The Top 10 Credit Mistakes

By John Ulzheimer for Credit.com

http://www.credit.com/credit_information/credit_help/The-Top-10-Credit-Mistakes.jsp

1. Closing Credit Cards Accounts

Some of you may wonder why Closing Credit Cards is number one on this list as the biggest credit mistake even above Missing Payments. In fact, closing credit cards is almost as bad of an idea to increase your credit scores as missing payments, but it is also a clear number one on the list of credit myths. It is perhaps the most common piece of advice that consumers are given when they ask,” How can I increase my credit scores?”. If there were ever a wolf in sheep’s closing as far as credit mistakes go, it’s this one. Closing credit card accounts will not increase your credit scores. So called “industry experts” such as mortgage lenders suggest that you close credit cards as a strategy to increase your credit scores to qualify for home loans. However, there are two huge reasons not to close credit cards that you no longer use. They are:

  • They will eventually fall off your credit reports – Information on your credit reports has to follow certain rules as far as how long it can remain on the report. In most cases credit information will remain on your credit files for no longer than seven years from the account’s Date of Last Activity or “DLA.” Your DLA will continue to update each month so long as the account remains open. So, an open account will never reach the seven-year mark because each month your DLA updates to the current month. However, once you close the account your DLA will cease to update and the clock begins ticking. Eventually the account will be removed permanently from your credit reports.

    Why is this a bad thing? The answer to this one is very simple. It’s all about your impressive past. Here’s an analogy that might make this easier to understand. Let’s say hypothetically that 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. This also applies in the credit reporting environment. If you have a perfect record of making your payments on time then this significantly helps your credit scores so why would you ever want that history to disappear? You wouldn’t.

    What should you do with old credit cards that you don’t use any longer? The problem with inactive credit cards is that you are not generating any revenue for the credit card company. Eventually they will proactively close the unused account because you are a liability, not an asset. Prevent this from happening by using the card once every few months for dinner or a low dollar item like socks or a new belt. Once the bill comes, pay it in full. Doing this will ensure that the account will never be closed and you’ll always get credit for your good payment history.

  • You will hurt your “utilization” measurements – This is significantly more important than your closed accounts eventually falling off your credit reports. Revolving Utilization is the amount of your revolving credit card limits that you are currently making use of. For example, if you have an open credit card with a $2,000 credit limit and a $1,000 balance then you are 50% “utilized” on that account because you’re using half of the credit limit. This measurement is almost as important to your credit scores as making your payments on time. If you had a second open, but unused, credit card with a $2000 credit limit and a $0 balance then your aggregate revolving utilization is 25% because you have $4000 in credit limits and $1000 in balances. $1000 divided by $4000 is .25 or 25%.

    How will closing an unused credit card hurt your credit score? Let’s say that you closed that second unused credit card from the above example. Once you do so then you remove it from any utilization calculation and now you’re stuck with one open card with a $2000 credit limit and a $1000 balance. Now your utilization has gone from 25% to 50% (divide $1000 by $2000 and you get .50 or 50%). As this percentage increases, your credit score decreases.

2. Missing Payments

The reason missing payments is number two on the list instead of number one is that it doesn’t take a credit scoring expert to tell you that missing payments is a bad thing. It’s common sense, unlike Closing Credit Card Accounts. The explanation why missing payments is a huge mistake is also fairly obvious. Credit scores look at your credit history to see how you have managed your current and past credit obligations in an effort to predict how likely you are to miss payments in the future. The most powerful “predictor” of future late payments is having missed payments in your past. There are three ways that missing payments will hurt your credit scores. They are:

  • How Frequent are Your Late Payments? – If you miss payments frequently then you will be penalized much more severely than someone who misses payments infrequently. Missing payments every once in a while indicates that you are a responsible consumer but you may have problems with finding the time to make your payments. Or, perhaps the bill was lost in the mail or you were out of town on travel when the bill came due. The point is that you are not making a habit of missing payments. Don’t start.
  • How Recent are Your Late Payments? – Since scoring models are designed to predict how you are going to pay your bills in the subsequent 24 months, it’s very common that they assign more value to how you’ve managed your credit in the most recent two years. If you have late payments that have occurred in the most recent two years then you are more likely to miss more payments in the next two years. As such, your score will suffer.
  • How Severe are Your Late Payments? – The severity of your late payment also plays a big part in your credit scores. This not only makes statistical sense but also common sense. Consumers who have missed payments by only a few weeks and then bring their payments up to date are going to score better than consumers who have payments that are 90 days past due or worse. If you have late payments it is in your best interest to do all that you can to bring them up to date.
3. Settling With Your Lender on a Past due Account

“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 $10,000 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 are happy that you didn’t have to pay the full amount. However, the lender will report that remaining amount to the credit bureaus as a negative item. This remaining amount is called the “deficiency balance”. A deficiency balance is considered just as negatively by credit scoring models as any other severe late payments. If you can arrange a deal with your lender so that they will NOT report the deficiency balance then that will be your best course of action. If they will not agree to this then you have to figure out a way to pay them in full or your credit will suffer for 7 years.

