Saturday, September 23, 2023
Credit Cards

Four Habits That RUIN Your Credit Score Without Realizing

Building a good credit score is one of the most important things you could do for your financial health, because not only can it literally save you tens of thousands of dollars in interest over the course of your life for things like a mortgage or a car loan, but it’s also going to help you do things like get approved for the best credit cards with the best rewards and benefits. The cool thing is, it’s actually pretty simple to build or increase your credit score fairly quickly if you just take a few simple steps, but unfortunately, the bad news is that it’s also just as simple to ruin your credit score if you’re not being careful. That’s why, in this blog, we’re going to go over four bad habits to stay away from when it comes to your credit score and how you can avoid them, so that way, hopefully, you’ll end up moving your score in the right direction towards 850 and not down towards 300. 

1. Making Late Payments

Let’s start with the first habit that surprisingly trips up a lot of people because they just don’t realize how bad it can be for your credit score, and that is making late payments. 

So the fact is that around 35% of your score is going to come from the factor of payment history, and as you can see from this breakdown, that actually makes this the most important factor. Now, to have the best effect on this, it’s pretty straightforward because all you have to do is not miss any monthly payments, so that way, your on-time payment history is 100%, and that’s really it. The credit bureaus just want to make sure that you have a good track record of making previous payments on time because, obviously, that’s going to be a pretty good indicator of how likely you are to make future payments on any new credit that you’re applying for as well.

Now, a late payment is typically defined as any payment that’s 30 days past due or more, and the longer the payment is late, the worse the effect on your credit score. So a 60-day late payment is worse than a 30-day late payment; 90 days is worse than 60 days; and so on. Now, a good thing here is that lenders don’t usually report a payment as being late if you’re within that 30-day window after a payment due date, so you have some time if you realize that you forgot to pay or something like that. 

Whatever you rely on, though, always aim to pay by the due date because you might still get hit with a late fee if you don’t, but you can typically get that wave too if you just call and ask nicely and try to assure them that it won’t happen again. Now it’s also important to remember this because a lot of people don’t realize it, but even going from a 100% payment history to 99% with one missed payment can drop your score by as much as 100 points or more, and then that missed payment stays on your credit report for 7 years as your score slowly improves back to its previous level over many months or even years depending on your situation, and of course that could just be really, really frustrating.

We want to try to avoid those harsh consequences at all costs, but luckily, as I said before, it’s pretty simple to do this if you just take a few quick steps to prevent missed payments. First, make sure that you’re only using credit cards if you know that you already have some money set aside in your bank account to pay off your balances on time and in full each month. I see too many people completely rely on their expected future income to pay off their credit card balances or to make any other type of debt payment, but doing this just really increases the risk of a late payment happening, so be prepared with some cash savings. Also, budget and track your income versus your expenses, and then cut back on your expenses if you need to so that hopefully, you’re not living paycheck to paycheck while using credit cards.

Then, as a second optional step, you can set up auto-pay to ensure that you make at least one of your monthly minimum payments. Now again, for things like credit cards, you should always aim to pay off your statement balance on time and in full by the payment due date and not just make the minimum payment because that’ll avoid interest charges from carrying a balance, but setting up auto-pay for at least the minimum payment is going to basically help you never accidentally miss an on-time payment, which is what we want to see for our credit scores.

Again, just make sure that you always have enough cash in your linked bank accounts so that you don’t run into any overdraft issues, but auto pay is what a lot of people like to have in place as a backup to avoid late payments. Finally, I believe it is a good idea to set reminders on your phone for each payment due date that you have. That way, you’ll be reminded when everything is due and won’t forget. You can experiment with these ideas and use what works best for you.

But personally, what I like to do is update my own personal balance sheet maybe twice a month so that it shows me how my assets are doing, and then I subtract any of my credit card balances or other liabilities that I have to give me my net worth, which hopefully keeps climbing over time. I like to follow the whole idea of treating yourself like a business, and that really has helped me to stay on top of not only my net income and my cash flow, but it also basically helps me to never miss a credit card payment or run my credit utilization too high either.

2. Maxing out your Credit Card or Having a High Credit Utilization

That leads me perfectly to the second habit that can ruin your credit score, which is maxing out your credit card or having a high credit utilization. I like to bring it up frequently because it is something that even fewer people are aware of and how it affects your credit score. Actually, just the other day, my girlfriend Jackie asked me why her credit score dropped by a few points because she thought that somehow an unauthorized new hard inquiry or something like that happened. But after a quick look, we saw that the balance on one of her existing credit cards was reported as being a bit higher than usual because she had made a larger purchase and didn’t pay that down.

