Do Medical Bills Hurt Your Credit Score?

MarketWatch recently addressed the issue of unpaid medical bills and the effect that those unpaid bills have on one's personal credit. The reader asked if medical bills are treated the same as outstanding credit card debt and whether it affects the FICO score.

According to the MarketWatch reporter, medical bills are treated differently than credit card debt and as a result, "don't always have a direct effect on your FICO score." That's because medical debt is not always reported to the credit bureaus – just the debts that have been sent to a collection agency. And the debt owed for medical bills does not count toward your total debt utilization ratio – that is, how much you owe on your credit card balances compared to your credit limits.

However, your Credit Mama has a few words of caution. Once your unpaid medical debt is forwarded to a collection agency, the debt is very likely to be reported to the credit bureaus. And as a collection debt, it will have a significantly negative impact on your FICO score.

If you are trying to qualify for a mortgage or car loan, a lender will look closely at any unpaid bills, including medical. Most mortgage lenders require that any unpaid bills over $500 (or multiple bills adding to $500) be paid in full before they will lend for a home or investment.

Fannie Mae guidelines generally require that collection accounts (including medical) in excess of $250 per individual account or $1,000 in the aggregate must be paid in full.

Given the current credit crisis, I believe most underwriters will not waive this requirement.

Medical bills are one of the top three reasons people file for bankruptcy, accounting for half of all U.S. bankruptcies. Most frightening is that 75.7% of those whose illnesses led to bankruptcy had insurance at the onset of the illness, according to a study published in the journal Health Affairs.

Bankrate.com suggests contacting the hospital directly to see whether you can qualify for low-income waivers or financial assistance, and researching nonprofit organizations that specialize in helping people with high medical debt to negotiate on your behalf to reduce the balance. Once you get sent to collections, you are dealing with a for-profit company that is not interested in you – just your repayment of the debt.

In case you missed it - a previous post on the new medical FICO scoring system that is being developed.

77 Percent Chance Your Credit Card Rate May Change for Any Reason

Imagine if after a year of owning your car and paying down your loan, the car dealer told you that your interest rate on the car loan was going up by double-digits because the dealer was having a bad year. Outrageous! you think. He can't do that!

Yet that is exactly what credit card issuers are doing. A survey released by Consumer Action, a nonprofit education and advocacy organization, found that 77 percent of the major financial institutions they contacted said they reserve the right to increase a cardholder's interest rates - even on existing balances - at any time and for any reason.

The reasons cited by bank officials included "the economy," "business strategies," or "market conditions" (the stated cause of recent rate hikes by Bank of America and Capital One).

At a time when a number of banks are finding themselves too heavily invested in failing mortgages, it is all too clear that some of the shortfall in profits may be covered by bumping rates and fees for consumers like you and me.

Other items of note:

• The average default rate is now 26.87 perent, up from 24.51 percent in 2007. The highest default rate in the survey was HSBC, with a default rate at 31.99 percent. Default rates can click in for a number of reasons, including late payments to another company, too many inquiries on your credit file, or even a small drop in your credit score. Once your rate adjusts to the default rate, it's very difficult to re-adjust it downward.

• "Chasing balances" is becoming a common practice whereby banks reduce credit limits based on their assessment of a customer's risk. A reduced credit limit negatively impacts your credit score by increasing your debt utilization ratio, which may then trigger the universal default clause. And if the consumer isn't aware that the limit has been decreased, he or she may very well be hit with an over-the-limit fee and then a penalty interest rate for being over the limit.

If you're not outraged, you're not paying attention. Contact your House and Senate representatives and tell them to support the Credit Cardholders Bill of Rights in the House (H.R. 5244), and the credit card bill in the Senate Banking Committee.

WaMu Suspends $6 Billion in HELOCs

As banks look for ways to stop the bleeding and reduce their losses, WaMu has decided to tighten its purse strings by joining Bank of America, Countrywide, JPMorgan Chase and others in reducing or suspending home equity lines of credit (HELOC).

The amount of money that WaMu has eliminated is about $6 billion. The company cites those customers with declining home values and poor payment histories as primary targets for a HELOC reduction or suspension.

If you have had your home equity line of credit suspended or reduced, you will want to keep an eye on your credit score. That's because this type of action can increase your debt utilization ratio and drop your score significantly.

For example:

If you had a $25,000 credit line and you have used $10,000, your debt ratio is:

$10,000 (debt) ÷ $25,000 (total available credit) = 40%

But if the bank suspends your account to your existing balance, your debt ratio is maxed out:

$10,000 (debt) ÷ $10,000 (total available credit) = 100%

Since 30% of your credit score is your debt ratio, going from 40% to 100% debt ratio will not only decrease your financial flexibility but also your credit score.

Should I Pay Off My Car Loan or Credit Cards First?

