger loans like residential mortgages.
Ardell, the reason they want to see the debt spread out is because it show they can handle writing three checks a month instead of one. That’s simplified, but basically true. It’s their ability to manage three lines of active credit that they are getting bonus point for.
Todd,
Makes sense from an algorithm’s standpoint
On some “breakpoints” where rate is affected, like 640 vs. 680, these little hairs of difference can affect a borrowers interest rate, correct?
So even if the “story” reveals $200,000 in savings, the borrower could still end up with a higher rate for a score of 640 vs. 680. Is that right?
If the borrower pursues a path of better fiscal health, they’d likely be better of any way. With a 640 FICO, if you can put down 20%, and have 30% debt ratio, your going to get a heck of a lot better deal on a mortgage than the 680 guy putting 10% down.
Also the 640 – 680 hit you mention could be as little as .125 points, or $500 on a $400,000 loan. Running all that higher interest credit card debt over the years could mean a whole lot more than that. On top of that, FICO hits are usually more common, and costlier on elevated risk loans. ARM’s Stated Income… If the borrower is a good saver and has a stable income, they are less likely to need these programs in the first place.
Credit scoring is a pretty screwy system. If a borrower has excellent credit and is offered a super low rate credit card and they transfer all their balances to it…they’re penalized if the balance is over 30% AND again if the it’s for the new credit card. (new debt dings you). AND AGAIN…if they closed their old accounts (credit scoring prefers established accounts).
Ardell – Sorry I did not get here sooner – I have been crazy busy in the office and out. I love your spin on it.
Here is one thing that I did not touch on either was the CELL PHONES. Cell phone bills and past dues come up on credit scores all the time. I am not sure how much they affect, but I know ALOT of people who want to cancel a service with one provider to go with another and they don’t pay the “early cancellation fee” and the next thing you know there are past dues popping up on the credit score. I am curious to know HOW badly that affects a score.