When her statement closed and her balance on that one card was higher than it normally is, a higher credit utilization was reported to the credit bureaus, which in turn caused your score to drop by a small amount. I know it was nothing to be concerned about because her credit score is already great and the utilization wasn’t that bad, but it does show the importance of credit utilization and how it can either drop your score or even hold you back. If you weren’t aware of the fact that it’s the second most important factor that goes into your score, since it impacts about 30% of it as a major part of the amounts owed, this factor and the other one we just talked about with payment history are what I like to call the “big two factors” of a credit score.

And actually, the nice thing is that these two big factors are also the two things that I think are the easiest for anyone to control once they’re aware of them, which means that you have more power over your credit score than you think. With payment history, the control you have there is to sort of create a system where you don’t miss payments. And then with credit utilization, like I’m going to explain next year, the control you have is to manipulate either your credit card balance, your credit limit or both to basically get whatever utilization you want.

Again, the first step here is to make sure that you have enough cash set aside when you’re using credit cards to be able to make your payment safely, but the second step is to identify what your credit card balance is, what your credit limit is, and when your billing cycle closes, which is also called the statement closing date. The reason we want to know these things is that your credit utilization is calculated as your balance divided by your credit limit, and it typically only gets reported once per billing cycle, on or around that statement closing date.

Now your credit utilization is going to be calculated on a per-card basis as well as across all of your credit card balances and limits combined. But as an example, let’s say that we only have one credit card open right now. To keep it simple, we’ll also say that today is July 15th, and our balance is $1,500 from purchases we made in the current billing cycle; we have a $2,000 credit limit; and our statement closing date is going to be July 31st.

If we did nothing right now, then on July 31st, when our statement closes, our credit utilization would get reported as 75%, which is way too high and would drop our credit score, especially since we only have one card in this example, so the impact should be greater. But here’s what we could do instead to address the amounts owed factor and improve our credit utilization: If it was July 15th and our balance was $1,500 with a $2,000 limit, sometime before the statement closes on July 31st, we could pay down part of that balance so that a much smaller balance gets reported instead because remember, our utilization is only reported about once per month on that statement closing date.

So maybe we could pay down $1,450 of that $1,500 balance before the statement closes so that on July 31st, our balance is only $50 with a $2,000 limit, and then our utilization would get reported as being only 2.5%, which looks like very responsible use of credit for our score. Or we could also address the denominator in that equation because maybe a $2,000 credit limit on this card just isn’t enough spending power. Over time, as we improve our credit score and do things that lenders prefer to see, like maybe increasing our income, we can ask for a credit limit increase or apply for another credit card that’ll give us a higher credit limit, where we can then spend a bit more freely.

So if we went ahead and opened another credit card, let’s say we were given a $15,000 limit this time after we’d shown that we were responsible with our first card. Now with that same $1,500 balance and a $15,000 limit, if that got reported on our statement closing date, that’s only a 10% credit utilization, which we could still partially pay down to get lower as well, but a 10% utilization looks a lot better to credit bureaus than the 75% utilization we had with our original card.

Now I know that I just spent a lot of time going over those two factors and some habits to avoid with them, but I wanted to do that on purpose since they really are the two things to focus on the most if you want to improve your score. Focusing on some of these next habits is important too, but if you don’t address the bad habits around those two big factors of payment history and credit utilization first, then fixing those other habits just won’t do that much.

3. Closing Older Credit Cards

So with that said, the third habit that’ll ruin your credit score if you’re not careful, is another one that I see too many people doing without even thinking most of the time, and that is closing older credit cards. Now, closing an older credit card, even if it’s one that you’re not really using that much anymore, is not a great idea because doing this is going to affect two credit score factors.

So if we’re looking at that breakdown of what goes into a score again, we’ll see that the length of credit history is the third most important factor, even though it only makes up about 15% of that score. But then closing a credit card is also going to affect the credit utilization factor, or amount owed, that we just went over as well. Now the way it hurts utilization is pretty much the opposite of the good effect that opening a new credit card can have. So when we open a new credit card, we’re adding an additional line of credit that increases the total credit limits available to us. And since overall credit utilization is calculated as the balances divided by the credit limits, some simple math tells us that when we increase the denominator here, we’re decreasing the utilization that’s calculated as long as the balances remain the same.

When we close a credit card, we’re removing a credit limit that was available to us, so we’re decreasing the denominator, which in turn increases our utilization. So hopefully that makes sense, and you can always rewind to the example I went through earlier in this blog if you need to understand the math here because it is really important to understand the role that credit utilization and that equation play in our credit score. But then, for that age of credit factor that makes up another 15% of our score, this is where a lot of people make the mistake of closing some older credit cards that they have that they might not really use much anymore.

So your average age of credit is a big part of this factor, and those older cards that have been open for the longest really help to bring up the average of your credit as time goes on. Generally speaking, the longer your credit history, the better it is for your credit score. But when you close those older accounts, you can be unknowingly hurt by this factor and then hurt your score when you really don’t have to. So what I think most people could do instead is follow two rules. Number one, if you have any credit card with no annual fee, even if the rewards aren’t that great and you’re only using it maybe once per year, just keep it open since it’s not costing you anything.

