The credit score of the average American is improving because of falling unemployment and recovering housing and stock markets. And that's good news, given that banks are relying on credit scores heavily in the post-recession world.
But sometimes credit scores tumble for seemingly inexplicable reasons. If that happens to you, then knowing why credit scores drop may help you get your credit score back in shape more quickly. Here are five big things to avoid if you don't want your credit score to fall, along with tips to make sure your credit score stays ship shape.
No. 1: Don't close credit card accounts with zero balances
It may sound counterintuitive to learn that credit bureaus punish you if you close an account, but that's exactly what happens.
Credit bureaus reward people who manage their credit well, and having multiple accounts open, even if they're unused, shows lenders you're not feeling financially under the gun.
There are a variety of reasons closing a credit account can hit your credit score, and we'll discuss them more later. But know that -- at least in terms of your credit score -- it's better to leave accounts active with a zero balance than to close them.
No. 2: Don't let balances on open accounts eclipse 30% of your limit
Credit bureaus love it when people have plenty of financial flexibility to weather an economic storm. For that reason, your credit utilization rate has a big influence on your credit score.
Typically, your credit score will drop if the amount you owe on accounts eclipses 30% of your credit line. This utilization rate is calculated on both your total credit and your individual accounts, so knowing exactly where you stand overall and on each account is important.
If you discover that your balances are above the 30% threshold, consider instituting a more aggressive plan to pay down your debt. There are plenty of free calculators available online that will show you how quickly debt drops depending on how much you pay each month.
Also, if a balance is too high on an individual credit card, consider transferring some of that debt to a lesser-used card so that utilization falls below the 30% rate. Of course, make sure you do the math beforehand to avoid having any debt you transfer cause the utilization rate on your lesser-used account to spike above 30%.
No. 3: Don't miss payments
Since 35% of your credit score depends on fulfilling your payment obligations, making payments on time goes hand-in-hand with a top-shelf credit score.
If you've fallen on tough times financially, don't skip your payment. Instead, contact your lender to see if it can offer some relief while you get back on your feet.
If you think your payment history is rock-solid but you're not sure, double-check your credit report or visit a site such as Credit Karma to find out whether there are any errors or forgotten blips from your past.
If there are mistakes in your payment history, contact your lender so that it can be fixed. If you've missed a payment in the past but it's never happened again, then call your lender and ask it to make a goodwill adjustment to remove the late payment from your record. There's no guarantee a lender will forgive a missed payment, but if your credit history is otherwise spotless, and you've been a longtime customer, it could be worth asking.
No. 4: Don't apply for new credit
If you're qualifying for a mortgage loan, auto loan, or another credit card, a lender will pull your credit report from the credit bureau, and that will result in a hard inquiry that will negatively affect your credit score.
Those hard inquiries catch lenders' attention because, absent a good reason, such as shopping for a mortgage rate, they can indicate that a borrower's finances are tapped out.
However, just because hard inquiries can lower your score doesn't mean you should avoid opening additional credit accounts. In fact, credit scores benefit from having more total accounts open and from having different types of credit accounts on your record.
Since the negative impact of a hard inquiry disappears over time and having a credit card and a home loan is better than having only one or the other, the long-term advantages associated with obtaining additional credit can outweigh the short-term hit to your credit score caused by hard inquiries.
No. 5: Don't allow an account to go to collections or declare bankruptcy
If one of your accounts goes to collections or if you declare bankruptcy, then your credit score is going to drop significantly.
Similar to missing payments, the inability to negotiate a payment plan with a lender makes borrowers look like a poor credit risk, and because of that, if payments are getting more than a couple of months behind, then it's vital to contact your lender, rather than let your debt get sold to a third party.
If collections or a bankruptcy can't be avoided, then you can take solace in knowing that the negative impact caused by these events diminishes over time. However, it can take a decade of perfect behavior to get back the points lost to your credit score because of collections or a bankruptcy, so you'll need to be patient.
Oh, and another thing
Remember how I promised that I'd explain more about the negative impact of closing accounts? Well, I didn't forget. If you close an account, it can cause a number of ripple effects. For example, closing accounts can increase your overall credit utilization rate and reduce the total number of accounts and mix of your open accounts. For that reason, leaving unused accounts open really does make a lot of sense.