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We like to think that when we deposit a dollar at the bank, it goes into a big vault and we can pull out that same dollar at any time. But that¿s not how the U.S. banking system works. Banks take that money and invest it to make money themselves, so cash gets spread around. This, naturally, leads to a big risk: What happens if those investments go sour? Well, you¿d be out of luck. You can¿t get your dollar back.
The Federal Reserve doesn¿t like that scenario, so it prohibits banks from putting all the cash it has on deposit on the line. In fact, the Fed forces banks to keep a portion of their assets at the Federal Reserve itself, to make sure that some of your assets won¿t get squandered if the bank¿s bets go south. These are called ¿reserves,¿ (hence, Federal Reserve. Got it? Good), and usually amount to 10% of the total cash kept in checking accounts.
These reserves are never exactly 10%, and banks like to keep a little extra in reserve ¿ not, as you might think, to make you more comfortable that they¿re in good financial shape, but rather so they can take that excess and lend it to other banks and make money off it. (They¿re banks, they can¿t help themselves.) The rate at which they make these loans is called the Federal Funds rate, which is set by the Federal Reserve¿s Federal Open Market Committee.
When you hear people chattering about how the Fed cut or hiked interest rates, this is what they¿re talking about: the interest rate banks can charge for lending money from their reserves. This begs the question: If these are essentially loans between banks, why is the Fed Funds rate so important for the rest of the economy?
Well, simply put, because loans make the financial world go round. Bank A lends Bank B $10,000 at a Fed Funds rate of 5%. Bank B then lends out $10,000 to a small business at 7%. The small business then takes that money and expands the business and hires new workers. Now someone is employed, Bank B has made interest off the loan, and Bank A is the richer for making it all happen. It¿s perhaps overly simplistic, but you get the idea. When you want the economy to thrive, you make lending cheaper.
Of course, sometimes you don¿t want the economy to thrive. In fact, you might want it to cool down, mostly to avoid money flooding the system and causing inflation. In that case, the Fed raises interest rates, making it difficult to lend or borrow.
Home / Personal Finance / Lifestyle & Money / Consumer & Debt
Friday, March 28, 2008
Closing Credit Card Dings Credit Score
Leslie McFadden
Bankrate.com
With no clear-cut answers as to how specific actions impact a score, consumers must resort to trial-and-error credit management, or they do nothing for fear of making any changes that might damage their credit ratings.
We decided to touch base with readers to see what they wanted to know about FICO scores. From the responses to our newsletter call for questions, we learned that many people wondered about the impact of closing credit cards and keeping inactive cards, as well as improving their scores and re-establishing credit.
We posed five reader questions to Fair Isaac product support manager Barry Paperno, who has worked for the credit-score keeper since 1995. Here he talks about the ins and outs of closing credit card accounts. (His discussion of the effects of foreclosure and how to build a good credit score will be reported in an upcoming article.)
Credit scoring misconceptions
A FICO expert discusses popular misunderstandings about closing accounts and department-store cards versus bank credit
cards.
5 questions for Fair Isaac expert:
Will closing lesser-used low-credit limit (less than $5,000) credit cards or lines of credit harm or help our overall credit scores, given two or three other higher-limit accounts?
I'm going to start by providing a couple of misconceptions that I hear regularly with regard to closing accounts. No. 1, that the FICO score penalizes you for having too much available credit, and No. 2, that if you close an account, you lose all the history associated with that account.
It's just not true that you can have too much available credit. That by itself is never a negative with the score. Sometimes the things you do to get too much can be a problem, such as opening a bunch of new accounts, but for the most part, that's just kind of an old wives' tale.
In terms of eliminating the history, the short answer is, that no, it does not eliminate the history. You can have a closed account, an account you haven't used for years, and if it's still on your credit report, if that account is 20 years old, you're getting credit for having 20 years of history for that account. As long as it's on the report, you get credit for the history.
Will closing a lesser-used low-limit account help or hurt your score -- that depends, and it depends mostly on how much you owe in relation to your limits on all of your accounts. For example, one of the most heavily weighted factors in the scoring -- and this accounts for about 30% of the score -- looks basically at your ratio of balances-to-limits on your credit cards. This is the area we call "amounts owed," if you're familiar with the five areas that the score considers. What's most important in terms of the scoring is credit card debt versus installment debt, such as mortgage or auto loans.
So, is there ever any reason to close a credit card, from a credit score perspective?
Not from a scoring perspective, no. There really is never any good reason to close an account. I don't get to say that about too many things that have to do with scoring because usually you're going to hear a lot of "it varies" -- because it does. I can tell you one other way that closing an account can hurt your score: Once it's paid off, that account will be on your credit report for no more than 10 years.
An account that is open with a good history can stay on forever -- it could stay on for 20 years. The bureaus will automatically remove (a closed account) in 10 years, but that could be removed sooner if that credit card issuer decides to remove it. Once it's closed and paid off, that account then becomes inactive, and it's not uncommon for the credit card issuer after a few years or even sooner to just delete that completely, just purge it from their records.
In the short run, you maintain that history. But once that comes off your credit report, you lose that good history. One of those five areas that the score considers looks at how long you've had credit -- that accounts for about 15% of the score. That may or may not impact your score a lot depending on your other accounts. If you've only got a few accounts, that could impact it heavily; if you've got a lot of credit for a long period of time, that will probably not impact it by much, if at all.
Is there a difference between the issuer canceling the card versus you closing it yourself?
Good question. That would be a good No. 3 for the misconceptions. No, there is no difference at all. That's a good one.
Even though on the credit report it will indicate "closed by consumer" or "closed by creditor,"
the score only cares whether it's closed or open, but not by whom, even though it will say so on the report.
No. In terms of the credit card utilization, it does not impact. My only hesitation (is) in the long run there could be a difference, and that's going back to those five areas (which make up your credit score). The credit mix (is) like 10% -- and that looks at the proportion of different kinds of credit. The big categories would be credit cards and mortgages and auto loans. But then within credit cards, it breaks it down into whether you have bank cards or department-store cards. If you close off all your bank cards and they get deleted from your report in a few years, and all you're left with is department-store cards, that can hurt your score a little bit. Down the road that can hurt you, but that's a very minimally weighted part of the scoring. For most people, it's not going to matter a whole lot.
But if the reverse was true and you closed all your store cards, and just had regular bank credit cards, would the impact be the same?
That would hurt you less, potentially, because the bank cards count for more than the department-store cards, all things being equal. If you have to be without one, you're better off being without the department-store cards.
For many people, a store credit card is their oldest card. If they no longer want that card, would it hurt their score to close it?
When that (the card) comes off, if that's your first card, it has your longest history. Now of course it depends again on how long you've had your other cards. If you had that one for 20 years and you've had your other ones for 18, it's not anything to be concerned with. But if you had that one for 20 and then the rest of your cards you got in the last six months, and that one comes off, that could impact you a little more.
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