Credit scores are very reliable predictors of the risk that a borrower will not pay back his or her debts, or miss a payment along the way. For that reason, lenders use your credit report and credit score to determine the interest rate you should pay and whether to approve you for a loan in the first place.
Getting a great credit score is as simple as avoiding major mistakes. Here are three things that can hurt your credit score the most.
1. Paying accounts late
Nothing is more damaging to your credit score than being late on your obligations, since your payment history makes up the largest part (35%) of your credit score. A single late payment can cost you as much as 100 points on your credit score, and in some cases, it can automatically disqualify you for a loan -- including a mortgage or a car loan -- if the late payment occurred in the past year or two.
Of course, to be negatively affected by late payments, you have to be more than just forgetful. Paying a bill a few days late won't hurt your score, and it won't even show up on your credit report. Late payments are only reported to the credit bureaus when you are more than 30 days past due.
Delinquencies are broken up into four categories -- 30, 60, 90, and 120-plus days past due. It should go without saying that being 30 days late is better than being 90 days late, but you want to avoid any late payments at all costs.
While late payments, accounts in collections, and judgments have less impact on your credit score as they age -- paying a bill late six years ago, for example, isn't nearly as bad as having a late payment this year -- late payments stay on your credit report for at least seven years, negatively affecting your score by some degree the whole time.
2. Carrying high balances on revolving accounts
Having a high balance on a student loan, mortgage, or car loan isn't necessarily that big of a deal, but carrying high balances on a revolving account like a credit card or line of credit can hurt your credit score. The amounts you owe to lenders make up 30% of your score.
Credit bureaus are mostly concerned with credit utilization, or the percentage of your credit limits you use at any given point. If you have a credit card with a $5,000 credit limit and carry a balance of $4,500, then you have a credit utilization ratio of 90% ($4,500/$5,000 = 90%). That's far too high -- the ideal credit utilization ratio is less than 30%.
Credit utilization is an early warning sign of financial stress. When people encounter financial problems or budget issues, they typically start building up balances on revolving accounts to make up for the shortfall. Thus, having higher balances on revolving accounts is a behavior associated with higher default risk, and the credit scoring algorithms reflect this risk by issuing lower scores to people with higher credit utilization.
The good news is that this is the one problem on a credit report that you can fix easily and quickly. Paying down your revolving account balances to 30% or less of your credit limit will result in an immediate increase in your credit score. Likewise, increasing your credit limit so that your balances are less than 30% of your limits will do the trick, too.
3. Closing important accounts
Closing an open credit account can potentially hurt your score, but the impact varies based on the account's importance to your credit report.
As Fair Isaac Corporation, the company behind the FICO score, states on its website, "How long your credit accounts have been established, including the age of your oldest account, the age of your newest account, and an average age of all your accounts," all play a role in the 15% of your credit score that relates to your credit history.
If you have just two credit card accounts as the only accounts on your credit report, one of which is 20 years old and the other one brand new, closing the 20-year old account would have a relatively large impact on your score. On the other hand, if you have several different accounts, all of them with similar amounts of age, closing just one account would have a relatively small impact.
Be sure to use any old credit card accounts at least once a year by making a purchase and paying off the balance, so that the account will remain open and reporting to the credit bureaus. Doing so will help you maintain all the history associated with your account and keep it on your credit report for the benefit to your credit score.
If you don't have one already, opening a no-annual-fee credit card account is a good way to establish an account that you can keep with you for life. As it ages, this account can act as the bedrock of your credit report, eventually becoming your oldest record as other loans -- like car loans or student loans, for example -- are paid off and fall off your credit report over time.
Getting the big things right
At a certain point, extra points on your credit score are purely for show. Once your score is above 760 or 780, the point at which you've hit the lowest-risk cohort for all practical purposes, more points on your credit score have little to no value when it comes to getting better rates or terms on a loan.
You can get to that level by avoiding the three mistakes we've covered here, and nothing more. Getting a good credit score is relatively easy; it's keeping it forever by managing your budget wisely that's the hard part for most people.