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When a credit bureau computes your credit score, their job is to produce a number that estimates—given your past and current financial history—how likely you are to default on future debts. Exactly how each bureau calculates your credit score is a bit of a mystery, but we do know that they take into account various indicators of your fiscal health.
There are five notable components of a personal credit score. But you might be surprised at some of the lesser-known factors that could affect your score and how they might affect you as a small business owner.
Below are the most frequently discussed aspects of your credit score. It’s important to understand these elements in order to see how other factors might fit into the picture.
This measurement examines whether you pay your bills on time and how often you’ve missed payments. No matter the type of debt, skipping payments doesn’t sit well with credit bureaus.
This part of your score tallies who you owe money to and how much you owe. Your credit utilization is part of this factor. Credit bureaus prefer when you have access to a lot of credit, but you don’t use it all. Your credit utilization ratio is calculated by dividing how much credit you’re currently using by how much total credit you have available for use. Experts suggest that you keep your credit utilization ratio below 30%, which means that you use only that percentage of your available credit. Such restraint shows credit bureaus that you can wield your credit responsibly.
This item accounts for how long you’ve had credit. The older your accounts or loans, the better—provided you’ve consistently made your monthly minimum payments on time. Your accounts’ longevity demonstrates your long-term ability to properly handle debt.
Credit bureaus like to see that you’ve dealt with different types of loans (a mortgage, car loans, credit cards, and so on), and your credit score increases when you’ve taken on debt of various types and managed to balance them all.
Every time someone requests information about your credit, the bureaus take notice. Such credit inquiries are divided into what are called soft credit inquiries and hard credit inquiries.
A soft credit inquiry is when anyone other than a potential lender solicits your credit score—like a future employer, for example—and generally does not harm your credit. Note that a lender also has the ability to run a soft credit inquiry. This is what happens, for example, when a lender checks to see if a potential borrower prequalifies for a financial product.
A hard credit inquiry occurs when a bank, lender, or other type of financial institution reviews your credit because you’ve applied for a business loan or some of other type of credit. These hard credit pulls can lower your total score. Precisely why hard pulls can ding your credit score is complicated, but suffice it to say that, the more often you request potential credit, the more the credit bureaus assume that you need money and may eventually default on your debt. That might be an unfair assumption, but credit bureaus make their decisions based on statistics and models of future risk—so it’s nothing personal.
Although the above aspects of a credit score are the most well-known, let’s look at some unexpected elements that might figure in as well.
Whenever you see an unexpected drop in your credit score, the first thing to do is look for possible errors on your credit report. Best-case scenario: One of the credit bureaus made an honest mistake in calculating your score. Worst-case scenario: You are the victim of fraud or identity theft.
You can get a free copy of your credit report every 12 months from AnnualCreditReport.com, the only site of its kind approved by the federal government. Be sure to order a report from all three major credit bureaus—Experian, Equifax, and TransUnion—and check for any transactions or inquiries that you did not authorize. Immediately dispute any errors you may discover.
The IRS does not have direct contact with the credit bureaus, the way that lenders do. But if you owe the IRS a lot of money or you’re a habitual nonpayment offender, they can file a Notice of Federal Tax Lien against you—which allows the IRS to collect your debt when any personal property you own is sold. Each credit bureau will receive notice of this lien, and your credit score will take a nosedive.
Unlike the IRS, your local municipality might report your unpaid tax bill directly to a debt collector. Referral to collections will undoubtedly hurt your credit, as such agencies have close relationships with the credit bureaus. If you find yourself unable to pay city or county fines of any kind, call your local government to establish a payment plan. Don’t let these debts fall by the wayside, as they may come back to haunt you.
And speaking of local government, make sure that you don’t leave any parking or speeding tickets outstanding. It doesn’t matter if you reside in the jurisdiction where you received the ticket. Once that municipality sends your ticket(s) to collections, you’ve entered the realm of delinquent payments. Such debts are often sold to third-party collectors, who report nonpayment to the credit bureaus, which will severely ding your credit score.
Although credit bureaus keep their calculation models a secret, credit score drops as large as 50 to 100 points have been reported after an unpaid ticket hits. This makes sense, because a delinquent ticket is a sign that one might not pay other fees on time—which is a lender’s biggest fear.
And credit scores may not be quick to recover from such a dip. Collections can remain on your credit report for seven years, plus 180 days from the date of the initial incident of nonpayment. Your score should begin to rise, though, as time passes—so long as you don’t make another error within that same period.
Like tickets, unpaid utility bills are often sold to debt collectors, who usually report the delinquent account to the credit bureaus. Be sure to send in your minimum monthly payment on time, and if you’re unable to do so for any reason, inform the utility company and work out some type of reimbursement plan.
We bet you never thought that library book you accidentally kept or that Netflix DVD buried somewhere in your basement would come back to bite you. But since the economic collapse in 2008, libraries and media rental companies began to fastidiously report delinquent accounts to collection agencies, which in turn rarely fail to notify the credit bureaus. A system born at the time out of financial necessity is now built into the fabric of the credit structure, so make sure any outstanding rental or borrowing fees get squared away.
