By now, pretty much everyone knows how important it is to maintain the best credit score possible. But so many myths surround scoring that it's difficult to pin down good practice, and it's perfectly possible to accidentally make things worse while you're trying to make them better.
Credit Scores and Common Sense
Your credit report (aka credit history) is an electronic file -- at least until it's printed out -- containing a whole lot of information about your financial past. Your credit score is a three-digit figure calculated using that information by highly sophisticated computer algorithms. On the whole, your score is likely to be a pretty accurate indicator of your creditworthiness, but those pesky algorithms sometimes throw up some -- usually temporary -- anomalies that seem to go against common sense.
One of these is that paying down and closing an account often results in a slight decrease in your score in the short term: maybe three months, according to VantageScore, one of the companies that builds scoring systems. That's because sudden, large changes -- even good ones -- in your financial circumstances are generally perceived as a sign of instability, at least until your continuing history shows it's not.
Paying Down Debt Is Good
Once that three months (or whatever; different scoring systems may make that period a bit shorter or longer) is up, your score could well bounce back to a higher figure than before you closed your account. However, that's likely to depend on other items in your report.
Even if you were lucky enough to be able to completely eliminate all your debt, and closed all your accounts, it would still take a while for the impact of old issues, such as missed payments and defaults or bankruptcies, to fade away. Don't misunderstand: paying down all or some of your borrowing should almost inevitably have a positive or very positive effect on your score in the medium and long term.
Closing Accounts Can Hurt You
However, having no debt at all could create another issue: If you have no active credit accounts, credit bureaus have no transactions to record, and eventually you could end up with no credit report and no credit score.
In addition, 30 percent of your FICO score is determined by credit utilization -- how much of your available credit you're using. If you owe $1,000 and your credit limits total $10,000, that's a ten percent utilization ratio, which is good and helps your score. But if you close out $9,000 of your credit lines, your utilization jumps to 100 percent, which is very damaging to your score. Pay balances off, but don't necessarily close the accounts.
Paid Bad Debt Doesn't Instantly Go Away
One of the most persistent myths surrounding credit scores concerns paying down bad debts to collection agencies. Many consumers believe that settling with agencies removes such accounts from credit reports, and therefore stops them from depressing scores. This is almost never true. In fact, making payments on a very old outstanding debt can worsen your score. That's because older accounts are given much less weight by scoring models, but any activity on an account makes it new and increases its weight.
The record of the bad debt is going to remain for years, and its impact is going to fade away only gradually, at least unless you take action. You could include its deletion from your report as a part of your negotiations with the collection agency, but you need to receive an understanding in writing from the collectors in order to make that actually happen. Even then, the original debt would remain on your report, and you'd have to launch a charm offensive on the original lender to get that removed. Legal website NOLO has a helpful article on this subject.
Timing Is All
It's a great idea to get your credit report looking as good as possible before you apply to open a major new account, such as a mortgage, auto loan or HELOC. Generally speaking, the higher your score, the lower the interest rate you're likely to be offered, and that can make a huge difference to the total cost of your borrowing when you're looking at big sums over years or decades.
However, it's probably best to get to work on your report at least six months before making such an application. If you leave it until the last minute, you may find you just make things worse.