When it comes to the world of personal finance and borrowing money there are few numbers more important than your credit score. Credit scores are used by financial institutions to determine the likelihood of the borrowed funds to be paid back. Moreover, it is one of the biggest factors in determining the interest rate offered on a loan. Credit scores are used to determine rates for everything from mortgage loans to insurance rates. There are three major credit reporting agencies: Equifax, Experian, and TransUnion. These agencies use your credit history and their proprietary numerical models to create a number that represents an individual’s credit worthiness. A good credit score will get you the best rates; by improving your credit score you can save tens of thousands of dollars over the course of a mortgage. Since most of us will need to borrow money at some point in our lives it is important to understand credit and the credit mistakes to avoid.
Too Much Debt
The first, and most obvious, credit mistake is too much debt. Although debt is essential to building a good credit score, it is important to be diligent with managing your debt. Credit cards in particular need some attention if you want to improve your credit score. All credit cards come with a limit — be mindful of this number. Exceeding 30% of the credit limit negatively impacts your credit score; especially if spending is continuous. If the credit card utilization is above 30%, or it looks like it is going to be, try paying down that line of credit to below 30%. An alternative option would be to ask your credit card issuer to increase your credit limit. However, if you are trying to maintain your budget and spending habits, the latter could potentially impact your expected output with increased monthly payments. When requesting a credit limit increase, your credit score may be pulled in order to validate your request.
One thing to note: Credit scores do not update automatically — it takes upwards of 30 days from the last reported change to be reflected on your credit score.
Not Enough Debt
A far less obvious credit mistake is no credit history. This one seems a little counter-intuitive, but having a healthy amount of debt is actually pertinent during the home buying process. As a rule of thumb, when applying for a mortgage loan, there should be a minimum of three open lines of credit that are well maintained. Even if you are opposed to debt, you need to show a history of successfully paying off debt in order to acquire new debt. If you have not had an open line of credit in a while or have no credit history, you might not have a credit score. If you do not have any open trade-lines, consider opening a credit card and using it like a debit card – but be sure to pay off the balance as you use it and avoid having a balance that rolls into the next month. This shows financial institutions and creditors that you are responsible with your debt. It might even come with some added perks — like cash back rewards — depending on the credit card provider.
Some first-time home buyers who have done everything right — such as keeping credit card balances low and having three or more open credit lines — can still suffer from not having enough “length of time” on their accounts. Credit bureaus give better credit scores to those who have longer account histories. If you have only recently acquired a credit card or a loan there is not much you can do to improve this. However, if you have a credit card that you no longer use, hold off on closing it. It could be your longest standing line of credit and is actually boosting your credit score. Let’s say you are 25 years old, you have two credit cards — one was opened at 23, and the other when you were 18 — but you are considering consolidating them. Closing the account you opened when you were 18 years old would shorten your credit history from 7 years to 2 years — negatively impacting your credit score. Consider this and choose wisely!
Not Understanding the Effects of Credit Inquiries
Are you looking into a new credit card? Financing a car? Or purchasing a home? In order to open a new line of credit, an inquiry will be made on your current credit score.
There are two kinds of credit checks — hard inquiries and soft inquiries. A mistake I see often is people not understanding the differences between these inquiries or not understanding when and how inquires will affect their credit score.
Soft inquiries are typically used when you are not applying for actual credit; for example, you are checking your own credit score or having a background check. Soft inquiries do not hurt your credit score. On the other hand, hard inquiries can negatively impact your credit score. Mortgage loans, auto loans, credit card applications and even apartment rental applications require hard inquiries — so keep this in mind during those transactions. These credit dings typically last for up to 2 years before they are removed from your credit history. Avoid store branded credit cards for discounts on products unless you plan on keeping the card open for the long-term. These are still credit cards and create hard inquires when you apply.
If you are applying for a mortgage loan, auto loan, or student loan the credit bureaus give you the ability to “shop around” — allowing you the opportunity to have your credit pulled as many times as you like by other mortgage companies within a 30-day window without having these inquires count against you. This is a useful tool if you are wanting to compare rates, but be mindful of the timeframe so that these inquires only count against you once.
Not Understanding the Different Types of Debt
Not all debt is created equal. People can make a lot of mistakes when it comes to understanding how different types of debt affect their credit score. Generally, debt falls into four categories: secured debt, unsecured debt, revolving debt, and installment debt.
- Secured Debt: Debt that has an asset backing it up. This could be a house in the case of a mortgage loan, or a bank account in the case of a secured credit card.
- Unsecured Debt: Debt that is not secured by an asset. This could be a personal loan or student loan.
- Revolving Debt: Debt that is open-ended. It can be charged up and paid down. Credit cards are an example of revolving debt.
- Installment Debt: Debt that is closed-ended. This debt has a fixed time period and is paid down throughout the length of the loan.
Installment debt would be considered the safest type of loan to help improve your credit. They are safe, they have fixed terms, and they are typically backed by a physical asset. The two most common installment debts are mortgage loans and auto loans. If you do not have a mortgage loan or auto loan, you can also improve your credit by having your rent reported to the credit bureaus. This will show a history of payments which in turn will improve your credit score. You can also get your cell phone bill reported. However, be cautious of reporting these when applying for a mortgage loan, as it will impact your debt-to-income ratio and could potentially lower your purchasing power.
Not Understanding the Impact of Late and Missed Payments
The last mistake I want to touch on is derogatory records. Derogatory records mark late payments, missed payments, charge offs and collections. All derogatory recordings will have a negative impact on your credit score. Do not make the mistake of missing a payment or forgetting you have an outstanding debt. As a lender I have seen cases where a borrower signed up for a credit card on a flight, bought a drink on the plane, then forgot to pay it off — ultimately suffering a much lower credit score because of a missed payment on a card they forgot about after they landed. If you find yourself in this situation you do have the ability to call the credit bureaus and the credit card issuer to try and dispute the missed payment and have it removed from your credit report. This is not always successful, but it is worth the effort to help improve your credit.
Open lines of credit can be a powerful thing. With these insights, you can better understand your credit score and address the areas that may need the most attention. If you are in the market for a home loan or other areas of personal lending, one of our banking experts can help walk you through the process. Find more information at https://cfbhfg.com/personal/personal-lending/
Max Lucas, NMLS ID# 2084908
Mortgage Loan Production Partner