January 15, 2014
5 credit blunders to avoid
Common mistakes borrowers make that put their credit scores into a tailspin
As 2014 kicks off, many Americans are resolving (as they do each year) to get their finances in order. Besides saving more, that means not repeating the mistakes that previously hurt their credit scores.
Nationwide, the average FICO score stood at 690 in October 2013, according to new data by FICO. That’s not great, considering that the FICO score — the credit score that’s used in most consumer lending decisions — runs up to 850, and most lenders won’t approve borrowers for a mortgage without a score of at least 720. Worse, almost a quarter of consumers have a FICO score that’s below 600; with most lenders, that’s considered subprime — meaning it’s very difficult to get credit. Those borrowers who do get approved typically pay very high interest rates.
Of course, the importance of a high credit score extends way beyond access to credit. Low scores can make it difficult to rent an apartment. Car and home insurers may choose not to provide coverage to applicants with low scores or to charge them excessively high premiums. Negative information on a credit report (which determines a credit score) can lead hiring managers to reject a job applicant.
To improve their scores, consumers will need to know what hurt them in the first place. Here are five common mistakes consumers make that send credit scores into a downward spiral.
Keeping high balances on credit cards
Nearly one in five consumers believes that carrying credit-card debt from month to month is a responsible way to manage household finances, according to a poll conducted in July by the National Foundation for Credit Counseling, a nonprofit financial counseling organization. Yet keeping a high balance often leads to a low score. Excessive credit-card debt can lower a FICO score by 100 or more points, says John Ulzheimer, consumer credit expert with CreditSesame.com, a credit management site, and a former manager at FICO. Scores drop even more once a cardholder has maxed out his or her credit card. This month, CreditKarma.com, a credit-management site, found that consumers with maxed-out cards have an average credit score of around 560.
Thirty percent of the FICO score is based on the amount a consumer owes on credit cards. The so-called credit-utilization ratio looks at how much debt a person is carrying compared with how much credit they have available overall. Once a consumer reaches a 10% ratio — say, $1,000 of total credit-card debt, with a $10,000 total credit limit — their score starts to drop by a significant amount, says Ulzheimer.
The problem for many consumers is that even a small amount of debt can eat up 10% of their credit line or more. Consumers with low credit limits tend to be hit the hardest. When Thomas Renna, who owns an equities-research firm in Cranford, N.J., checked his credit reports, he was surprised to find notations that he had excessive debt, since he only has one credit card with a $300 limit. But his balance on that card was $311 (due in part to the card’s annual fee), which meant he had a 104% debt-to-credit ratio. As a result, his credit score was lower than it could’ve been.
Closing credit cards
Many consumers shut down their credit cards to avoid taking on more debt. Unfortunately, the tactic often hurts their credit score, mainly because it messes up that credit-utilization ratio.
By shutting down the card, they’re eliminating a line of credit — lowering their total available credit. As a result, the credit-card balance they have on other cards suddenly makes up a greater proportion of their overall credit limit. For instance, someone with $2,000 of credit-card debt on one card and a total credit limit of $10,000 on all cards has a 20% ratio. But should that person shut down a card with a $2,000 credit limit, bringing his or her overall credit limit to $8,000, the credit-utilization ratio jumps to 25% and results in a lower score.
Consumers who are concerned about going into debt if they don’t close their credit cards may want to store those cards in a place where they won’t have easy access to them, like a safe-deposit box.
Making late payments
The fastest way to lower a credit score is to miss a payment, says Ulzheimer. Payment history — specifically whether a person is late with payments or misses them entirely as well as derogatory information like bankruptcy and foreclosures — determines 35% of the FICO scores, according to FICO. Yet just over a quarter of people surveyed said they did not pay their bills on time in 2013, according to an NFCC report.
Missed payments haunt borrowers’ credit scores even after they catch up on their bills. A late payment stays on a credit report for seven years — and just one late payment can decrease a consumer’s credit score, says Ken Lin, founder and CEO of CreditKarma.com. Matt Capristo, an online advertising executive in Alexandria, Va., says he fell behind on his federal student loans and credit cards shortly after graduating college. Capristo, who is now 27, says his income at the time was not large enough to pay those bills but that he caught up early last year. A few weeks ago, his FICO score stood at 666, only slightly higher from a year prior.