I had a reader write in to tell me he was going to use his economic stimulous tax rebate check to pay down some of his debt. As a married father of four, he is expecting to receive a fairly sizeable rebate.

"I am so close to paying off my car loan, but I have some debt on my credit cards, too," he wrote. "I was fortunate to get a fairly low interest rate on my credit cards, so I'm torn between trying to pay off my car loan or pay down my credit card debt."

Your Credit Mama recommends paying down your credit card debt first, for a couple of reasons.

1. First, we all know how capricious credit card lenders are. Just look at Bank of America's recent move to increase interest rates on credit cardholders for no apparent reason. Because so many credit card agreements contain clauses such as any time-any reason rate changes and universal default (where a drop in credit score - even if inaccurate and/or unrelated to the account - will trigger a rate increase), carrying balances on credit cards is becoming a dangerous gamble.

2. Paying off credit cards improves your score more than paying off the other loans. The FICO scoring algorithm places a higher importance on your credit card balances. Your score will increase as your debt ratio on your credit cards decreases, while your score may not increase much at all by paying off your car loan, or student loan, or other type of installment loan.

Your goal should be to get your credit card balances to less than 30 percent of your total credit limits. So if you have a $1,000 credit limit, you should charge no more than $300. If you have several credit cards with balances, rather than paying off one card entirely, you may want to pay enough toward each card in order to get all of the balances down to 30 percent or less.

You May "Discover" New Fees in Your Credit Card Bills

Discover is introducing another way to enforce fiscal responsibility – or, as others may see it, another way to collect additional fees from its customers.

Beginning May 1, Discover will penalize its card holders for exceeding their credit limit twice by imposing the "penalty interest rate" (which, not surprisingly, is being raised from 29% to 31%). This action is in addition to the $39 over-the-limit fee Discover already charges.

Discover is not the only card issuer that is instituting rate increases for exceeding credit lines – Chase and Bank of America are including similar clauses in their member agreements.

According to calculations by The Red Tape Chronicles, affected customers will pay heavily for going over their limit:

A consumer with a $10,000 balance and a 15 percent interest rate who pays the minimum payment each month would pay $2,800 in a year and still owe $8,598 on that balance.

A consumer with a $10,000 balance and a 31 percent interest rate who pays the minimum payment each month would pay $4,047 in a year and still owe $8,891.54 on that balance.

If you are a regular user of credit cards, you should know that credit card issuers generally allow you to exceed your credit limit by 10 percent or more without warning. Credit card companies say they do this to prevent embarrassment or inconvenience in the check-out line. But with these stiff new penalties in place, you will pay for years for the privilege of using more credit than you have.

To maximize your credit score, you should not be charging more than 10 percent of your credit limit anyway, because of the negative impact of a debt utilization ratio. Know your credit limit. Stay below 50 percent of your limit (10 percent if possible). And if your credit card company offers e-mail warnings to let you know that you are approaching your credit limit, sign up today.

FICO Says… You Can't Have Too Much Credit

Once upon a time, not so long ago, having lots of available credit meant that you were "inevitably" doomed to go on a massive spending spree of epic proportions. Each unused dollar was a ticking debt time bomb, because even responsible users of credit would surely be lured into the vortex of temptation caused by those shiny cards with winking holographs.

But while conventional wisdom held that excessive credit – even unused – was a liability, Fair Isaac says there is no such thing as too much available credit when it comes to how they score credit. In fact, Fair Isaac's Barry Paperno states, "There really is never any good reason to close an account."

Three reasons why NOT to close an account:

1. The FICO score does not penalize you for having too much available credit. (Opening a bunch of new accounts may be a problem, but by itself, available credit is not a factor.)

2. While closing an account does not immediately eliminate all of the history associated for that account, the bureaus will automatically remove a closed account in 10 years (or less, if the credit card issuer decides to remove it). History – or how long you've had credit – accounts for 15% of your score. If you close an account that you've had for a long time, and your only remaining credit history is from credit cards or loans that were opened recently, it will negatively impact your score once that account falls off your report.

3. Closing an open account with a good history may negatively impact your ratio of balances-to-limits. Say, for example, that you have four cards with credit limits of $2,000 each, for a total available credit limit of $8,000. If you owe $1,000 on three cards, and you close the fourth, your debt ratio will increase from $3,000:$8,000 (37.5%) to $3,000:$6,000 (50%). This ratio accounts for 30% of your credit score. The higher the debt ratio, the lower your score.

AmEx Artificially Deflates Credit Scores

As you may recall from previous posts, 30% of your credit score is based on your debt ratio. The Big Three credit reporting agencies – that's Experian, TransUnion, and Equifax - use special software to calculate this ratio.

We've already discussed the Sneaky Credit Industry Trick where some credit card companies do not report the actual credit limit, which causes the software to use the highest reported balance as the "credit limit," biasing debt utilization calculations against the consumer. This was one way to artificially deflate their customers' credit scores, making them unattractive to their competitors.

