Many people view their credit score as a mysterious, almost magical number that dictates their financial destiny. But the truth is, understanding your credit score and how it’s calculated can empower you to take control of your financial health. Unfortunately, numerous myths surround credit scores, leading to confusion and potentially harmful financial decisions. This article aims to debunk those myths, providing you with accurate information to build and maintain a strong credit profile.
Myth 1: Checking Your Credit Score Hurts It
The Reality: Soft Inquiries vs. Hard Inquiries
A persistent myth is that checking your credit score will negatively impact it. This is false. There are two types of credit inquiries: soft inquiries and hard inquiries.
- Soft Inquiries: These occur when you check your own credit report or when businesses check your credit for pre-approved offers. Soft inquiries do not affect your credit score.
- Hard Inquiries: These happen when you apply for credit, such as a loan, credit card, or mortgage. Hard inquiries can slightly lower your credit score, especially if you have many in a short period.
- Practical Example: Checking your credit score regularly through free services like Credit Karma or AnnualCreditReport.com is a soft inquiry and will not harm your credit score. Applying for five credit cards in one day, however, will result in multiple hard inquiries, potentially lowering your score.
Why is This Myth Harmful?
Believing this myth can prevent you from monitoring your credit report for errors or signs of identity theft. Regular monitoring is crucial for identifying and correcting inaccuracies that could negatively impact your score.
- Actionable Takeaway: Check your credit report regularly – at least once a year from each of the three major credit bureaus (Equifax, Experian, and TransUnion) – to identify any errors or fraudulent activity. This won’t hurt your score and can help you maintain a healthy credit profile.
Myth 2: Closing Credit Cards Improves Your Score
The Problem with Reducing Available Credit
Closing credit card accounts might seem like a responsible move, but it can inadvertently lower your credit score, especially if you have a low overall credit limit. A significant factor in your credit score is your credit utilization ratio, which is the amount of credit you’re using compared to your total available credit.
- Example: Let’s say you have two credit cards:
- Card 1: $1,000 credit limit, $500 balance
- Card 2: $500 credit limit, $0 balance
Your total available credit is $1,500, and your total balance is $500. Your credit utilization ratio is 33%. Now, if you close Card 2, your total available credit drops to $1,000. With the same $500 balance, your credit utilization ratio jumps to 50%. A higher utilization ratio can negatively impact your credit score.
When Closing a Card Might Make Sense
There are some limited situations where closing a card could be beneficial.
- High Annual Fees: If a card has a high annual fee that you’re not benefiting from, closing it might be worth considering after weighing the impact on your credit utilization ratio.
- Temptation to Overspend: If you’re struggling with overspending on a particular card, closing it might be a necessary step for your financial well-being, even if it slightly impacts your credit score in the short term.
- Actionable Takeaway: Before closing any credit card, consider its impact on your credit utilization ratio. Try to keep your utilization below 30% for optimal credit scoring. Instead of closing the account, consider putting a small, recurring charge on the card and paying it off in full each month to keep the account active and improve your credit history.
Myth 3: You Need to Carry a Balance to Build Credit
Credit Card Usage and Payment History
Many people believe you need to carry a balance on your credit cards to build credit. This is simply not true. You only need to use your credit card and make on-time payments.
- Payment History: Making on-time payments is the most crucial factor in determining your credit score.
- Reporting to Credit Bureaus: Credit card companies report your payment history to the credit bureaus each month.
The Danger of Carrying a Balance
Carrying a balance means you’re paying interest, which is essentially throwing money away. Building a good credit score shouldn’t require incurring unnecessary debt.
- Practical Example: Use your credit card for small, everyday purchases like gas or groceries, and then pay off the balance in full each month. This demonstrates responsible credit usage and builds a positive payment history without costing you any interest.
- Actionable Takeaway: Always pay your credit card balance in full and on time each month. This is the most effective way to build and maintain a good credit score without accumulating debt.
Myth 4: Income Affects Your Credit Score
Credit Score Calculation Components
While your income is a crucial factor in your overall financial health, it is not a direct component in the calculation of your credit score. Credit scores are primarily based on your credit history, including:
- Payment History (35%): On-time payments are crucial.
- Amounts Owed (30%): Credit utilization ratio.
- Length of Credit History (15%): How long you’ve had credit accounts.
- Credit Mix (10%): Variety of credit accounts (e.g., credit cards, loans).
- New Credit (10%): Recent credit applications.
Why Lenders Ask About Income
Lenders ask about your income when you apply for credit to assess your ability to repay the debt. While your income doesn’t directly influence your credit score, it plays a vital role in the lender’s decision to approve or deny your application.
- Practical Example: Someone with a high credit score but low income may still be denied a large loan because the lender doubts their ability to repay it. Conversely, someone with a moderate credit score and high income might be approved.
- Actionable Takeaway: Focus on managing your existing credit responsibly by making on-time payments and keeping your credit utilization low. While income doesn’t directly impact your score, it greatly influences a lender’s decision.
Myth 5: Closing an Old Account Removes it from Your Credit Report
Negative vs. Positive Information
Closing an old account doesn’t automatically erase it from your credit report. Both positive and negative information remains on your credit report for a certain period.
- Negative Information: Late payments, defaults, and bankruptcies can stay on your credit report for up to 7-10 years, depending on the type of information.
- Positive Information: Positive payment history on closed accounts can remain on your credit report for up to 10 years, continuing to contribute to your credit score.
Impact on Average Age of Accounts
Closing an old, established account can actually lower your credit score by reducing your average age of accounts. This is because the length of your credit history is a factor in determining your score.
- Example: If you have a credit card you’ve had for 15 years and another you’ve had for 2 years, your average age of accounts is 8.5 years. Closing the 15-year-old account will significantly reduce your average age of accounts, potentially lowering your score.
- Actionable Takeaway: Avoid closing old, established accounts unless absolutely necessary. The positive payment history and age of these accounts can contribute significantly to your credit score.
Conclusion
Understanding the truth behind credit score myths is crucial for making informed financial decisions. By dispelling these misconceptions, you can take proactive steps to build and maintain a healthy credit profile, opening doors to better financial opportunities. Remember to regularly monitor your credit report, pay your bills on time, keep your credit utilization low, and avoid unnecessary credit applications. Taking control of your credit health empowers you to achieve your financial goals.
