The credit scoring models used by the three national credit repositories have long been a mystery to many consumers. While the methods used to determine credit scores have become much more transparent in recent years, many consumers still choose to take advice from friends and family members that have the best of intentions, but aren't credit experts. The result can potentially be a catastrophic drop in credit score. Knowing the right steps to take is very important to managing your credit wisely.
Quite often, many actions that common sense would seem to indicate would have a positive effect on the credit score actually have a negative effect! Here are the most common mistakes that consumers make that either results in a lowering of their credit score, or may have no impact at all when they believe it will raise their score:
CLOSING CREDIT CARD ACCOUNTS
Credit scoring is an algorithm. That means it's a mathematical formula that considers many factors when determining the score. One of those factors is the length of time accounts have been established. The credit bureaus figure that long-established accounts should carry more weight in the scoring model thanhly than newer accounts. As luck would have it, the longest reported accounts are often credit cards since they are revolving and remain open indefinitely.
Many people who struggle for years to pay off a credit card with a high balance are tempted to close the account as a means of self-discipline to insure they will never get caught in the trap again. While this may be a good feeling and a natural reaction to the victory over debt, it can drastically lower the score, especially if the account has been open for a long time.
Instead of closing the account, consider asking the credit card issuer to reduce the credit limit. This way the account will stay open but there will be no way to charge the balance higher than your personal comfort zone without asking for a credit limit increase. If the card issuer will not lower the credit limit for some reason, then cut up the card but keep the account open. Without the physical card and the information such as expiration date and the 3 digit card security number, there will be few places, if any, that you could use the card. This should reduce the temptation and the ability to charge things you can't afford but keep your credit score from falling.
PAYING OLD COLLECTIONS WITHOUT ESTABLISHING NEW CREDIT
Many people assume that their credit score is low because they have old collections. While collections can certainly have a negative impact, failure to reestablish new credit if you don't have any will keep the score down much lower than simply not paying collections. I'm not about to suggest that it's a bad idea to pay your bills, but paying collections that are over one year old will have little to no effect on the credit score. Once an account is reported as a collection, the damage has been done and a record of the collection will exist for seven years. So if you're trying to increase your score because it's low due to collections and a general lack of established credit, consider establishing credit first and then repaying or negotiating a settlement with the collection agents. Many creditors will settle old collections for pennies on the dollar, and the older collections are, the less they're worth to the collection agents in general.
I've occasionally seen people pay large amounts on collections in hopes their credit score would dramatically increase, only to discover after paying them that their score has barely changed at all. This is MOST COMMON in people who have a low credit score and don't have any new credit established. If you happen to be one of those people who has a low credit score because you made some mistakes in the past and now you don't have any open accounts (credit cards, car loan, etc), I can almost guarantee that's the main reason why your score is low. If increasing your score is your #1 goal, again, you must REESTABLISH credit in order to get your credit score out of the doldrums. Secured credit cards are an excellent way to do this for people with low credit scores since many secured credit card issuers do not even require a credit check. They only require a savings deposit equal to the credit limit in order to secure payment, and having some skin in the game encourages people to be more responsible.
OPENING TOO MANY ACCOUNTS TOO FAST OR HAVING TOO MANY OF THE SAME TYPES OF ACCOUNTS
On the flipside to reestablishing credit, don't get carried away and open too many accounts. It's also important to have a fair mix of credit since that's another factor that is counted in the credit scoring algorithm. Ideally, you should have at least three open and active lines of credit, especially if you are planning to buy a home in the near future since most mortgages require a minimum of three established accounts to qualify. Credit is like asprin: One or two is good, but too many will make the problem much worse. Keep the number of accounts in check and try to have a good mix.
If you are applying for credit because you don't have any accounts and are trying to reestablish, then don't worry as much about the effect of getting too much credit at once. It's true that your score may temporarily drop, but it should come back up once a few months of payment history is recorded on the accounts. Don't lose sight of reality: If you're reestablishing credit to improve your chances of qualifyng for a loan in the future, especially a mortgage, you should be more concerned with raising your credit score over time and less concerned about the short term impact that opening new accounts will have on your score. Simply getting a credit card is not going to magically make your score increase 100 points in a week, but over time it will increase steadily if the credit card is paid on time. Credit scores change frequently, and the impact of things you do today will not count as much six months or a year from now. You have to keep your mind set on the big picture.
REFUSING TO HAVE A LENDER PULL THEIR CREDIT BECAUSE THEY FEAR AN INQUIRY WILL DESTROY THEIR CREDIT SCORE
I constantly get calls from clients seeking advice about their credit, but they refuse to let me pull a credit report because their friends told them it will destroy their credit score. First of all, it's impossible to get a home loan without having a lender pull your credit anyway, so even if it did destroy your score (which it doesn't), you wouldn't really have a choice. But fortunately the credit bureaus are smarter than to destroy peoples' credit for just inquiring about a loan. Mortgage inquiries have very little impact on the score, and if I don't know what's on their report, it's impossible for me to tell you what to do to help rebuild and repair your credit.
The credit bureaus deduct the most points for credit card and other finance-type revolving account inquiries, ESPECIALLY if there are too many within a short period of time. Why? Remember, credit scoring is a RISK score. Who would you think is more risky? Someone applying for a home loan or someone filling out 50 credit card applications a week because they don't have money to pay their bills? Obviously it's the latter. The good thing about mortgage inquiries is you can have an infinite number within a 30 day period and it only counts against your score once. In other words, the credit bureaus are not going to penalize you for applying for a mortgage or even talking with several mortgage lenders.
So keep your eye on the prize. A good credit score over time. And make sure you consult with an expert before taking advice from people that aren't credit experts. Making the wrong decisions can have long lasting consequences. As a result of the financial crisis, credit is becoming harder to get, and consumers with mediocre scores will either have to raise theirs or pay higher rates for car loans, mortgages and unsecured loans, assuming they can get credit at all.
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