You're ready to take out a loan, only to realize that your credit score actually dropped since you last checked it. With a low credit score, you'll be paying higher interest rates than you expected – and you may not qualify for the loan at all.
Remember that your credit score reflects your risk to a lender at any point in time. As new information is reported to credit bureaus, your credit report is updated. Your credit score is periodically recalculated to incorporate that new information. If the update implies any risk of non-payment, your score will suffer.
To find out why your score dropped, ask the following five questions and think like a lender. Would you be less likely to lend someone money if you didn't like the answer?
1. Did You Miss a Payment? – On-time payments are the most important factor in your credit score. Lenders assume that if you've missed a payment before, you're more likely to do it again. Higher risk of non-payment leads to a lower credit score. Matt Schulz, Senior Industry Analyst at CreditCards.com confirms, "...even just one single late payment can really impact your credit."
To prevent this drop, always make at least minimum payments on time. When your credit card information changes, make sure to update all automatic payments linked to that card.
2. What's Your Credit Utilization? – Your credit utilization ratio, or the amount of credit you are using compared to your total available credit, shows lenders how close you are to maxing out your current credit. Have you made large purchases – or many small ones – that pushed your debt near your limits?
Keep credit utilization well below your limit (30% or less). If you need flexibility for a large purchase, ask your credit card issuer for an increase in your limit.
3. Have You Opened or Closed Accounts? – Both can damage your score, at least temporarily. Each credit check will drop your score slightly, as lenders see you asking for more credit and possibly overextending yourself. Multiple pulls in a short time can cause a significant credit score drop.
It seems responsible to close old accounts, but your score can drop in two ways as a result. The average age of your credit accounts (a sign of stability) decreases, and your credit utilization ratio increases because your total available credit decreases.
4. Is Your Credit Mix Different? – Lenders like to see that you can handle different types of debt responsibly. If you retain a revolving credit card debt but have paid off a student loan or car loan, your debt is now concentrated in one area. Perversely, if you are down to a single credit card that's paid off regularly and have no other debts, your credit score can be lower – because potential creditors have less recent information on how you handle multiple debt sources.
Obviously, you wouldn't take out an unnecessary loan just to maintain a high credit score – but you can increase your score by keeping two to three credit card accounts with a low balance on each and paying the balances off regularly.
5. Is Your Credit Report Accurate? – If bad information is submitted to the bureaus in your name, your credit score may drop. Fraudulent charges/accounts registered in your name can run up debts and sink your credit score before you notice the damage. "I think most credit bureaus, they want consumers to check their credit, they want to make sure it's accurate," says Nav Education Director Gerri Detweiler. "And here's the thing, ultimately, we are the only ones who can tell whether that report is correct or not."
Don't forget to check your credit report periodically to see if it matches up with your credit score. Make sure to check your score prior to making a large purchase or taking out a loan – and think about whether your bank account and credit score can afford the hit from the increased debt.
You can check your credit score and read your credit report for free within minutes by joining MoneyTips.