4. Over Utilization of Your Available Credit Card Limits

Having high balances on your credit cards will undoubtedly cause your credit scores to go down, and in most cases, in a big way. The mistake you are making is called “over utilization.” Over utilization is the practice of running up balances too close to your credit card limits. For example, if you have a Visa card with a credit limit of $10,000 and a $5,000 balance you have a utilization percentage of 50% because you are using 50% of your credit limit. The higher that percentage the fewer points you will earn for your credit scores. If your balance is $9,500 then you will be 95% utilized and in big trouble. Your best bet would be to use your cards sparingly and pay them down as much as possible each month. If paying your cards off every month is unrealistic then try your best to keep that percentage as low as possible. There is no magic target to shoot at, but it’s safe to say that the lower the percentage the better.

5. Excessively Shopping for Credit

Every time you fill out a credit application you are giving the lender permission to access your credit reports. When they access your credit reports they automatically post what is called an “inquiry”. The inquiry is a record of who pulled your credit report and on what date. Federal law requires that the lender post the inquiry. It also requires that the inquiry remain on the report for 24 months.

Inquiries are used by credit scoring models to determine whether or not someone is shopping for credit. It is a statistical fact that consumers who have more inquiries are higher credit risks than consumers with fewer inquiries. As such, the more inquiries you have the more points you will lose in your credit scores. While the exact point value is a closely guarded secret by the credit scoring companies you should assume that your scores would suffer if you have an excessive amount of inquiries.

Probably the most troublesome byproduct of holiday shopping is the collection of inquiries that consumers end up with. Think about this scene: you go to the mall to go shopping and are enticed by offers of “10% off today’s purchase” in exchange for applying for a store credit card. This sounds like a great idea because you are saving a few bucks on your purchases. But if you look at the big picture you will see that this is a horrible idea with dire consequences. If those excessive inquiries cost your credit score 10, 20 or 30 points you could expect to pay higher interest rates on either a future home or car loan. Either way, the thousands of additional dollars that you will spend in interest far outweigh the $20 you saved at the mall.

Think twice about applying for a store card simply to save a few dollars. It’s a better idea to pay for the product with cash, a check or a credit card you already have.

6. Thinking that all Credit Scores are the Same

Credit Scoring is already a confusing enough topic to understand. Add to the mix that there are as many different types of credit scores as there are soft drinks and it gets really confusing. The most commonly used credit score is a credit risk score. A credit risk score is designed to assist lenders by predicting whether or not a consumer will pay their bills on time in the future. The most common credit risk score is designed and developed by a company called Fair Isaac Corporation. This Minneapolis based company builds the industry standard “FICO” score. FICO is an acronym for Fair Isaac Corporation. The vast majority of lenders use their scoring models as part of their standard lending procedures.

There are many different places where consumers can purchase their credit reports and credit scores however not all of the scores being sold are, in fact, the authentic FICO score. On the surface this might not seem like a big deal but it certainly can be. For example, if you are in the market for a new car and you purchase a credit score from a web site that no lender uses then you are really no better prepared to go car shopping. If, however, you purchase the authentic FICO scores then you will have the same exact score that the car dealers will eventually see when they run your application for credit. This can be incredibly empowering for the shopper because you’ll know what your credit situation is before the dealer does. Given that there is a general distrust of car dealerships this will ensure a fair negotiation process when it comes to dealer financing. It will be more difficult to be taken advantage of by an unscrupulous dealership.

When you are shopping online for your credit reports and credit scores be sure that the score you are buying is branded as the authentic FICO® Credit Score. These can be purchased through various reputable web sites such as www.myfico.com and www.equifax.com.

