One of the things I often hear when talking about personal finance and credit is that people are afraid to wreak damage to their credit scores. They obsess over hard vs. soft inquiries and are reluctant to make any kind of financial move when their FICO score might take a hit. We treat our credit scores like fragile little eggs that might break if we even look at them the wrong way.
Well, stop thinking like that. Don’t let your credit score hold you hostage. There are plenty of times when taking a small hit is perfectly acceptable, even advisable.
Here are eight scenarios in which making a sound financial decision trumps protecting your credit score.
1 .To establish a payment history
You’ve worked hard, paid off all of your debt and now expect your credit score to be great and stay that way. Unfortunately, because your payment history comprises only 35 percent of your FICO score, what actually happens is that your score slowly begins to free-fall. On the surface, it doesn’t make much sense, but when you look more closely, the reasons become clear. If you’re not making payments on something, then the nice, helpful pattern of on-time payments goes dark. What’s more, your credit utilization falls to 0. Both scenarios are less than ideal.
Opening a new credit card for the sake of continuing a pattern of on-time payments will trigger a hard pull: the kind that remains on your credit record for two years and can actually affect your credit score for up to one year -- resulting in a slight dent in your credit score. However, without it, your high credit score will continue to fade, and you’ll recover from the hit pretty quickly. In fact, your score will come back as even stronger if you pay off the entire balance every month.
2. To increase your available credit, to achieve a better credit utilization ratio
The average hit from a hard inquiry amounts to only five points off your credit score, and if your score is already high, it’s going to take a lot of inquiries in a short period of time before you see any significant damage. The initial inquiry affects your score for up to a year afterward, but when that move results in better credit utilization, your score recovers much faster.
If you’re skeptical, consider my own experience: In October 2008, I applied to 17 credit cards in one day. My credit score fell from 722 to 684 a month later. But, by early December, it was back up to 705, simply because my credit utilization ratio had dropped drastically once those lines of credit were approved. By February, just four months later, my score was higher than ever, at 741. The conventional wisdom is that applying to 17 credit cards should be a disaster. The conventional wisdom is wrong.
So, where does this leave you? Ideally, you want to be using less than 30 percent of your available credit. The more credit you use, the more your credit score suffers. If you’re over 30 percent, one way to get back under is to open a new credit card and immediately put it in a drawer with no plans to use it, just as I did. You may even be able to apply to a card you’ve been preapproved for, which is ideal, since "preapproved" offers only require a soft credit check (which doesn’t ding your score.)
Is all of that gaming the system? Absolutely. But the credit-card issuers are the ones who set the rules, so use them to your advantage.
3. To start a business
Credit cards are one of the easiest, most accessible sources of startup capital around. Yes, your score will plummet, and there’s no guarantee your new business will succeed -- and that problem will stick you with a load of credit-card debt to pay back long after you’ve shut it down.
The key here, then, is to know that you can pay back your debt even if the business ultimately fails. If you make regular payments to lower your business debt, your credit score will eventually recover.
4. To diversify your credit mix
As the old saying goes, don’t put all of your eggs in one basket. Your FICO score is based on five different factors, including payment history, credit utilization, length of the history of your open credit, new credit and your credit mix -- that’s how many different types of credit you’ve got.
If all you’ve got on your record is your car loan, for example, adding a car payment or a credit card to your profile can be a good thing, both to broaden your credit and diversify your portfolio's types of credit.
5. To apply for a better credit card
Let’s say you’ve got a great opportunity to transfer your balance to a 0 percent APR credit card, but you know that applying for a new card is going to ding your score. Take a deep breath and go for it. Credit scores tend to recover quickly, and adding a card will improve your credit utilization. So, the immediately tangible financial benefits of paying zero interest are worth a temporary dip.
However, don’t close your old card unless absolutely necessary. The length of your credit history makes up 15 percent of your score, and closing an old card can shorten that history, essentially cutting your credit history length off at the knees. Just put that paid-off card in a drawer and let it get dusty.
6. To refinance a loan for a better interest rate
A loan application will trigger a hard pull, but when you’re refinancing for a better interest rate, as I described with my last example, the pros definitely outweigh the cons. You’ll be paying a lot less in interest once that loan is refinanced, and your score is going to recover just fine.
7. To shop around for the best loan
Prospective lenders will need to look at your credit report to give you a quote, which means that if you’re shopping around for the best deal, you’ll be taking multiple hits at once. However, this is yet another case in which the interest you save in the long run is totally worth the temporary hit to your credit score.
8. To join a debt-management program
Your credit score is already in trouble, so some people are reluctant to sign up for credit counseling when they learn that doing so is yet another black mark on their credit scores. However, this line of thought is extremely shortsighted. Where is your credit likely to be a year from now if you don’t? How about in five years? Do what you’ve got to do to keep the ship from sinking. Get yourself out of trouble. The financial-management skills and habits you learn from going through credit counseling will set you up for success and better scores later on.
The bottom line for all of these cases? Most of the time, good behavior after the initial hit results in a quick recovery and, often, a higher credit score than you had before. So, go for it.