We discussed how hard pulls on your credit can ding your current score. But what you might not realize is that it’s not only banks and credit card companies whose inquiries count as hard pulls. Here are some other companies and individuals that can lower your score when they request your credit information:
Some of these pulls are unavoidable for the necessities of life, and may only decrease your score by a few points. Try not to seek out all these services out at once, and your score shouldn’t substantially suffer.
Once again, the credit bureaus look unfavorably on any sort of unpaid debt. Child support is no exception. The municipality or agency that collects such payments will often report delinquency to the credit bureaus. Even the associated courts fees, if left outstanding, could prove problematic for your credit score.
Any contract where you choose to default on your payment obligations can end up in collections—gym memberships included. Be sure to cancel monthly payments for any goods and services you no longer use in the manner dictated by your agreement.
Yes, this process can frustrate the best of us, especially when there are specific rules about how long you must keep your account before closure, etc. Fail to play by the rules, though, and your credit will suffer. And don’t even think about simply closing the account from which you paid your monthly fees—this will only wreck further havoc on your credit (see number 11). As much as it might sting, go by the book here and put these debts to rest properly.
If you request a credit limit increase or a lower annual interest rate from your credit card company, they’ll need to check your credit to determine if your history warrants such an appeal. This will likely result in another hard pull, which we know can ding your score.
A credit increase will raise the amount of credit available to you (and thus lower your credit utilization rate), so this may mitigate the damage caused by the inquiry itself—though there’s no guarantee. If possible, spread your debt over multiple accounts rather than request a credit limit increase on one account.
Remember that any time a financial institution requests your credit information, this results in a hard pull. Although that department store branded credit card may sound like a good deal, consider whether it’s worth a dip in your credit score. After all, whether you’re denied or approved, the inquiry will stay on your credit report for about two years.
You’ll face the same issue whenever you decide to switch banks, as most new accounts will necessitate a hard pull. Even though moving to a credit union may seem beneficial for your overall fiscal health, for example, don’t forget the effect it may have on your credit score. Thankfully, though, the subsequent decrease in your credit score shouldn’t be too large, and can usually be mitigated with consistent positive credit practices.
Unfortunately, the same cannot be said for closing old accounts—pre-existing credit cards in particular. We discussed above how credit bureaus examine your credit utilization, or how much of your available credit you’ve actually used. If you close a credit card account, you’ve lowered the total amount of lending capital accessible to you. And whatever loans you still have outstanding now use a greater percentage of your existing credit than before you closed the account (remember the golden rule of a credit utilization rate below 30%), which hurts your credit score.
Closing a credit card is particularly problematic if the account is an older one, as credit bureaus look at how long you’ve had credit when they compute your score. If you absolutely must close an account, select the one you opened most recently. Close only one account at a time, and wait several months for your score to recover before you close another.
If possible, a better option for your credit score is to pay down the debt on a card and keep the account open. This will decrease your credit utilization rate and raise your credit score. If you completely pay off the debt on a particular card, it’s still preferable to maintain the account and use the card on occasion. This will boost your credit score, rather than tank it.
A note on paying down/off credit cards: If you reach a settlement with a credit card company, it may help you get out of debt faster, but it will hurt your credit score. Credit bureaus see a settlement as proof that you were unable to pay your debts in full, and worry that you may repeat this pattern in the future.
Credit bureaus prefer that you pay off the original amount of your loan. Although payment in full may take longer and cost you more money up front, your diligence might pay off when you receive lower interest rates on future loans due to your higher credit score.
Although some people prefer to use cash as a way to control their spending, complete inactivity on your credit cards is not ideal for your credit score. After six months of account dormancy, a bank may choose to cease reporting your card information to the credit bureaus, or might close your account altogether. As explained above, this cancellation can have a negative effect on your credit score. To avoid this problem, pull out your credit card every few months and make small purchases that you’re able to pay off in full at the end of the statement period.
The following financial obligations may or may not be taken into account if reported to collections, depending on the credit bureau and the situation, so it’s best to avoid them whenever possible:
A lot of us try to maintain good personal credit, and it’s helpful to know that the above issues may come into play as we strive to do so. But you may wonder how this specifically affects small business owners, and that’s a fair question.
In order to issue a business credit card, most banks require a personal guarantee from an individual, which means that—until your business develops its own credit—your personal credit score and your business’s credit score are (for all intents and purposes) one and the same.
Such commingling of scores will remain the case as long as you are a sole proprietor, as there is no legal separation between you and your business. If you tank your personal credit score, it will be difficult for your business to obtain a credit card or a line of credit at reasonable rates. Similarly, if your business racks up a ton of debt, your personal score will suffer.
Even if you establish an LLC, a bank is likely to lean on your personal credit history to make its lending decisions until your business has enough history of its own. You can select a business credit card that doesn’t report activity to consumer credit bureaus (just commercial ones) if you wish to mitigate some of the personal credit risk involved. But if you’ve signed a guarantee, none of that will make a difference if you’re forced to default on your business debt. You’ll still be individually liable for all outstanding payments.
You can also seek out a business credit card that doesn’t require a personal guarantee (although most do), or try to negotiate with the bank to exclude a personal guarantee requirement from your business credit card contract. But the takeaway here is that your personal credit can and will affect your small business, so do everything you can to maintain an excellent score. With this list, you can avoid some surprising pitfalls, and get your personal credit shipshape—so your business credit can follow suit.