6 Debt Mistakes That Ruin Your Credit

trillions in debt

The real impact of debt mistakes isn't the $3.50 on a morning latte. It's the total package, and the interest that goes with it. As of Nov. 12, 2012, the Federal Reserve Bank of New York reported a total of $11.3 trillion in American personal debt. 

That consisted of:

  • $8.03 trillion in household debt
  • $956 billion in student loans
  • $768 billion in auto loans
  • $675 billion on credit cards
  • $312 billion in other types of debt 

Some of that debt represented smart investments in real or educational assets, but the rest comes from making mistakes with money. Using credit well means avoiding the most common mistakes consumers make when spending more than they've earned. 

1. Making Late Payments

bad credit history leads to high debt

FICO, the company that compiles and reports credit scores, says that payment history represents 35% of your credit score -- meaning that even a single reported delinquent payment can drop a score by up to 100 points. That results in more expensive credit in the future, and higher interest rates on some accounts you have right now. 

2. Not Monitoring Credit Reports

Given the effects even a single damaging entry can have on your credit report, it's surprising that the Consumer Financial Protection Bureau found less than 20% of consumers check that report annually -- and that over a quarter of credit reports have substantive errors. The difference between good and fair credit can mean 3% extra interest on a car loan -- adding up to spending more than $1,000 over the life of the account. 

3. Making Only the Minimum Payments

Minimum payments on debt accounts are calculated to extend the life of the loan as much as possible, and to maximize lender profits. Putting $1,000 on a credit card with an average APR of 14.6 percent costs $12 per month in interest. At an average minimum payment (based on industry standard of interest+1% of balance) of $25, that loan will take 4 1/2 years to pay off, at a total interest of $375 -- more than one-third the cost of the purchase. Paying $50 a month on the same account of debt will shrink the time to pay it off to less than two years, with an interest cost of just $139.

4. Borrowing to Buy Liabilities

 high consumer spending ruins credit

Taking on debt for a home or for education has traditionally been a good investment, and largely remains so even in this difficult economy. However,15% of American debt is for consumer spending, and buying cars is one of the top three uses Americans report for accessing equity in their homes. This violates one of the prime rules of successful finances: Borrow for things that increase in value and pay cash for things that lose value.

5. Restructuring Without Changing Spending Habits

Debt consolidation works by combining existing debts into a single large account, with a longer term of payment and a single bill each month. The result is an easier-to-manage debt situation that can potentially save thousands. The Federal Trade Commission warns that this solution only works if you combine it with a change to the habits that got you in debt. Without that shift, families end up with high debt and multiple monthly payments in addition to the bill from their earlier consolidation.

6. Accepting Higher Spending Limits

Even credit cards -- the riskiest form of consumer debt -- can work well if you pay off the balance every month, preferably during the grace period offered by most high-quality cards.  Those higher limits can lead to maintaining a balance month after month, and paying interest fees you had avoided earlier. Other versions of this same problem include using home equity to finance consumer purchases, and using high student loans on expenses other than education

Effectiveness expert Tony Robbins defines discipline as "suffering short-term pain to reap a long-term gain." The same can be applied to smart use of credit. If you accept the pain of putting off frivolous purchases until you can pay cash, you will reap the long-term benefit of a better financial position.