Have you ever been surprised when your FICO score dropped? Most likely, it's because you made one of the five mistakes below. Most people aren't aware of the impact some of these actions have. And what's interesting is that it appears that the higher your FICO score, the greater the drop when you make a mistake.
#1: Closing an account
People often decide to close a credit card account for one of two reasons. One, they think they have too many cards and that closing one will increase their score. Two, their credit limit has been decreased and they decide the card is no longer useful to them. But whatever your reasons are, closing an account can lower your score.
"There's a misconception that having too many accounts lowers your score. FICO scores don't take this into consideration. But when you close an account, it raises your utilization rate and that can lower your score," says Barry Paterno, Consumer Operations Manager for myFICO.com.
Your utilization rate is the ratio of your credit card balances to your credit limits. For instance, let's say you have two cards and one has a zero balance and one has a $1,000 balance. If each card has a $2,000 limit, your total limit (across both cards) is $4,000. Your utilization rate is $1,000/$4,000 = .25, or 25%. Not fabulous, but not too bad.
Close the account with the zero balance and your utilization rate jumps to 50% ($1,000/$2,000). Obviously, the amount of the impact on your score will vary according to your individual circumstances, but since the utilization rate accounts for about 30% of your score, you're FICO score will probably take a negative hit.
#2: Maxing out your credit cards
Many consumers make the mistake of thinking that their credit limit is an invitation to spend until it's gone. Now that you understand utilization rate, you probably now understand why maxing out your cards is a problem. Let's look at our example from #1 again. If you max out your two cards, you'll have a $4,000 balance with a $4,000 limit. It's doesn't take a math genius to quickly figure out that your utilization rate is now 100%.
Your FICO score will take a hit. How much? "It depends on a lot of variables, including what your FICO score was before you maxed out your cards," says Paterno. MyFico.com recently did a comparison of how much a score drops when one individual has a FICO score of 680 and the other individual has a FICO score of 780. Maxing out credit cards was one the "mistakes" they used in the comparison.
Results showed that the consumer with the 780 score experienced a 25-45 point drop and the score fell into the 735-755 range. The person with the 680 score saw only a 10-20 point drop and the score fell into the 650-670 range. You can check out the study here.
#3: Making late payments
One problem with making late payments is that, depending on the terms and conditions of your card, you might trigger the penalty APR. The other problem with a 30-day or more delinquency is that it can make your score drop like a rock. "Someone with a 780 score could experience a drop of 100 points or more with a 30-day delinquent payment. If your score is in the 680 range, expect to lose about 60-80 points," says Paterno. Now, if this late payment stretches into collections, then expect a really big drop.
#4: Impulsively opening accounts to save 15%
This happens every holiday season, doesn't it? Whether it's a Labor Day sale or Black Friday, you're standing in line in your favorite department store holding a lot of merchandise, and then the cashier tempts you with a "get 15% off if you open an account today" offer. When you open a new account, this results in a hard inquiry, which affects your score. But that's only part of the problem.
"Typically, inquiries knock only about five points off your score. The bigger problem is opening an account with a high interest rate and putting yourself in a situation where you get behind on a payment," says Paterno. If you're on the bubble between having good credit and excellent credit, those five points can mean a lot. And of course, if you end up with late payments, matters deteriorate from there.
#5: Not understanding the importance of the length of credit history
This mistake often ties into the #1 mistake on this list. Sometimes when people close a card, they close one they've had a long time. The length of your credit history makes up 15% of your FICO score. Now, FICO scores are calculated based on the average length of time you've had your credit cards. "If you close a card you've had for ten years, this will bring down the average length of your credit history," says Paterno.
Another part of the "credit history" portion that makes up your FICO score is "account activity." So if you have a card you don't use often (maybe one that's had a credit limit decrease) use it for a tiny amount every couple of months. Just keeping it active can boost your score a little.
About the Author
Beverly Blair Harzog is a spokeswoman and contributing editor for CardRatings.com. She's a former CPA and an award-winning personal finance journalist. She's a former columnist for the Navy Federal Credit Union's magazine, Home Port, and has written about credit issues for CNNMoney.com, FoxBusiness.com, Good Housekeeping, Bankrate.com, Bottom Line Wealth, CreditCards.com, AARP Bulletin Today, and more. She's also the co-author of The Complete Idiot's Guide to Person-to-Person Lending (Alpha Books/Penguin, April 2009). Follow her on Twitter @beverlyharzog .