Article originally published by Edward Jamison, Esq.
It's surprising how many consumers make the same credit scoring mistakes over and over again. In an effort to educate consumers on credit and credit scoring, we've compiled 5 common credit scoring mistakes into a list that defines each mistake and explains why they are bad and how to avoid them:
Credit Mistake #1: Closing Credit Cards Accounts
This is probably THE biggest credit mistake that consumers make. What you may find surprising is that closing credit card accounts can hurt your credit score almost as badly as missing a payment.
Not only is this the number one on the top five credit scoring mistakes, it's also number one on the list of credit myths.
Ironically, most consumers make this mistake based on poor advice from a mortgage lender as a strategy for improving their credit scores. A word of advice people, when you're dealing with something as sensitive as your credit and credit scores, make sure you do your homework before trusting some of these so called 'industry experts' before following through with their advice.
There are two important reasons why you should not close credit card accounts:
1. Eventually, the accounts will fall off of your credit reports - The information in your credit reports are subject to certain rules in regards to how long it can remain in the report. In most cases, credit information will remain in your credit reports for seven years from the account's DLA or date of last activity. When an account is open, the DLA will continue to update each month and the open account will never reach that seven-year mark. If you close the account, the DLA will stop updating and the clock will start ticking. Eventually the account will be completely removed from your credit reports.
Why would this be a bad thing?
It's simple - you never want to get rid of old, positive information in your credit reports. This information actually helps your credit scores.
Credit scores want to see this positive account information. They want to see your long, perfect history of making your payments on time because this information significantly helps your credit scores.
This information significantly helps your credit scores so why would you ever want that history to disappear? You wouldn't! Here's an analogy for you: let's say you made straight A's in high school. What if the record of that perfect scholastic accomplishment were permanently deleted seven years after you graduated? Would you ever want that history deleted? Of course you wouldn't. The same is true for the credit reporting environment.
So, what should you do with old credit cards that you don't use any longer?
What you don't want to do is to let the account become inactive. When this happens, the credit card companies aren't generating any revenue for your account.
Eventually they'll close the unused account because you're more of a liability than an asset. You can prevent this from happening by using the card every few months for low dollar purchases like dinner or a tank of gas.
When the bill comes in, just pay it in full. If you do this, it will ensure that the account will never be closed and you'll always get credit for your good payment history.
2. You could cause a spike in your revolving utilization and tank your scores - The percentage of your available credit in comparison to the debt you owe is a very important factor in calculating your credit scores. This is often called "revolving utilization," or your debt-to-limit ratio. For example, if you have an open credit card with a $1,000 credit limit and a $500 balance then you are using 50% of your available credit. This means that you are 50% utilized on this particular credit card. Now lets add a second credit card to the mix. Let's say you have another open, but unused credit card account with a $1,000 limit and a $0 balance. This would put your total revolving utilization at 25% because you have $2,000 in available credit limits and $500 in total balances. If you divide your total balances by your total credit limits, you'll get your total aggregate revolving utilization: $500 divided by $2000 equals .25 or 25%.
So how will closing unused credit cards hurt your credit score? When you close an account, the amount of available credit decreases, which could result in a higher revolving utilization and lower your score.
Let's use the example from above and close the second unused credit card account. When you close the account, you remove it from any utilization calculation and now you're stuck with one open credit card account with a $1,000 limit and a $500 balance.
This caused your utilization to go from 25% to 50%.
Remember, you divide the total balance by the total available limit so $500 divided by $1,000 is .50 or 50%. As this percentage increases, your credit score decreases.
When you're talking about several unused credit cards with high limits, you can just imagine what closing credit card accounts could do. I've seen consumers go from a 10% utilization to almost 100% utilization because they closed all of their credit card accounts except the one they were currently using.
Credit Mistake #2: Missing Payments
It doesn't take a credit scoring expert to tell you that missing payments is a bad thing. The only reason I made missing payments second to Closing Credit Card Accounts is because this one is a no brainer.
It shouldn't take a credit expert to tell you that missing payments is bad. Common sense should tell you that missing payments is bad. Credit scores are designed to predict how likely you are to miss payments in the future.