Doing this is going to allow you to keep the age of that account and the credit limit, which both can have a positive impact on your credit score. And number two, if you have an older credit card with an annual fee that you don’t want to pay anymore because maybe it’s not worth it, look to see if you can downgrade that card to a no-annual fee credit card with the same issuer before you close it.

Many credit cards have this option if you just do some research or call and ask, and not only will you get rid of that annual fee, but again, you’re going to keep the account open and still have the same age and credit limit. Now if you can’t downgrade and you really do want to cancel because of an annual fee, or if you really think that you have too many credit cards and it’s doing more harm than good for you, then you still can close an account, and it’s not going to be the end of the world, especially if your credit score is already in a good place.

A credit card closed in good standing will actually stay on your report for up to 10 years and continue to positively impact your score during that time. Even though your credit utilization could still see an impact with fewer available credit limits, my point here with this habit is to be more intentional with your decisions to either keep open, downgrade or close a credit card. If there is no annual fee, it is usually best to keep a card open, but make sure to keep your oldest credit cards open so they can continue to help with your credit score and age of credit.

4. Taking Credit Cards to the Extremes

Finally, here is the fourth habit that ruins your credit score: I’m going to sort of address two very different types of people with this, so let me explain. But that habit is taking credit cards to the extreme. Now what I mean here is that if we ask for everyone’s opinion about things like whether they use credit cards or how often they want to apply for new credit cards and then line everyone up on a spectrum, imagine that we could look at both extremes on both ends here because I think we could point out some things to avoid.

On one extreme, we might have people who say don’t use credit cards at all; just stay away from them because they’re debt and lead to more debt and trouble and all that. But then, on the other extreme end, we probably have people with dozens of credit cards who may be constantly hunting for new bonuses and opening new credit cards every single month. I think that in order to use credit cards the right way for most people looking to build their credit score and not hurt it, we want to aim to be somewhere right in the middle of these two extremes, and here’s why.

We don’t want to stay away from credit cards entirely because we’re leaving out a big part of your credit mix, which also accounts for another 10% of your score. Now you can still get different installment loans, mortgages, and other credit payments reported, which will contribute to your credit mix, but usually, these things involve bigger financial decisions that you don’t make every day, like buying a house or a car or taking on student loans.

Credit cards are more of a credit product that we can use on a daily basis and that really has no additional cost for us to use as long as we’re spending intentionally within our budget, treating our credit cards like cash, and just paying off our balances on time and in full every single month. So by viewing credit cards as evil and not using them, yes, you are going to be eliminating the chances of you getting into credit card debt and overspending, but you’re also sacrificing the positive impact that can have on your credit score.

And without having at least a beginner credit card to start building credit, if you don’t have a credit score and then go buy something like a house, unless you have all cash, you’re going to have a tough time getting approved for a mortgage. So I think it’s good to have even just one basic credit card at a minimum, even if you barely use it because that’s still going to be good for building credit. I think that the extreme habit of avoiding credit cards entirely for most people is just not necessary because they can actually do a lot of good if you take the proper precautions.

But then there’s also the habit to avoid on the other extreme end of that spectrum, which is applying too often for new credit cards. So, I know I said it’s a good thing to get a new card with a new limit because it can help with overall utilization in the long run, but in the short term, you can actually overdo it because, with every new credit card you open, that issuer will do what’s called a “hard inquiry,” which is basically just pulling your credit report to look at it.

When any lender does a hard pull like that, it’s going to show up on your credit report and drop your score by maybe just a few points in the short term. Now, hard inquiries only stay on your report for around two years, and the drop they cause is usually only minor and goes away fairly quickly, so the impact isn’t as bad for someone who already has a good score. But for people who take it to the extreme and apply for several cards within a few short months or apply for a mortgage, then a credit card, then a car loan, those people are going to see more of a negative impact on their score.

Even if you are early in your credit journey, these frequent hard inquiries will have a negative impact. So basically, just avoid the habit of applying for credit cards or any other type of credit too much too soon, and if you’re trying to get a mortgage, don’t get a new credit card or apply for a bunch of other credit in the months leading up to that because that is just going to drop your score and not give it enough time to recover for you to get the best interest rate on your mortgage.

If you do want to get a few new credit cards, just space them out over maybe three to six months on average. Not only is that good for the new credit factor of your score, which also makes up the remaining 10% of your score, but it’s also just a good practice with credit cards because it allows you to meet the minimum spend requirement for a bonus on whatever card you just opened. It also allows you to see if you can handle your current number of credit cards because the appropriate number varies from person to person.

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