Q: I have two credit cards that are almost maxed out. I recently got approved for a new one with a $2,000 limit and 0 APR through next August. Should I use my new credit card to pay off my old ones that have a higher interest rate? What would that do to my credit score?
A: You can play this a few different ways. If you focus on getting your debt paid down as fast as possible, you'll save money in the short term. But, your lower credit score could put you at risk of paying more in the long term for financial products like insurance and home loans. On the other hand, you can use a strategy that may take a little longer to clear your credit card debt, costing you more in finance charges in the near future but stabilizing your credit score.
Maxing out your credit cards signals stress in your life. Maybe you've been paying off some emergency expenses, or maybe you've been treating yourself to a few indulgences. Either way, it's time to get focused on knocking down some of that credit card debt. You're lucky to have earned approval for a balance transfer credit card, but opening that new account may already have dropped your credit score. "New credit" accounts for ten percent of your FICO score, so it's time to get strategic.
Strategy #1: Maximize short term cash flow. Dave Ramsey and other financial experts use the "debt snowball" strategy to help consumers who need the immediate emotional and spiritual boost of seeing at least one major bill completely wiped out. Using this strategy, you want to clear as many of your revolving accounts as possible.
If you want to maximize your credit score, you should end up with just two active credit cards: your oldest account, and the account with the largest credit limit. Consolidate as much of your other balances onto your low introductory rate card. Close out accounts with zero balances, then focus on paying off the credit card with the lowest balance first. You'll reduce the likelihood of maxing out your credit in the future, while gradually getting your credit back on track.
Strategy #2: Boost your credit score. I've seen the debt snowball process work really well, but it might not help you save money on a mortgage or on your insurance policy. If you've got a major financial change looming in the next year or two, you may prefer a technique that leverages FICO's scoring algorithm.
FICO's system rewards you for getting back on track with credit card payments if you've had a rough patch. It also awards you more points when you monitor your credit utilization: the percentage of your available credit that you're using right now. A few credit scoring systems measure credit utilization across all your accounts. That's why you'll see an improvement in your score when you use balance transfer offers to even out your accounts.
If you've got balances of $500 and $1,000 on your maxed out credit cards, transfer $250 from the smaller card and $500 from the larger card to your newest card. Then, make routine monthly payments on all three accounts without racking up any new charges. Your credit utilization on each of the three cards will drop below 50 percent, and your credit score will get better as you move that needle closer to 30 percent.
Whichever strategy you choose, you're taking a positive step to getting in control of your personal finances.
Correction, Jan. 17, 2012: According to John Ulzheimer, president of consumer education at SmartCredit.com and an expert on the FICO score, the ideal percentage of credit utilization is not 30 percent, but from 1 to 10 percent.