This means that they look at your credit history to view how you've managed all of your credit obligations.
Missed payments is the most powerful predictor of future late payments. The FICO score evaluates previous late payments in three different layers:
How Severe - How severe is the late payment? It doesn't take a statistician to tell you that a 30-day late isn't as bad as a 90-day late. The more severe the late payment, the more damaging it is going to be to your credit scores.
Consumers who have missed payments by a few weeks and then bring their accounts current score much better than consumers that have gone 90+ days past due. In fact, a 90-day past due is the threshold that will wreak havoc on your scores.
If you are unable to avoid a late payment, the next best option is to get those accounts current as quickly as you can.
How Recent - How long ago did the late payment occur?
If you've read some of my previous articles on credit scoring, you'll know that the last 24 months of your credit history are critical because the FICO score places more emphasis on your recent credit patterns.
This means that a late payment 6 months ago is going to carry much more weight than a late payment from 4 years ago. To recover from late payments it's important that you get current and stay current.
How Frequent - How often have the late payments occurred? Consumers that miss payments frequently are penalized much more severely than those that have missed a payment here or there in their past.
If you have a tendency to make late payments your credit scores will reflect your bad habits. Make your payments on time and you'll never have to worry about losing points in this category.
Credit Mistake #3: Settling Accounts
One of the most common mistakes consumers make is assuming that 'settling' with a lender is a great way to save a little cash.
Unfortunately, they don't realize what that a 'settled' indicator in their credit reports is actually derogatory.
"Settling" is a term used in the consumer credit industry that means accepting less than the amount you owe on an account. For example, if you owe a credit card company $5,000 but you can't pay them the full amount then they will likely make you a deal for less than that full amount. They have "settled" for less than the full amount, which is likely much less than you contractually owe them.
This may seem like a good idea because you save quite a bit of money but as far as the credit scoring models are concerned, this is just as negative as other severe late payments.
The only way to avoid the damage to your credit scores is to arrange a deal with the lender to report the account as 'paid in full' as opposed to 'settled'. If they don't agree then it's in your best interest to figure out how to pay them in full or else be prepared to suffer the damage to your credit for the next 7 years.
It's also important to understand that if the account has already made it to the collection phase, the damage is already severe and settling won't really make a difference. Settling is only an option if the account has already made it to a severe delinquency state.Ã‚
Credit Mistake #4: High Revolving Utilization on Your Credit Cards
Most consumers believe that making your payments on time is all it takes to have good credit and earn great credit scores.
What they don't realize is that almost a third of your score is determined by how much you owe on your credit card accounts. If you have high balances on your credit card accounts, you're credit scores could be severely impacted by your revolving utilization.
In order to score the most possible points in this category, I advise keeping your revolving utilization at 10% or less.
Don't be fooled when you hear some of these celebrity experts telling you that 50%, 30% or even 25% is best.
While 30% is considerably better than 50%, 10% or less is ideal. The lower the utilization percentage, the better your score will be. (*To read more about revolving utilization and how it's calculated, please read the revolving utilization bullet in Mistake #1.)
Credit Mistake #5: Excessively Applying for Credit
Whenever you apply for credit your application gives the lender permission to access your credit reports. When they pull your credit reports, it automatically posts an inquiry in your credit record. This inquiry is a record of who pulled your credit report and the date it occurred.Ã‚
Credit scoring models use inquires to determine if and when you shop for credit. Statistics show that consumers who have more inquiries are higher credit risks than those with fewer inquiries.
It is for this reason that the more inquiries you have, the more points you lose in the credit score calculation.
The exact point value of inquiries is a much argued topic and is impossible to give an exact point value because it really depends on all of the other information included in your individual credit file.
The best strategy would be to only apply for credit when you absolutely need to.
This means that you should avoid those in store offers of "10% off" in exchange for applying for a store credit card. This may sound like a great idea but the reality is that while you may save a few bucks on your purchase, those inquiries could end up costing you a lower credit score which could result in higher interest rates on auto or mortgage loans in the future.
There you have it. Now that you know the top 5 credit mistakes, you can avoid making the same mistakes that so many other consumers make.