5 Ways to Ruin Your Credit

If you're relatively new to credit, you may have questions. It's easy to understand that making payments on time and controlling your debt can build your credit score, but how can you damage your credit score? Here, we cover five ways your credit can take a hit.

1. Cosign a loan

Perhaps a dear friend or close relative approaches you, upset because they could not get a loan in their name. However, if you're willing to co-sign the loan, the lender will use your credit history to determine whether the loan application is approved. What would you do?

Cosigning a personal loan can kneecap your finances. Let's say you assume your friend or loved one is making all the payments. However, one day you receive a call saying payments haven't been made in months. Your credit score takes the same hit as the person you cosigned for.

Solution: Only cosign for a person if you're confident they will make payments. To protect yourself, request a copy of proof of payment each month so late payments don't come as a surprise.

2. Attempt to keep up with the Joneses

One of the most expensive mistakes you can make is taking on debt to impress others. The more debt you carry, the higher your debt-to-income (DTI) ratio is. While DTI is not a factor used to calculate your credit score, lenders review your DTI before determining whether you qualify for a loan.

Let's say your income is $5,000 a month, and your monthly debt is $2,000 (including rent, credit card payments, car loans, child support, and other loan payments). A lender divides your total debt by your monthly income: $2,000 ÷ $5,000 = 0.40 (40%).

DTI guidelines vary by lender, loan type, and purpose of the loan. For example, most lenders prefer to see a DTI below 36%. So if your DTI sits at 40%, you may have trouble qualifying for an auto or personal loan. That said, some mortgage lenders allow DTIs up to 45% (or up to 50% if you're applying for an FHA-backed mortgage).

If you're thinking of buying a home or car that's more than you can afford to impress all your friends, think about how many sleepless nights you may face as you look for ways to lower your DTI.

Solution: Even if you were never a Scout, it pays to be prepared. You never know when you might need a consumer loan. Your best bet is to keep your DTI as low as possible, and the two best ways to lower your DTI ratio is to pay down debt or increase your income.

3. Make late payments occasionally

It's easy to believe that a lender will overlook an occasional late payment if you pay most of your payments on time. That's not the way it works, though. Most lenders make a monthly report to the three major credit bureaus -- Equifax, Experian, and TransUnion. That report tells the credit bureaus how well you met your financial obligation that month. If you miss a payment even once, it damages your credit score.

Another common misconception is that making a partial payment is better than making no payment at all. A partial payment may be penalized the same as a late payment.

Solution: Be proactive. If there is no way to make a full payment, contact your creditor, explain the situation, and ask if there are options available that will protect your credit.

4. Open too many credit cards at once

Getting approved for a new credit card is a good sign; it means that your credit score is healthy. Open too many, though, and the situation may change. Here's what happens:

• You feel confident about your credit and open a handful of cards around the same time. You apply for a cash back card, a card that rewards you with airline miles, and two store credit cards.
• Each time you apply for a credit card, the card issuer runs a hard credit check, and each credit check drops your score a bit.
• The next time you apply for credit, the creditor looks at your record, realizes how often you've applied for credit, and a red flag pops up. You seem desperate for credit or, at the very least, unsure of what you're doing.

Solution: When you apply for credit, do so sparingly.

5. Close credit card accounts

Let's say you find yourself in debt. You want nothing more than to close your cards and cut them into a million pieces. However, there are a couple of ways closing credit cards can damage your score.

Debt-to-credit utilization ratio

Closing existing accounts impacts your debt-to-credit utilization ratio, sometimes called your credit utilization ratio (or rate). This ratio represents the total amount of revolving credit you currently use divided by the total amount of credit available.

In short, creditors prefer you to have access to more revolving credit than you use. Revolving credit includes credit cards and lines of credit that don't require you to pay the same amount each month. Mortgage or car loans are not revolving credit and don't factor into your debt-to-credit utilization.

Credit history

Another thing about closing a credit card account: Lenders want to see evidence that you've managed several different types of credit accounts over time. When you close an account, you shorten your credit history.

Solution: Take steps to pay off your credit card debt rather than close a card.

No one can protect your credit score but you. The trick is to take a beat before making a financial move to ensure it will enhance rather than hurt your score.