A good credit score goes a long way to a brighter financial future, but there’s still a lack of understanding about what goes into this figure.
In a Capital One Credit Confidence Study from January, 53 percent of 2,300 survey respondents say they are very confident when it comes to understanding credit, and the majority say they know they will be able to improve their credit.
But financial advisors counter that they see a lot misconceptions regarding what helps and hurts a credit score, misconceptions that may inadvertently lower a person’s score.”People tend to obsess about the minutiae of credit scores without focusing on the low-hanging fruit,” says Greg McBride, chief financial analyst at Bankrate.com in Palm Gardens, Florida.
Pay bills on time. The biggest impact on a person’s credit score is on-time payments, financial experts say.
Julie Myhre-Nunes, director of content at NextAdvisor.com in Burlingame, California, says on-time bill payment makes up 35 percent of a person’s credit score and is the largest factor in determining credit.
“Even if you only pay the minimum payment, you’ll want to make sure all payments are on time,” she says.
That goes for every bill, not just credit cards, but mortgage payments, rent, utilities and other bills, says Lyall Friedline, founder of Friedline Financial, located in the greater Kansas City, Missouri area.
Pay down card debt and keep low balances. The Capital One survey showed 52 percent of respondents believe that holding a credit-card balance is good for their credit. Not so, say the experts.
Credit-card debt is known as revolving debt because the amount changes. The ultimate goal is to pay off debt, McBride says,
“Pay down your revolving debt; that’s one that can pay pretty immediate dividends,” he says. “If you have a large revolving balance that’s using up a large chunk of your credit line, that’s actually working against your score. If you knock that balance down, that’s something that can be quickly reflected in your credit score by reducing your debt-to-credit ratio.”
That debt-to-credit ratio is known as credit utilization, and Myhre-Nunes and Friedline say creditors like to see credit utilization ratios around 30 percent or less. That figure is calculated by dividing total used credit by total credit limits.
“For example, if you owe $50 on a credit card with a $500 limit and $150 on another card with a $700 limit, your credit utilization ratio is 17 percent, $200 owed divided by a $1,200 credit limit,” she says.
McBride says the 30 percent threshold is the point where a high balance is no longer a negative, but if the ratio is below 10 percent then it’s actually a positive for the score.
There’s a bit of a nuance with credit utilization, McBride and Friedline say, and a reason to keep the ratio as low as possible, even for people who pay off their cards each month. When revolving debt is reported to credit bureaus, it’s like a snapshot of that day’s balance and it doesn’t distinguish between whether that balance is temporary or has been carried for a while. For people who are looking for loans, keeping a low debt-to-credit ratio can make a difference, and it may require making multiple payments per month, McBride says.
“That’s particularly important if you’re in the market to buy a home,” McBride says. “You can ill-afford something that is going to ding your score, even if it seems innocuous.”
Think twice about inquires to raise credit limits, McBride says. Those are considered “hard pulls” by credit agencies because it’s an application for more credit. Too many of those will hit your credit score temporarily, they all say.
“The inquiry is on there, whether you get the higher credit limit or not. And it may backfire if your financial situation has deteriorated. They may reduce your credit line,” McBride says.
Establish a credit history. Creditors want to see that debtors know how to handle debt wisely, and the longer a person shows that he or she has on-time payments and low debt-to-credit ratios, the better it is. Instead, two common mistakes people make are not opening credit cards and closing old ones when they’re paid off, Friedline and Myhre-Nunes say.
“One of the (top) myths I hear is ‘if I get a credit card, it will hurt my score’,” Friedline says, a refrain he hears with younger people and retirees.
Myhre-Nunes says she has heard this myth, too.
“A lot of people believe that credit cards are evil and should be avoided altogether,” she says. “Responsible use of a credit card, like only purchasing what you know you can afford and paying the balance off every month, can be an easy way to build your credit and earn some rewards on your purchases if you opt for a rewards credit card.”
Thirty-one percent of Capital One’s survey respondents think that closing unused cards is good for credit, but closing old cards can be a double-whammy hit, Friedline and Myhre-Nunes say. Not only will it lower your debt-to-credit ratio, but it might shorten your credit history, both which may affect credit scores.
“If you have $20,000 worth of credit spread equally on four cards and close one, you now have the accessibly of $15,000,” Friedline says.
That’s especially true if it was one of the first cards the person opened.”Instead, your best course of action is to keep the card open and use it occasionally for small purchases to ensure it stays open and active,” she says.