Most people think responsible credit use means paying your bills on time and never taking out more than you can afford to pay back, but credit reporting agencies and the businesses they serve don't quite see it that way. While those basic best practices can certainly help you build and keep a decent credit history, there are a myriad of other factors that go into your credit score, some of which may not work how you think.
1. Using your credit cards too much
Your credit utilization -- or the percentage of your total available credit that you're using across all accounts -- makes up 30% of your score. There is a somewhat nebulous sweet spot for perfect utilization, but normal use of your cards could very well push you out of that range. The common wisdom is that using more than 30% percent of your credit limit can actually hurt your score, even if you've never missed a payment. This is because creditors may see you as over-leveraged and therefore at greater risk of late payments or defaults. So if you have $15,000 in total available credit and balances that add up to $6,000, then you're already at 40% utilization -- and your score may be taking a hit.
2. Not using your credit cards enough
Keeping your utilization at 0%, however, may not be the answer. Avoiding unnecessary use of credit is financially prudent, but creditors want to know that you not only pay your debts on time but also use your credit regularly. After all, they make their money on the interest you pay on your purchases, so someone who doesn't use their credit isn't very good for business. Besides, research shows that people with a 0% utilization rate are ultimately more likely to default on their debt than those who keep it a bit higher. Credit Karma has found that consumers with the highest credit scores tend to have a utilization ratio between 1% and 10%.
3. Applying for credit
When potential creditors check your reports during the application process, it shows up as an inquiry. These notations stay on your report for two years and provide information about the lender, as well as the date your credit was pulled. Single inquiries can drop your score up to five points, although the decrease usually only lasts a few months. However, several inquiries within a short period of time, say five or more within two years, will multiply the damage to your score. Although you're just shopping around for the best deal, creditors may think that you're having a hard time qualifying for borrowed funds, or that you're in financial trouble and desperate for credit, both of which scream "high-risk." Keep in mind that you can apply for multiple auto loans or mortgages within a short time frame without seriously damaging your credit score. That's because lenders recognize your need to shop for the best rates on these loans, so they treat multiple inquiries in these categories as one, so long as they're made within a few weeks of each other.
Even if you're approved for the credit you requested, credit reporting agencies don't look too fondly on fresh debt. Since you have yet to prove yourself with your new account, your score will drop a bit as a signal to creditors that your risk profile has recently increased.
It may not be possible to avoid all inquiries, but you can decrease their occurrence and the harm they cause by researching offers carefully, only applying for credit that you actually need, and spacing your applications out over a few months.
4. Closing accounts
It's always a good idea to give your financial house periodic cleanings, but this housekeeping shouldn't include closing credit accounts. Even if you don't use them, long-standing credit cards and other revolving lines of credit raise the average age of your accounts, which constitutes 15% of your score. They also boost your total available credit, decreasing your utilization. Closing those accounts shortens your credit history and increases your utilization, both of which cause your score to drop.
The only way to minimize the damage here is to not close old accounts at all -- except, of course, in cases of fraud or other serious problems.
5. Paying collections and charge-offs
Delinquent accounts without any new activity have less impact on your score over time. If you make a payment, however, the trade line is updated and pushed to the forefront once again. This holds true even if you pay it off completely, because the previous history remains even after the account status is changed to "Paid."
It's still a good idea to pay back these debts, but you shouldn't necessarily expect a score boost for doing so. It may be more helpful to contact the creditor and request a "pay-for-delete" arrangement that will completely remove the negative account from your reports once you send in the agreed-upon amount.
The complicated, clandestine nature of credit reporting creates a number of opportunities for seemingly innocuous activities to hurt your score, even if you think you're doing everything right. The damage each of these missteps can cause varies, impacting those with shorter credit histories or thinner files more than seasoned credit veterans. Although you may not always be able to avoid them, there are ways to at least minimize the damage these common activities can cause.