Your credit score is an integral part of your financial picture. It stands as one of the most important metrics that institutions use to gauge your financial health and viability for several considerations. For example, banks will assess your credit score if you request a loan or are looking to take out a mortgage when purchasing a house. Your credit score will determine the interest rates you receive in these scenarios and many more.
But how exactly do your actions affect your credit score? Let’s look at the composition of the FICO Score before we dive into some common pitfalls individuals run into when approaching this important topic.
The most critical aspects of your credit are your ability to pay on time and the amount of debt you’ve taken on as a percent of the credit you have available to you, as this makes up about two-thirds of your score.
The first area of focus is on the “Payment History” part of the FICO chart.
Mistake: A lot of discussions on credit cards cover the issue of carrying a balance as the top, but I argue that missing a payment is the worst thing you can do to yourself from a credit score standpoint. A missed payment not only incurs late fees but will also significantly hurt your credit score for an extended period of time. Payment history accounts for 35% of your FICO score, making it the most critical factor.
Solution: An easy way to avoid it is to setup an autopay using the card’s payment section found on their site or app. Just check off the “autopay minimum payment” option and you’re set on this front. As long as you can pay the minimum from your linked account, you’ll never miss a payment.
Pro tip: Move all of your credit card payment dates to a single day, so it’s easy to remember. I chose the 10th since we get paid monthly. It always allowed me to get my paycheck in and figure out my payments before they were due. And a calendar reminder for the 5th to review my balances was always helpful to never missing a payment.
The next two mistakes revolve around “Amounts Owed” in the FICO chart.
Mistake: Carrying a balance so you can get points that are never as valuable as the interest you paid to earn them. Many cardholders also believe carrying a balance from month to month helps build credit. This is a myth – keeping cards open with zero balances helps credit. Carrying a balance doesn’t improve your credit score—but it does result in paying interest, which can be costly. According to Experian, the average credit card interest rate in the U.S. is over 20%, which can add up quickly.
Solution: Pay your balance in full every month. If you can’t, prioritize paying more than the minimum to reduce interest charges and lower your balance faster. If you need to extend payment to purchase something, look into the store’s or service provider’s deal on financing instead of using a credit card for the points, as a lot of retailers offer 0% financing with no hidden fees if you can manage the monthly payment. It’s important to note that credit card 0% financing deals often incur a 2% or 3% fee. This move can also diversify your credit by putting some of your debt in the installment loans bucket. The same balance split between credit cards and installment loans should result in a higher score than if you used only one of them.
Mistake: The percentage of your available credit in use – called credit utilization – negatively impacts your credit score if you carry balances. I’ve seen comments about keeping your utilization below 30%, but no one knows the true number in the algorithm. What we do know, however, is that lower is always better.
Solution: If you are going to make the leap to utilizing credit as part of your life, then you have to be serious about monitoring your spending. You need to plan big purchases ahead of time and make multiple payments each month if you need that kind of discipline to keep utilization low. For example, if your credit limit is $10,000, aim to keep your balance under $3,000 at any given time. It shouldn’t affect your score for long if you carry a balance or go too close to your limit from one month to the next and then pay that down, but it will rapidly reduce your score if you carry that high balance relative to your limit for more than a couple of months. If you have three $5,000 credit limits and max one card out, it’s thought to be worse than spreading that same $5,000 across the three cards since credit utilization is tracked across each card and across each type of debt (credit cards vs. mortgage vs. other installment debt).
If you take care of those two areas, you’ve set yourself up with a fantastic base, but there are other dangers to note, as well as opportunities to improve.
Mistake: Closing cards you don’t use anymore may run counter to everything you’ve heard about credit, but it is a terrible idea if you’re trying to build your credit score. Think about it – if 850 is the max credit score, and 15% is length of credit history, then the max you can have without history is 722, which is in the third tier of scores and won’t qualify you for the best interest rates (740 generally is needed for the 2nd tier and the best rates, although this varies).
Solution: Length of Credit is meaningful – it’s the third highest factor in your score. Keep those cards with no balances open for a bit.
Mistake: Applying for too many cards at once will lower your score by a bit for a short period. These are called hard inquiries, and they lower your score by a few points each time they come in. Multiple inquiries in a short period can lower your score by 20 or 30 points, because it’s a signal to lenders that you may be financially overextended.
Solution: Be strategic about credit card applications. Research cards that fit your financial goals and apply only when necessary. Space out applications by a couple of months to avoid excessive inquiries. If your credit is pristine and your score is in the 810+ range, you can ignore this one. Most of the reading I’ve done on this seems to suggest this doesn’t affect you meaningfully if you have a score at the higher end of the range.
Quick hits:
Mistake: Ignoring rewards programs.
Solution: Find a card that aligns with your spending habits. If you’re a traveler, consider a card with travel rewards – literally free money for doing things you’re already doing. I’m a traveler, so I’m a fan of the Chase Sapphire Reserve card, but the Amex Platinum and Capital One Venture X are two other options with great travel benefits. The steep annual fee is offset several times by using the travel benefits and not carrying over a balance. If Betsy and I spend $3,000 on round-trip, business-class tickets using Chase points and their site to book the flight only costs $2,000 worth of points. Try that two or three times a year, and the savings pile up.
Mistake: Not reviewing statements. You’d be surprised by how many times a year something random shows up on your statements. Whether a mistake or fraudulent, you need to know.
Solution: Review your statements monthly. It’s not that hard. Set a calendar reminder.
Mistake: Not having an emergency plan. Relying on credit cards for emergencies can lead to debt spirals if you don’t have a plan to pay off the balance quickly.
Solution: Build an emergency fund with at least three to six months’ worth of living expenses. Use your credit card for emergencies only as a last resort. If you’re a homeowner, inquire about having a home equity line of credit (HELOC) available to you, even if you don’t plan on or end up using it. Rates in these loans can be significantly lower than credit cards.
Mistake: Overlooking fees. From annual fees to foreign transaction fees, credit card costs can add up if you’re not careful. Another common danger is if you think you’ve stopped using a card, forget that it had an annual fee, and then don’t pay that bill.
Solution: Understand fee structures and choose cards that offer value without excessive costs. For frequent travelers, look for cards without foreign transaction fees. For people who reluctantly use cards, find a great cash back option.
Credit is a vital metric that you need to stay on top of to maintain your financial health. You can get a free copy of your credit score at myfico.com or all three reports, each year, from annualcreditreport.com (pro tip: stagger your downloads by four months each and you’ll get free reports 3 different times each year).
Looking for ways to build your credit score or incorporate better practices? We’re here to help. Reach out to your financial advisor today.