7. Thinking that all Credit Scores Predict the Same Thing

Adding to the confusion in number six above is the fact that there are models that predict other things than general credit risk. Scoring models can be built to predict almost anything including:

  • Insurance Risk – That’s right. Insurance companies use credit scoring models to predict whether or not you are likely to file an auto or homeowner’s insurance claim. A poor insurance score will mean that you will pay higher premiums or be declined coverage outright.
  • Response Rates – Raise your hand if you receive pre-approved offers of credit in the mail everyday. There is an incredible amount of science behind those offers and why you get them. It’s not random. You have been selected from hundreds of millions of other consumers to receive that offer because you have a “Response Score” that indicates you are more likely to respond to that offer than someone else who didn’t get it.
  • Revenue Potential – Credit card companies also use revenue scoring models to predict whether or not you will use their credit card and, therefore, generate revenue for them.
  • Collect Ability – For those of you who have collections on your credit reports you can feel certain that the collection agencies assigned to collect those past due debts are also scoring you to determine whether or not you are likely to repay your collections.
  • Bankruptcy Potential – Bankruptcy scores predict the likelihood that you will file for personal bankruptcy. You can assume that if you have a poor bankruptcy score that your credit applications will likely be declined.
  • Attrition Potential – These scores predict whether or not you will stop using one card in lieu of another. This is called attrition and it is considered the cancer of the credit card industry. If you have a score that indicates that you are likely to attrite and start using another lender’s credit card then you should expect to begin receiving special bonus offers as an effort by your current credit card company to dissuade you from moving on to another card.
  • Fraud Potential – Amazingly sophisticated, these models actually can predict whether or not a purchase you are trying to make with a credit card is fraudulent or not. What’s even more amazing is that it takes about 2 minutes to complete your check out at a store and in this short amount of time you have been scored to see whether or not the retailer will accept your credit card.
8. Not Understanding Your Rights Under The Fair Credit Reporting Act

This act, commonly referred to as the “FCRA”, is a list of the rules and regulations that govern lenders and the credit reporting agencies. You should become familiar with your rights under this act which can be accessed at no cost at the Federal Trade Commissions web site. The address is www.ftc.gov. Some highlights are:

  • Permissible Purpose – There are only eight legal reasons why your credit reports can be accessed. These are called “Permissible Purposes.” Some of the more obvious reasons are: Consumer Disclosure – If you ask for a copy of your own credit report then this is a permissible purpose. As Part of a Legitimate Business Transaction – If you fill out an application for credit then this gives the lender permissible purpose to pull your credit reports.
  • Your Right to Dispute Your Credit Information – Every consumer in the U.S who has a credit report also has the right to dispute the information in that report if they feel it is incorrect, outdated or unverifiable. The FCRA lays out the process and requirements on how to file a dispute and what kind of turnaround time your lenders and the credit reporting agencies have to complete their investigation.
  • Your Right to a Free Copy of all Three of Your Credit Reports – Recently the FCRA was amended by an act called FACTA also known as the Fair and Accurate Credit Transactions Act. FACTA calls for national disclosure of credit reports for free. By September 2005 every person in the U.S can get a free copy of his or her three credit reports. Requesting your free copies if very easy. Go to www.annualcreditreport.com to verify your eligibility.
9. Not Knowing that you Have Three Credit Reports and Three Credit Scores

Most consumers understand that they have a credit report. However, most consumers do not know that they have three credit reports compiled and maintained by three separate and competing companies called “Credit Reporting Agencies.” These companies are essentially warehouses that store your credit history and sell it to lenders who want to grant you credit. These companies are:

  • Equifax – Equifax (NYSE: EFX) is based in Georgia. Their web address is www.equifax.com
  • Experian – Experian is a division of an English based company called GUS (Great Universal Stores). Several years ago Experian purchased the credit database that was formerly known as TRW Credit Services. Their web address is www.experian.com and they have U.S corporate offices in California.
  • TransUnion – Based in Illinois, TransUnion is privately held. Their web address is www.transunion.com.

Each of these companies maintains credit files on over 250,000,000 consumers, which they sell to lenders. They do not share credit information with each other since they are competitors. As such, you will likely have a unique credit report and credit score at each of these companies. Do not assume that your credit reports and scores are all the same.

10. Not Having Credit (or a Credit Score)

That’s right. Not using credit is a huge mistake. The way the credit system in this country works is that it rewards consumers who manage credit responsibly. The reward is in the form of easy access to inexpensive loans. However, choosing to not use credit will prevent you from building a solid credit history and score and will subsequently make it very difficult to secure home or auto loans when the time comes.

Secondly, not having a credit history will result in you not having a credit score. Credit scoring models depend on your previous credit history from which to generate a score. Not having a credit score will make it more difficult to apply for and obtain credit because most lenders use automated systems in order to process your applications. A lack of a credit score will make it more difficult for lenders to process your applications. Some will simply chose to decline your applications rather than manually process them.