How Does Closing a Credit Card Affect My Score?

January 8, 2022CreditBy toptierfinancial

The NFCC often receives readers questions asking us what they should do in their money situation. We pick some to share that others could be asking themselves and hope to help many in sharing these answers.

This week’s question: I heard my friend closed her oldest credit card of 4 years and lost all of that credit and her credit score went down. I have one year of credit on a credit card that has a $98 fee after one year, if I close the card do I lose all my credit?

Generally, you can expect your score to drop when you close a credit card, especially if it is your only credit card. So, consider keeping it open. However, if you are primarily motivated to close this credit card to avoid the $98 annual fee, you may have the option to downgrade your credit card for one that doesn’t have an annual fee. Contact your credit card and ask about your options. This way, you can keep your account and its history on your credit report. You could also consider adding another credit line to help you establish a new credit history if you need to close your credit card for good.

But there are more critical factors that impact your score. Understanding what factors influence your credit score can help you understand how your credit score could be affected if you close a credit card and what you can do to build it back up.

What goes into your credit score

Your score is calculated using a secret formula based on the information on your credit reports. Five common factors influence your credit score. Below, we explain how these factors affect your FICO score, which is the scoring model most lenders use. Other scoring models, such as the VantageScore, use a similar system to calculate your scores.

Payment history (35%): This part of your score takes into consideration whether you make on-time and complete payments every month. Late or missed payments lower your score and stay in your report for 24 months. When you close a credit card, your past credit history it’s not erased. Instead, it stays in your report for seven years, influencing your score to a lesser degree. But, if you close your only credit line, your score will likely suffer more because you won’t have any monthly activity to use to calculate your new score.
Amounts owed or utilization ratio (30%): This category factors how much credit you use compared to your available credit. It’s calculated by adding all of your credit card debt and dividing it by your overall available credit. Creditors like to see that you use little of your available credit. Ideally, you should use less than 30%. For instance, let’s say you have two credit cards with a credit limit of $1,000 each and $500 debt in one of your cards. In this scenario, you have $1,500 in available credit, equal to a 25% utilization ratio. Suppose you close one of those credit cards (even if it has a balance). In that case, you are decreasing your total available credit by $1,000, increasing your utilization ratio to 50%, lowering your score.
Credit history length (15%): This percentage of your score is set by how long you have had accounts reporting to your credit file. Influencing factors include the age of your oldest account, the newest, and an average of the other accounts. So, closing your oldest account can directly affect your credit history length, shortening it. Generally, the older your credit history, the better it’s for your score. The only way to create a long history is to be patient as time goes by.
The credit mix (10%): Diversity in your credit lines may not be the greatest influencer of your credit score, but it does make a difference. Ideally, it would be best to have a healthy mix of revolving credit (your credit cards) and installment loans, such as mortgages, car loans, and student loans. There’s no set rule of how many credit cards or loans you need to have.
New credit (10%): How often you ask for new credit defines this category. Any new credit request generates a hard inquiry in your report, which stays there for 24 months. Too many inquiries in a short period not only brings your score down but makes you look like a risky borrower because it seems that you are borrowing too much too fast.

Now that you have a better understanding of what goes into your score, you have more insight into how closing your credit card can affect you. Remember, your best strategy will depend on why you want to close your account, your current credit report, and your financial goals. If you need additional guidance, talk to an NFCC Certified Financial counselor by visiting NFCC.org or calling 800-388-2227. Your counselor can review your credit report to help you decide what works best for you.

If you have a question, please submit it on our Ask an Expert page here.

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How Can I Prepare for Repayment of My Student Loans?

December 24, 2021CreditBy toptierfinancial

(2 min 8 sec read) The NFCC often receives readers questions asking us how they should handle their student loans in their money situation. We pick some to share that others could be asking themselves and hope to help many in sharing these answers.

Question: I have $80,000 in student loan debt under my dad’s name with a parent plus loan at 5% interest and $16,000 in my name with federal loans at 0% interest. I am extremely anxious about my ability to make monthly payments on my student loans while also gaining financial independence from my parents. My goal is to move out in three years once my career takes off. I just signed up for my masters program. I’ll hopefully get a hospital management position when I’m done. Is refinancing a good option or are there other  options I should consider? 

Outstanding debt, whichever the type, can be daunting. However, taking action and setting a plan in place not only can alleviate your anxiety but can effectively reduce your financial burden and help you become financially independent in the future. So, you have to start by evaluating your financial situation now and being flexible to accommodate your future financial goals.

Your ability to repay these loans quickly will depend on your current payment agreements and your financial solvency to make new payments. If your loans are under any COVID-19-related plan, your payments and interest are likely suspended in both loans. However, this relief will end in May 2022. So, it’s essential to be ready. One of the quickest ways to pay off your Parent PLUS loan is to refinance it with a private lender for a lower interest rate. The main downside of refinancing is that you’ll lose all the federal loan payment benefits, which include payment options if your income drastically changes. On the upside, you can pay your loan quicker and save money in the long run.