According to SmartMoney, American Express is among a number of credit card companies that are now employing another Sneaky Credit Industry Trick: chasing balances. Consumers are reporting that as they pay down their credit card balances, the credit card company is penalizing them by lowering their available credit limit.

They tell the story of Trent Charlton, who paid off more than $8,000 in credit card debt in the last six months, with the goal of paying off an additional $10,000 in the coming weeks.

Six months ago, Charlton paid his American Express credit-card balance down to $14,000, AmEx decreased his limit from $20,000 to $14,300. Another payment several weeks ago brought his balance down to $10,000 — AmEx then cut his limit to $10,300. AmEx has also slashed the $2,000 limit on a card he rarely uses down to $500, barely above his $300 balance. And the limit on his GE Money Card (issued by General Electric Money Bank) where he owes $7,000, was recently cut from $15,000 to $7,500.

With an increasing number of delinquencies, credit card companies are doing everything they can to tighten lending standards and reduce the risk of default. CNN's latest statistics show the percentage of people who are late on their credit card payments is the highest it's been in three years.

Looking at the subprime crisis and weakening economy, this would be a logical rationale - except they are not targeting just high-risk customers. Lenders now are including customers that - not that long ago - would have been considered good customers, even considering factors such as where the customer lives (ie: in an area of high foreclosures) or where he or she works (mortgage companies, construction-related businesses and home builders).

Trent's credit score SHOULD have increased significantly based on his repayments. His original credit limit was $20,000. After paying the balance down to $10,000, he should have a 50% debt utilization ratio. Instead, by dropping his credit limit to $10,300, the scoring algorithm calculates his debt utilization ratio to nearly 100% - making him a "bad" candidate for credit.

The same goes for the GE Money credit line. With a credit limit of $15,000, his debt ratio SHOULD be just under 47% after paying down his balance to $7,000. Instead, by dropping his limit to $7,500, his debt ratio is over 93%.

According to Craig Watts of Fair Isaac (the company that created the FICO score), if your credit utilization is 50% or more of your credit limit, "you are doing some real damage to your credit score." And when the new FICO scoring model is released in May, "if you have a utilization of over 50%, you'll be penalized even more heavily."

Clearly, the system is flawed as it is not accurately representing the borrower's willingness or ability to pay. And with such high debt ratio calculations, other lenders will probably think twice before issuing Trent more credit - keeping him locked in with American Express and GE Money Bank until his debt is completely paid off.

It's Good to Have Limits

A couple of years ago, Federal Reserve researchers reviewed 310,000 individual consumer credit files. Among their findings: nearly half (46%) were missing at least one credit limit on their report.

For anyone who is concerned about improving or maintaining their credit score, this is bad news... because when companies like Capital One do not report credit limits to the credit reporting agencies (Equifax, Experian and TransUnion), your credit score can drop significantly.

The first question: How does this happen?

Part of your credit score -- 30% -- is determined by how you use your credit. If you tend to maintain balances at or close to your credit limit, your score will not be as high.

Credit reporting agencies use special software to calculate your credit utilization ratios. Credit utilization refers to how much of your available credit you are using. If a company does NOT report your card limit, the software may substitute your highest balance in place of your actual limit to calculate your ratio.

So, for example, if you have a credit card with a $5,000 credit limit, and the highest monthly balance you've ever had on the card is $2,500, you have a 50% utilization ratio. However, if your most recent balance is $2,000, and the credit card company doesn't report your $5,000 limit, the scoring software may use the highest monthly balance ($2,500) to determine your limit. That would make it appear as though you are nearly maxxed out with a credit utilization ratio of 80% - which could drop your score 20 to 50 points or more.

Recent data from Experian revealed that those with the highest credit scores used only, on average, 17.8% of their available credit.

The next question - Why do companies withhold credit limits?

The answer: Competition and the almighty dollar.

With the average American carrying four credit cards with balances of $9,000-$13,000, it's becoming increasingly difficult for lenders to gain new customers. As a result, they are trying to lure existing cardholders with offers of low balance transfers, cash rebates and more.

Companies like Capital One hope to reduce "poaching" of customers by their competitors, who routinely sift through national credit bureau data looking for prospective customers. The practice of withholding credit limits artificially lowers the credit scores of their customers, theoretically making them less attractive to other lenders. And it might mean that consumers using Capital One cards are paying higher interest rates on their other credit accounts. This makes it more likely that you will remain a captive customer of Capital One and less likely to be offered the credit you deserve from other companies.

Those hurt the most by this practice are consumers with few credit accounts and those just beginning to build their credit history.

Class action lawsuits have been initiated, accusing the Big Three of deliberately shielding data despite knowing that this practice reflects negatively on credit score calculations.

Until the lawsuit is settled, consumers would be wise to review their credit files to see which companies are not reporting accurate credit limit data, and to be cautious about using these cards.