5 Credit Traps

Even if you’re not looking to get new financing right now, credit is something that should concern you in everyday life. Bad credit can affect you daily in the form of higher insurance payments, failed pre-employment screens, and higher interest and fees.  Most people think the commonsense approach to good credit consists mainly of paying your bills on time.  However, paying your bills on time counts for only 35% of your credit score. Here are five surprising things that can tank your credit score in a hurry.shutterstock_96276791

Co-signing a Loan for a Relative or Friend

When you co-sign a loan for someone, you become personally responsible, monetarily and credit-wise, for the loan should the primary borrower default.  Meet a personal friend of mine whom I’ll call Dave.  Dave is a U.S. Army veteran who always pays his bills on time.  Dave wanted to take advantage of the VA home loan program and buy a house.

Not so fast.  Dave co-signed a motorcycle loan for his son, and you guessed it, 6 years ago the son had the motorcycle repossessed. Now Dave’s credit report shows the defaulted loan. The VA is still willing to approve his loan, but they want Dave to pay off the $10,000 balance on the debt, now in collections.  Dave is on disability and cannot afford to pay that large of a debt at the moment.

Not Pulling Your Credit Report Every Year

Just like Dave, nasty surprises may await you if you wait until you apply for new financing to see what’s on your report.   If Dave knew about the collection, he could have made a deal for less money with the collections firm and encouraged his son to help pay it off years in advance of applying for financing.  Dave has gotten the collections firm to reduce the debt, and he and his son are now making payments, but to pay off the whole debt will take time. In the meantime, Dave has to wait to get his house.  If he had pulled his credit in advance, he could have taken care of the debt years ago and not have the delay in VA financing now.

Being proactive in advance of applying for new financing isn’t the only reason to pull your report.  Identity theft happens frequently in this country.  According to the FTC, 290,056 complaints about identity theft were received in 2013.  The 2013 FTC consumer complaint report showed identity theft topping the list of FTC complaints for 14 consecutive years.

If someone steals your identity, they can open up new credit in your name — and they usually quickly default on that credit.  Though there are many protections in the Fair Credit Reporting Act in cases of ID theft, correcting your credit report takes time and, unfairly, often money as well. If you pull your credit report at least once a year, you can look for suspicious activity and stop an ID thief from doing any more damage to your report.

Getting a copy of your credit report is absolutely free through annualcreditreport.com.  You can get copies of all three credit bureau reports once a year through this service.  Keep in mind, though, that credit scores aren’t provided through annualcreditreport.com along with the credit reports. However you don’t need your score to see suspicious activity or mistakes within the underlying report.

Closing A Credit Card

When you’re trying to turn your financial life around by paying down credit card balances, you may want to avoid the temptation of closing the paid accounts altogether.  This would be a big mistake.

Thirty percent of a credit score is based on credit utilization.  Credit utilization is the percentage calculated by dividing the amount of used credit by the credit card’s overall credit limit.  Your credit score looks at both individual card utilization and the combined utilization of all the credit cards you have.  If you have three credit card accounts with $1000 limits on each, and you are maxed out on the cards, your total utilization rate is 100%.  Having 100% credit utilization will be penalized heavily in the credit scoring system, to the tune of 100 points or more.  (Most experts recommend having 20% total utilization or less.)

To continue the example, paying off one of the three cards and then closing it would seem like common sense, but if you leave the card open, your total utilization rate would be 66.7%.  If you close that card with a zero balance, you are back at 100% total utilization.

Maxing Out a Credit Card

Never ever max out a credit card, not even if you pay it off in full each month.   You are penalized almost as heavily for maxing out one card in addition to having a high total utilization rate.

Even if you pay off your card every month, you will still never see a zero balance on for this account your credit report.  Credit card issuers update the information in your credit files only once each month — soon after your statement closing date. You’ll notice that the balance sent to you on your monthly statement is what is reflected on your credit report.  You could then still show a your card as maxed out on your credit report month after month, even after sending your check for payment each time in full.

Maxing out your credit card can also put you into a penalty rate, as some credit cards terms state that default occurs when you max out the limit.  Penalty interest rates on credit cards typically run 30%.

If you’re buying a home, having large balances could get you disqualified, even with an acceptable credit score.  Mortgage lenders like to see no more than 36% of your monthly income used to repay the bills listed on your credit report.  High balances mean high monthly payments, which could put you over the 36% limit. shutterstock_89775622

Opening a Retail Store Card

Usually store credit cards have reduced credit requirements and as a result are easier to get than “regular” bank-issued cards.  If you’ve ever shopped at a department store, the clerk has offered you 10-15% off your entire purchase if you open a store credit card.  Sounds like a good deal, right?

Store credit cards can negatively influence your credit score.  Their credit limits are low, and it’s easy to max out the card — and as we’ve seen, that is a bad thing.  Applying for the card puts an “inquiry” on your credit report, which will also drop your score.  These inquiries, noted within your reports when applying for credit, make up 10% of your credit score.  Although inquiries remain on your credit report for two years, they only lower your score for the first 12 months, but that’s still a good long time if a credit application is planned in the short term.

The other bad news?  Retail cards don’t help your credit score as much as regular bank-issued cards.  The credit scoring system looks at the type of cards and gives less weight to a retail store card than a general purpose credit card.  Sure, a good payment history helps, and if you can’t obtain a regular card, acquiring a retail store card might actually help you.  Just keep the balances low.

In Summary

Poor credit choices you unknowingly make in your everyday life can cost you money, time and aggravation. You can have a perfect payment history and still not qualify for the loan, job, insurance or interest rate you want.

Posted in Credit 101
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