Refinancing with a private lender

Based on your comments it appears that your parents have taken a federal Parent Plus loan to help fund your college education.  According to the U.S. Department of Education, the Parent Plus loan belongs to parents– no matter who is actually making the payments.  However, considering how that loan will be repaid shows that you are a responsible person.  However, because the Parent Plus Loan is not in your name, you can’t simply take it over or use a federal student loan consolidation.

You may be able to  refinance your Parent PLUS loan with a private lender in two ways, under your dad’s name or yours, transferring the loan to you. The most important aspect of refinancing a loan is to qualify for a loan with a substantially lower interest rate. The terms and conditions of private student loans vary by lender so it’s always wise to compare loan offers from multiple lenders.  If your dad’s or your credit is not ready, you may not get the interest you need to lower your payments and save money, so determine if you are both ready to take this step. If you are not, you can work to get your credit ready or consider other options.

Can you make extra  payments?

Making extra payments is another way to pay off your loans quickly. Has your dad started making payments already? Even if the Parent PLUS loan was deferred before COVID, interest would continue to accrue, so early payments are always recommended. However, sending in extra payments is not always an option if you don’t have enough income. So, it’s important to review your budget and determine in which ways you can prioritize your student loan payments over other expenses. Some people opt for frugal living for a couple of years; others may get second-jobs or side hustles to earn the extra cash they need. In your situation, you may be able to get a job while you are in grad school and maximize your savings in your living expenses while you stay at home after graduating.

Other alternatives

When it comes down to paying debts, there is usually more than one way to do so. And the best strategy is unique to each person because it depends on how much you owe and how much income you have to make your payments. It helps to be prepared and put a plan in motion to take care of your debt early. You are on the right track, but if you want to get a personalized repayment plan, you can talk to an NFCC Certified Financial counselor by visiting NFCC.org or calling 800-388-2227. You and a certified financial counselor will review your overall financial situation and help you create a personalized plan to help pay your loans while you get ready to become financially independent.

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Do I Need A Zero Percent Debt-to-Income Ratio (DTI) To Buy a Home?

December 12, 2021CreditBy toptierfinancial

The NFCC often receives readers questions asking us what they should do in their money situation. We pick some to share that others could be asking themselves and hope to help many in sharing these answers. If you have a question, please submit it on our Ask an Expert page here.

This week’s question: I have the ability to pay for my debts and I’m wondering if a zero DTI is good. I’m looking at buying a house next July.

A 0% debt-to-income ratio (DTI) means that you don’t have any debts or expenses, which does not necessarily mean that you are financially ready to apply for a mortgage. In addition to your DTI, lenders will review your credit score to assess the risk of lending you money. The specific requirements vary from lender to lender. But, most lenders look for a 35% or lower DTI and a minimum credit score above 620 to qualify for a conventional loan. On the other hand, FHA loans have more flexible requirements.

How to calculate your DTI

Your DTI determines the percentage of your gross income used to pay for your debts and certain recurring expenses. There are two types of ratios, the front-end and the back-end DTI, which is what lenders focus on the most when applying for a mortgage. To calculate your front-end DTI, add your home-related expenses such as mortgage payments, property taxes, insurance, and homeowner’s association fees. Then, divide them by your monthly gross income, and multiply it by 100. Most lenders look for a 28% front-end DTI.

On the other hand, to calculate your back-end ratio, add your monthly expenses such as rent/mortgage, credit cards, and other debts, like car payments, student loans, child support, or alimony. Then divide them by your total gross income and multiply it by 100. If your DTI is 35% or lower, you are likely to satisfy the DTI requirements for most lenders to qualify for a loan with the most favorable terms. Having a lower-than-required DTI does not guarantee better terms or rates. Instead, focus on the other parameters that lenders review as part of your loan application, such as your credit score and income.

Monitor your credit score

Your credit score is like a screenshot of your financial behavior as a consumer. So, lenders pay close attention to how you manage your credit. Being solvent to pay off your debts puts you in an excellent position to boost your credit score. If you haven’t reviewed your score, it may be a good time to do so. You can usually get your score free of charge if you are a customer of specific banks or purchase them directly from the credit bureaus, Equifax, Experian, and TransUnion. It’s important to note that either FICO or VantageScore generates most credit scores. And although both models calculate your score using the same information on your credit reports, they differ in how they process it, which results in different scores. Since most mortgage lenders use FICO scores, you should make sure your FICO scores from the three main credit bureaus meet the lenders’ requirements. As a prospective home buyer, you should aim to score higher than 760 to qualify for the best interest rates.

If you are not where you want to be with your credit score or DTI, you have time to get your finances ready to buy a home. You can also enlist the help of an NFCC Certified Financial Counselor to help you understand the lender’s qualifying criteria, save for the down payment, and navigate through the homebuying process. Being prepared enables you to make the most of this exciting step in your life. You are on the right track, good luck!

 

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