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Bizarre Factors that Can Affect Your Credit Rating

May 7, 2019
Small Business

Anyone can end up with bad credit–sometimes from being irresponsible, but often from unexpected things like losing a job or big medical bills. What many people don’t understand is that your credit score is determined by multiple factors, some you may not have considered.

For example:

Julia got a sudden windfall, and decided to pay off a high-balance credit card with it. She took a look at all of her accounts while she was at it, and noticed there were a couple she hadn’t used in years. Concerned about the possibility of fraud, Julia thought it would be a good idea to close these accounts, and she did so. The following month she checked her credit score, eager to see how much it had improved since she paid off the high balance card. She was astonished to see that her score had actually gone down!

Why? Because when she closed out the cards she hadn’t been using, her available credit on these cards ($5,000 each) was gone. So even though she had paid off another card with over $3,000 on it, the ratio of her available credit versus the amount she was utilizing deteriorated. Another factor was the age of the cards she had closed. These were store cards that she had opened more than 15 years ago, while living in another town. They were the oldest cards she had, and that really matters. Even though she hadn’t used them in several years, she had established a good payment history on them. That history dropped off when she cancelled the cards, along with the age of the credit history. The average age of your credit accounts has a significant impact on your overall score.

Shopping Around is Good, Right?
Here’s another example of how you can damage your score:

John got a great job offer in a new city. A big boost in pay, benefits, the works. The company would even pay for the move, so John’s financial future looked bright. His wife Sarah was excited too, and began to look at houses in the area, and shop mortgage rates. She was also happy because her old car was on its last legs, and they could finally afford a new one. She went down to the dealer to see what the trade-in value was, and look at the new cars on the lot.

These were all innocent activities, and John and Sarah always paid their bills on time...but their credit still took a hit. Because she was shopping around, there were several new hard inquiries on their credit report. If Sarah had only been shopping mortgage rates it wouldn’t have been so bad, because credit bureaus can see the type of credit you’re shopping for and conclude that you are comparison shopping. But the auto dealer had made a hard inquiry too, and that hurt them.

Another thing Sarah didn’t consider was the new utility accounts they would need to establish when they moved. The electric company, the gas company, the water company, the phone company, all of these would probably make hard inquiries before opening a new account for them. All of those inquiries, on top of the ones she had initiated, would definitely have a negetive impact their score.

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Be Smart About New Credit Lines
The lure of “free money” is difficult to resist. If you are planning a big appliance purchase, a new washer and dryer for example, it’s hard to resist applying for the store card that gives you a “$100 credit and free financing for 18 months!” Of course, the fine print specifies you have to spend over $2,000 to qualify, so you suddenly find yourself looking for things you can buy to reach that amount. You leave the store feeling proud of yourself, the owner of a new washer and dryer, and that roto-tiller you’d been eyeing. It was a perfect opportunity!

Here’s the catch: Miss one payment and that interest-free financing turns into a 25% APR. Of course, they also performed a hard inquiry before granting you the credit, which is fine if there are no more big purchases in your immediate future. Not so good, however, if you were also planning to buy a new car in the next six months. The increased APR on the car loan will cost you way more than that $100 of “free money” the store card gave you. On the flip side, if you get new credit accounts, and pay them down quickly, this increases your overall amount of available credit, which should improve your utilization ratio.

Who Judges Your Credit and How Do They Do It?
There are three major credit reporting agencies, Equifax, Experian, and TransUnion. They all have slightly different algorithms to determine credit-worthiness. Your FICO score is actually determined by a company called FICO, that uses predictive analytics to forecast consumer behavior. They use information provided by the big three to determine how likely someone is to pay their bills on time, and whether or not they are able to handle a larger credit limit.

Your payment history is the most important factor and makes up 35% of your FICO score. The next thing lenders look at is your “utilization ratio” or how much of your total available credit you are using. They like to see it under 30%, and it accounts for 30% of your score.

The third thing they consider is the age of your credit. This accounts for 15% of your score. New credit inquiries, and the variety of accounts you have make up the remaining 20%.

It’s All About Perceived Risk
It’s ironic that those who are struggling financially are the ones who pay the highest interest rates, while financially secure people with good credit typically get the lowest rates. Credit issuers think the probability that the wealthier person will pay them back is much higher, so they get a favorable interest rate. Meanwhile, the financially strapped will be saddled with a higher interest rate, which means the person who can’t afford it will end up paying much more if they finance the same item. (No one said life was fair).

Businesses Need Credit Too
If you are a small business owner, you have a lot going on, and a solid credit rating is important. You may need equipment loans, or perhaps you will have to borrow money to make payroll during a slow income month. Regardless of your situation, keeping your credit in good shape is essential for a successful business. If you ever find yourself in a situation where you can’t pay your quarterly payroll taxes, you’d better scramble, because the last thing you want is to get in trouble with the IRS. If you don’t have time to keep up with everything, Halon Tax can help. Don’t wait until it’s too late! Call us today at 612-293-8094 or email us at support@halontax.com.

Christopher Ragain, CPA

Christopher Ragain, CPA is the founder of Halon Tax and one of the industries top authorities on micro-business taxation and tax planning.

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