Mortgage Confidential: closing an account can hurt your credit score

The old adage, if 10 years ago makes for an adage, was to monitor your credit and close down any unused credit accounts. Before the advent of "instant" mortgage approvals and automated underwriting systems, loans were actually evaluated completely by a living, breathing human being: an underwriter.

When a borrower would make an application for a home loan, an underwriter would look at other credit accounts. Some that had a credit limit with a low or zero balance. If the potential borrower had any past history of running up his credit line to or beyond his credit limit, it would make an underwriter nervous. What if a borrower who was pushing his debt ratios to qualify for a home loan would suddenly go out and buy a boat, a new car and take a trip to Cozumel right after he closed on his mortgage loan? Suddenly that new homeowner might not have the ability to pay his brand new mortgage.

From another prudent point of view, having old, unused credit accounts simply should be canceled should anyone ever attempt to steal an identify or otherwise charge something on an old card. But that's old school. Here's the new school.

Lenders now rely on automated underwriting systems which also rely heavily on credit scores. Credit scoring is a secret science with algorithms designed by a company called Fair Isaac Corp., sometimes called FICO, a registered trademark of Fair Isaac. And I certainly don't have the secret formula. But FICO has made it known that the top five things of which a credit score is comprised include payment histories (35% of your score), amounts owed (30%), length of credit history (15%), new credit accounts (10%) and types of credit (10%). But notice the second item: amounts owed.

Amounts owed, which makes up nearly a third of your score, means the amount of money you owe on credit accounts compared to available credit. Certainly if you had a $10,000 balance and your credit limit was $8,000 then you would be over your limit and targeted as a person not currently responsible with your credit. Your scores would dive.

On the flip side, credit scores are nice to people who show the ability to buy things on credit and make regular payments. If you have an $8,000 limit and your balance was $2,500 then the "amounts owed" section of your credit score would be handsomely rewarded and your scores would rise. But you need to have a balance that you pay on each month which means you also need to have an open credit account.

Scores seems to favor accounts with balances at approximately one third of their available limit and not "zeroed" out. That makes sense if you think about it, a credit history can only be evaluated if you actually charge something and pay it off on a regular, monthly basis. This means two things: carry a small balance and whatever you do, don't cancel credit accounts with zero balances unless your total "amount owed" still equals somewhere around 1/3 of your available balance.

That means that if you have three credit cards that each have a credit line of $5,000 you would have a $15,000 cumulative credit line. Let's also say you transfer two of your credit card balances of $5,000 to just one card and cancel the other two; you would have one card with a $5,000 balance and a $5,000 limit. Your score could be hurt because now your "amounts owed" is at 100% of your available credit.

Closing unused credit accounts, while perhaps a prudent move, need to be examined more carefully because of the "amounts owed" category in credit scoring. Don't charge up as much as you can. And certainly don't close old accounts just because it used to be "the prudent thing to do." Because if you want to heighten your scores, it's a whole new school of thinking these days.

Real estate finance expert David Reed is president of CD REED Mortgage Bankers in Austin, TX and author of Mortgage Confidential: What You Need to Know That Your Lender Won't Tell You and Mortgages 101: Quick Answers to over 250 Critical Questions About Your Home Loan.

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