A good credit score can make it easier for you to get a loan and can make it far less expensive for you to borrow money for big purchases, like a new home. Unfortunately, while many people have the best of intentions when it comes to earning a high score, it's not always easy to know what you need to do to become a credit superstar. Different credit reporting agencies calculate your score in different ways, and none of the agencies are fully transparent about the specifics of the formula they use.
Compounding the problem: some behaviors you may think will help your credit could actually result in your score dropping. You don't want to inadvertently hurt your efforts to earn good credit by making an innocent and avoidable mistake, so check out these five ways you could be messing up your credit score to avoid preventable errors.
1. Letting your balance grow -- even if you pay it off at the end of the month
One of the key factors in determining your credit score is how much of your available credit you've used. A low credit utilization rate -- typically below 30% of your available credit -- will earn you a better score than if you're closer to maxing out your cards. If you've got a $1,000 credit limit and you've charged more than $300, you'll be above your 30% recommended utilization rate and your score can take a hit.
You may think paying off your credit card balance in full each month would mean you have a very low credit utilization rate so you won't have to worry about hurting your score if you charge a lot each month. The problem is that your credit card company doesn't constantly report your balance in real time. Instead, credit card companies generally report your available balance and your credit limit on the date when your billing cycle closed. This means if you have a $1,000 credit limit and you charged $900 during the month, you'll have a 90% utilization rate reported to the credit bureaus -- even if you pay off the $900 the day the statement arrives in the mail.
You don't want to stop using your cards because you need a history of on-time payments to build credit -- and because you may be earning generous points or rewards for using your cards. But, if you're going to be applying for a mortgage or other large loan where your credit score really matters, you may want to sign into your online account a few days before your billing cycle closes and pay off the current balance on the card. That way, your creditor should report you have a $0 balance or a very low balance and you can get the best possible score for your low credit utilization.
2. Opening new cards all the time
Have you ever been asked at the cash register to open up a store card for a generous percentage off of your purchase? Or received credit card offers in the mail promising you free airline tickets or other perks if you open a new credit card? These types of offers are common and lots of people take them because they seem like good deals. The problem is, opening up a new card -- for any reason -- can hurt your credit score in a few different ways.
When you open up a new credit card, the card issuer is going to check your credit. This means an "inquiry" will be placed on your credit report where it will stay for two years. Having too many inquiries on your credit report can lower your score because it could be an indicator to creditors that you're about to get in over your head with debt.
Your new card is also going to lower the average age of your credit, which is also an important factor in determining your score. The longer your credit history, the happier lenders are because they can see your track record of successfully managing credit. Average age of your credit history accounts for about 15% of your score, so you don't want a bunch of new cards to make your credit history look much shorter. That store discount could end up costing you a fortune if opening the card causes your credit score to drop dramatically before you take out a big loan.
3. Closing old cards you're no longer using
If you're trying to improve your credit and you have a bunch of old cards open, getting rid of the accounts seems logical. Unfortunately, closing old cards can hurt your credit history as much -- or more -- than opening new ones. If you close your oldest card because you don't use it any more, your credit history becomes much shorter and your score suffers. Closing cards also reduces your available credit, which makes your credit utilization ratio appear higher than it was before.
If you had an old card with a $5,000 limit and a new card with a $1,000 limit and you had a $500 balance on your new card, your overall credit utilization ratio would only be around 8% ($500/$6,000). But once you close that card with the $5,000 limit, all of a sudden your utilization rate is a much more problematic 50% credit utilization.
4. Not correcting mistakes on your credit report
Did you know that around one in five Americans have a mistake on their credit report? Most people aren't aware how often mistakes are made -- or how damaging those mistakes can be. In one study conducted by the Federal Trade Commission, around 20% of consumers who identified errors on at least one of their credit reports experienced a meaningful credit score increase after fixing the problem.
These 20% of consumers didn't just see their credit scores go up slightly after the problem was corrected; the increase in their score improved their credit risk tier. Where they may have been considered a poor risk before, they're now considered to be an average risk borrower, while an average rating could be bumped up so the borrower is now low-risk. This change from one tier to another could substantially reduce the costs of borrowing, and could make it possible to get loans which might otherwise have been denied.
5. Not having a mix of different kinds of credit
If you don't have to go into debt, you don't want to borrow for no reason and pay interest. But, the catch 22 is that you've got to have debt in order to earn a good credit score. Not only should you use credit cards to build up a history of on-time payments, but you should also have a mix of different kinds of debt to get the highest possible credit score .
Borrowing for a car or other costs you don't need help paying seems counterintuitive, but it's something to consider if you want a diverse mix of different loan types to boost your credit. One possible option: take a loan for a car or a college class and pay it off right away. However, you shouldn't do this if you have to pay high fees for the loan, if there are prepayment penalties, or if it would hurt your score more than help it.
Don't forget, if you apply for new credit -- even if you're doing it to diversify your credit history -- you'll still lower your average credit age and end up with an inquiry. If you're going to go into debt for a big purchase, like buying a house, within the next year or two, it's likely not worth it to take out a loan just to improve your credit mix. But if you're not planning to borrow substantial sums any time soon and you have the chance to take a no-fee or low fee loan that will give you a new credit type on your account, it may be worth doing. Since your credit score can make a huge difference in what you pay to borrow throughout your entire life, a little extra paperwork and hassle can be worth it to boost your score.
The Motley Fool has a disclosure policy.