A great credit score is your ticket to getting the best terms when you apply for a loan or a credit card. However, many people are confused about what to do to improve a credit score. Sometimes, an action that seems like it would be helpful actually lowers a credit score. Here are five frequent credit mistakes people make and how you can avoid them.
Mistake No. 1: Closing credit accounts
Closing an old account that you're no longer using should help your credit score, right? Wrong! According to FICO, the most popular credit scoring company, closing old accounts is not recommended and will usually hurt your credit score. Here's why:
There are two components to credit scoring that are negatively impacted when you close an unused credit account: credit utilization and length of credit history.
Credit utilization is the ratio of your credit card balance to your credit limit. In other words, it measures the amount of your credit limit that's being used. You should always keep your credit utilization ratio below 30%.
For example, imagine you have three credit cards. The first card has a $500 balance and a $1,500 credit limit. The second card has $1,500 balance and $3,500 credit limit. The third card has no balance but a $5,000 credit limit.
In this situation:
The total credit card balance is $2,000 (=$500 + $1,500 + $0).
The total credit limit is $10,000 (=$1,500 + $3,500 + $5,000).
The current credit utilization ratio is 20% (=$2,000/$10,000).
Now, imagine canceling the third card because it's old and you don't use it, and recalculate the utilization ratio.
Credit card balance: $2,000 (=$500 + $1,500)
Credit limit: $5,000 (=$1,500 + $3,500)
Utilization ratio: 40% (=2,000/$5,000)
Your spending habits haven't changed, but canceling that unused card doubled your utilization ratio. This ratio increase will reflect poorly to the credit bureaus who provide information for credit scoring. Since 30% of your credit score is made up of your credit utilization, this action will hurt your credit score.
Additionally, 10% of your credit score is made up by your length of credit history. If you cancel a card you've had for a long time, you reduce the average account age, which will also negatively impact your score.
While it seems counter-intuitive to keep old, unused credit card accounts open, it hurts your credit score to close them.
Mistake No. 2: Opening too many new accounts
We've all been asked when making a purchase if we'd like to save an extra 10% by opening a store card. While it's tempting to get that extra discount, opening too many new accounts can hurt your credit.
Each time you apply for credit, a hard inquiry is made on your credit. Applying for additional credit will typically impact your credit score by only about five points, and this hit will last about six months (inquiries stay on your credit report for two years and count in your score for one year). However, according to FICO, people with six inquiries or more on their credit reports can be up to eight times more likely to declare bankruptcy than people with no inquiries on their reports. If you have too many inquiries, you are considered a credit risk, and your credit score will drop.
Additionally, adding new cards will reduce the average account age, which negatively impacts your length of credit history.
Rather than apply for a new card for the discount at each store you shop, choose the right card that matches your objectives and priorities. If you use that card carefully, the improvement to your credit utilization will improve your credit score. As a rule of thumb, wait six months between applications for credit.
However, if you're about to make a major request for credit, like a home or auto loan, put the brakes on applying for any other new credit until you've closed on the major purchase or you could derail your loan.
Mistake No. 3: Maxing out one credit card while leaving others unused
There is a lot of misunderstanding about credit utilization and what goes into the calculation. According to FICO, credit utilization is measured both by total utilization across all accounts and by utilization of individual credit accounts.
Let's say you have four credit cards and each has a $1,000 credit limit. Your total credit utilization is the same (25%) if you charge $250 on each of the four cards or max out one card and leave the other three unused.
However, there's a huge difference when credit utilization is examined on each account. If you spread the charges between the cards, the utilization on each card is 25% ($250 / $1,000 for all four cards). If you max out one card, your utilization on that card is 100%, and this will negatively impact your score.
Even if you pay off your balance in full each month, having a high balance at times during the month can impact your score. It depends at what point in your credit cycle your credit card company reports the data to the credit bureaus.
If you prefer to make charges on one card (for points or cash back) and then pay it off each month, you can call your credit card company and ask what day of the month they report this data to the credit bureaus. Then, make the payment before your company reports your balance to the credit bureau. You can also make more than one payment a month to your credit account to ensure that your balance doesn't get too high.
Mistake No. 4: Co-signing
It's possible that being a co-signer on a credit account can actually improve your credit, and co-signing is sometimes marketed as a way to improve credit. However, it's still a bad idea.
When you agree to co-sign on a credit application for a friend or family member, you are legally liable for the debt. The debt will show up on your credit report as an obligation and the payment history for the account will be reflected in your credit score.
If the account holder makes all payments in full and on time, you're golden. In this case, you are likely to see an improvement in your score.
Unfortunately, too often, this doesn't happen.
According to a Creditcard.com survey, 38% of people had to pay some or all of a debt because the primary borrower did not. Additionally, 28% of those surveyed indicated their credit score had dropped because the co-signed account was paid late or not at all.
If someone needs you to co-sign on a loan, it's because the person either doesn't have good credit (which means they have a record of not paying obligations) or doesn't have enough of a credit history to be approved (which means you really have no idea whether they'll pay or not). If the person doesn't pay the account on time and in full, you are also responsible for the debt. Frequently, the bill collectors will come to you first for overdue payments.
If you decide to co-sign for someone anyway, ask the lender to agree in writing to notify you if a payment is missed or if payment terms change. Unless you are financially fit enough to take over payments at any time on the co-signed account and you will never hold a grudge against the co-signer if the account defaults, co-signing is not worth the risk.
Mistake No. 5: Not using credit
How is it possible that not utilizing credit can hurt you? Wouldn't your credit score be great if you're never late on payments because you have no credit accounts?
Unfortunately, no. Your credit score is a measure of how responsibly you've used credit. Not using credit provides no opportunity to be evaluated.
Some personal finance experts recommend not using credit and say that your credit score doesn't matter. However, not having a credit history can cost you in several ways.
1. Mortgage: If you need to take out a loan for a home (and let's face it: few people can fork out cash for a house these days), the interest rate offered by the bank will be higher if you have no credit history than for a client with a good credit score. This increased rate may cost you tens of thousands of dollars over the life of the loan.
2. Rent: If you rent a home, your landlord will pull your credit report. Without a strong credit history, you present more of a potential risk and will likely be charged more on your deposit.
3. Utilities: You will be charged deposits (or more on deposits) when you set up utilities.
4. Insurance: The insurance companies recognize the correlation between good credit and good driving behavior. Therefore, customers with good credit get better insurance rates than those with poor credit or no credit. If you drive, you will pay more for insurance if you don't have a credit history.
Give yourself some credit
Just as Rome wasn't built in a day, a great credit score takes time to build. Use credit responsibly, utilize a mix of different types of credit, and avoid the mistakes mentioned above. In time, you'll have a credit score that will make you proud.