Credit is like trust; it must be earned. In order to extend credit to you, a creditor must feel confident that you will repay. Otherwise, you will pay higher interest rates to cover the risk or be denied credit altogether.
The key to earning good credit is to avoid making fundamental credit mistakes like these seven errors. Think of them as the 7 Deadly Sins of Credit.
1. Late or Missing Payments – Few things sink a credit score like missing or late payments. Even a single missed payment can produce a significant drop in your credit score, and that error will stay on your report for some time. Should your payment be ninety days late or more, the payment can stain your credit for up to seven years.
On the bright side, time will heal your score if you don't compound the problem with other missteps. "The beauty of credit scoring is that it gives greater emphasis to current events and less emphasis on previous events with each passing day," says Greg McBride, Chief Financial Analyst at Bankrate.com.
2. Failure to Budget – The convenience of credit makes it easy to overspend. Perhaps your spending is excessive because you don't realize how much you spend and how that spending matches up with your income.
A budget is the building block of financial responsibility. By tracking your income and expenses and managing your cash flow in advance, you are more likely to make wise purchases and avoid impulse spending. Helpful hint: to increase the chances of sticking to your budget, make sure that it contains a bit of money for you to spend as you like.
3. Making Minimum Payments – If you only make minimum payments, you are likely to rack up significant interest debt. Minimum payments should only be made as part of an overall debt reduction strategy, where you make minimum payments on certain debts while devoting the remaining funds to paying off other debts (usually with higher interest).
4. High Credit Utilization – Your credit utilization is the ratio of your outstanding credit to your credit limit. This principle holds for both individual accounts (each of your credit cards, for example) and cumulative credit. When you are using a large amount of your available credit, creditors assume that you are at greater risk of missing payments or defaulting on your obligations.
Generally, credit utilization approaching 30% is a danger zone. Experts often suggest staying well below 20%. Interest rates aside, if you have two cards with similar credit limits, it’s better to owe 20% of the limit on each rather than 40% on one.
5. Co-signing a Loan – You take a great risk when you co-sign a loan, regardless of how good your intentions may be. You could end up being stuck with the bill, and should you not realize that your co-signee is missing payments, your credit score will be damaged.
6. Poor Collective Account Management – The number of accounts that you maintain and how you use them has an effect on your credit score. For example, shutting down old, unused accounts may actually harm your credit score by reducing your available credit and lowering the average age of your accounts. Similarly, applying for an excessive number of credit cards at the same time sends a signal to creditors that you may be overextending yourself.
7. Ignoring Your Credit – You always make your payments on time, why should you bother checking your credit report? There may be an error on your credit report affecting your score without your knowledge — until you need to take out a loan and find that you don't qualify for a good rate (or even qualify for a loan at all). There may also be fraudulent accounts opened in your name.
Maintaining good credit requires planning and discipline — putting together a realistic budget and having the willpower to stick to it. Granted, budgeting and judicious spending are not always fun tasks, but they are far preferable to repairing bad credit. Heed the words of Rod Griffin, Director or Public Education at Experian: "There are a lot of things in life we want to learn from our mistakes. Credit is not one of those things." Learn more about these sins and how to raise your credit score in our new free eBook, Give Yourself Credit.