Credit Score. Those two words alone can strike terror into the hearts of even the most courageous small business owners—and with good reason. Your credit score is a huge factor in opening—or closing—financial doors throughout your lifetime. And for many, how it’s calculated is shrouded in mystery and misconceptions.
When it comes to credit, what you don’t know can hurt you. And because as an entrepreneur your business credit options are determined mostly by your personal credit, what you don’t know can hurt your business, too. (The good news is that there some small business lenders, like Fundbox, don’t require a credit check).
Avoid these six pitfalls that could damage your personal credit, cost your company funding options, or limit you from obtaining lower rates in the future.
Mistake 1: You depend too much on one factor of determining credit.
FICO® uses five separate factors to calculate your score: the punctuality of payments over time (generally constituting 35% of score), the amounts you currently owe (30%), the length of your credit history (15%), how frequently you apply for new credit (10%), and the types of credit you are using (10%). Under certain circumstances, these factors may be weighted differently; for example, for a newer borrower without much credit history, the other four considerations increase in significance.
Making payments on time often gets touted as the most important factor in determining your score. For most people, this is technically true, with payment history clocking in at 35% of your score calculation. But at 30%, your “utilized credit”—how much you owe in comparison to your available credit—isn’t far behind. It’s important to remember that all five factors affect your score and to be savvy about how to improve in each category.
Mistake 2: You carry high balances.
It’s important to keep your utilized credit low at any given time—even if you make payments on time and even if you regularly pay off balances in full.
FICO® explains: “Using a high percentage of your available credit means you’re close to maxing out your credit cards, which can have a negative impact on your FICO Scores. On the other hand, using a low percentage of your available credit can have a positive impact. …Your account balance on your credit report will reflect the account balance your lender reported to the credit bureau (typically the balance from your latest monthly statement). So even if you pay your credit card balances in full each month, your account balance won’t necessarily show on your credit report as $0.”
Revolving credit, such as credit cards, comes under particular scrutiny by FICO®. If, for example, you have a large number of cards carrying a balance, or you are close to maxing out cards, this may hurt your score.
Other factors to keep in mind: the mix of types of credit lines (e.g., revolving credit, installment loans, mortgage) you have open—and carry balances on—matters, as does whether you still owe a large amount of a loan’s initial installment.
Mistake 3: You close long-term credit lines or frequently open new ones.
Closing a credit line, especially if you’ve been conscientious about payments and low balance on that line, can harm your score. Once a credit line is closed, it no longer adds to your history. Closing a credit line you’ve had for ten years essentially erases a decade of your credit history. Even if you have paid off your debt on that line, or if don’t often use it, consider keeping it open to maintain that history.
Frequently opening (or applying for) credit is another red flag for FICO®, which views this behavior as an indicator of a risky borrower: “Statistically, people with six inquiries or more on their credit reports can be up to eight times more likely to declare bankruptcy than people with no inquiries.“ Don’t open credit accounts without first carefully considering the pros and cons of adding another line of credit to your load. When looking for the lowest rate for a mortgage, auto loan, or student loan, however, you can shop around as much as you like within 30 days, as FICO® allows this grace period for rate comparison.
Mistake 4: You co-sign loans for loved ones.
Co-signing loans can jeopardize your credit. Co-signing means that both parties—you and partner—are equally responsible for payments for the life of the loan and for paying off the debt. If your loved one is late making payments, doesn’t make them at all, or defaults on the loan, your credit score will be damaged.
Once your credit is linked with someone else’s, it is extremely difficult to detangle, so be very thoughtful about co-signing for any loans.
Mistake 5: You don’t monitor your credit
Check your score with all three credit bureaus (Equifax®, TransUnion®, and Experian®) on a regular, frequent basis. This will help you catch errors or identity theft immediately before they can cause significant damage to your score. Credit bureaus are obligated to investigate any error or questionable transaction you find, typically within 30 days.
Report inaccuracies to the bureau—with documentation of the problem— and let your lender know you are disputing the issue. It’s important that you consistently check your score from all three bureaus, as their reports may contain slightly different information (and different inaccuracies).
It’s also smart to check that lenders are reporting your most recent credit limits. Meghan Rabbitt of LearnVest.com writes, “While companies always report your debt, they may not be consistently updating your maximum available credit limits.” If your limits increase and your balances don’t, your percentage of utilized credit will go down and your score will improve. Make sure that lenders keep your limits up-to-date with the bureaus.
One last thing to regularly check: if you have co-signed credit with someone, their missed or late payments will appear on your credit report.
Mistake 6: You use your personal credit to fund your business.
Using your personal credit for business expenses is tempting, especially if your personal score is high and you have a long individual credit history. However, this greatly increases your risk of overloading your personal credit and damaging both your own credit and your business’s finances. It also doesn’t help you establish borrowing history for your business.
Finally, using personal credit for business costs limits available credit to the range for individuals—a small percentage of what a lender might offer a business.
Understanding factors lowering your personal credit score and taking steps to rectify them will open more doors for your small business’s borrowing needs.