One of the things that most credit card hobbyists take for granted is a good credit score. In all the talk of Sapphire Reserves and Amex Platinums, we can sometimes forget that not everyone is yet in a position to quality for these products. While we’ve talked at length about how a credit score is calculated, ways to improve your credit score, and debunked various credit card myths, I want to talk today about credit score variance. To set the stage, let me first share with you a question that I received from a podcast listener recently.
I’ve been building my credit and had a score of around 680, with two cards to my name and a total of $2,500 in available credit. My utilization had been rather high, near 80%, but I recently paid off my credit card in full so my utilization dropped to 0%. While I had expected my score to rise, it dropped precipitously to the 650 range. Whats up with that?
Its a great question, and I think its of fair concern to anyone who is trying to build up their credit score. Before we get into the nitty gritty of what im referring to as “credit score variance”, lets recap how your score is calculated.
How Credit Scores Are Calculated
- 35% Payment History – This is a measure of whether or not you pay your bills on time, every time. You need to keep this number at or near 100% at all times to reap the full benefits. In fact, if your payment history falls below 97% you should expect a significant drop in your credit score.
- 30% Amounts Owed – This is also referred to as “credit utilization”, and it is the percentage of credit you’ve used vs. what has been made available to you. For example, if your total available credit across all cards is $10,000 and you owe $1,000 then your utilization is at 10%. According to our friends at CreditKarma.com, the green range for this is 0-29%, with yellow being 30-49% and anything above 50% will put you in the red.
- 15% Length of credit history – This is the average age of all your accounts, the higher the better. CK says that 7 years or more is ideal with 4 or less being in the red.
- 10% Hard Inquiries – Whenever you request a new line of credit (be that a mortgage, credit card, car loan, etc.) a hard inquiry goes on your report. These generally stay on your report for up to 2 years. A handful is okay, but once you start to rack up 5 or more, they can adversely affect your score.
- 10% Types of Credit – Auto loans, mortgages, credit cards, school loans, etc. The more diversified you are, the better. Lenders typically like to see that you’ve used a variety of accounts responsibly.
Credit Score Variance
Now that we’ve recapped what goes into calculating your score, what is it that I mean by credit score variance? Basically its the idea that the newer your credit report is, the more you stand to be affected by large changes to your report. Lets go back to the $10,000 / $1,000 example. For that user, he/she could spend $3,000 and be at a 30% utilization ratio. While this isn’t great, its also not bad per se and shouldn’t, in and of itself, negatively affect the score over the long term. In the case of our podcast listener however, spending $2,000 out of their available $2,500 puts them at an 80% utilization ratio which will definitely adversely affect the score. Because the user has fewer cards, they’re unable to insulate themselves from large changes caused by spending on their cards.
In the case of a payoff, the user went from nearly 80% to 0% in a short time span, and their score dropped. While I can’t say for certain, my hunch is that the score was reacting to a large change on a fairly green credit report. Remember, companies want to see that you can have credit available to you, and use it responsibly. When you’re at 0%, you’re not actually using the credit that is available to you, and if you’ve only got the one account then that drastic of a change can result in a drastic scoring change.
How to Defend Against Score Variance
Since credit utilization is the sum of all of your available balances, one option to defending against such variance is to have more than one card. Lets say the 2nd account has a credit limit of $10,000, now spending $2,000 puts us at a 16% utilization which is much more favorable. Another strategy is to request a credit limit increase from the card issuer. Lets say you currently owe $1,000 and have $2,500 in available credit, this puts you at a 40% utilization. If you request and are granted a limit increase to say $5,000, all of a sudden your utilization dropped by 50% overnight and that alone can improve your score. It also helps to further insulate you from large changes in the future.
So does this mean I shouldn’t pay off my credit cards?
Absolutely not, I have mentioned many times on the podcast that I treat my cards more like debit cards than credit cards. What that means for me is that I pay them off monthly if not weekly, in full. I would encourage readers of Pursuing Points to do the same. The reality is that if you’re consistently using your card and paying it off, your score will improve over the long term. As you obtain more cards, and your average age increases, your utilization can decrease (if you maintain your spending) and you’ll be affected less and less by changes to your utilization, which should stabilize your score.
Im of the opinion that while this users score saw a drop after paying off the card, the score will recover in due time. In the mean time, the advice I have for them is the same I have for you. Focus on using your cards responsibly, paying off the balances whenever possible, and adding more cards to your portfolio as you’re able. While it won’t happen overnight, this strategy will yield a positive score over the long term.