Your credit score. Those three little digits wield immense power over your financial life, influencing everything from interest rates on loans and credit cards to your ability to rent an apartment or even get a job. Because it’s so important, a lot of misinformation swirls around credit scores, leading to confusion and potentially harmful financial decisions. Let’s debunk some common credit score myths and empower you with the knowledge to build and maintain a healthy credit profile.
Myth 1: Checking My Credit Score Will Hurt It
The Truth About Credit Inquiries
- Hard Inquiries vs. Soft Inquiries: This is perhaps the most pervasive credit score myth. It’s crucial to understand the difference between “hard” and “soft” credit inquiries.
Hard inquiries occur when you apply for credit, such as a credit card, loan, or mortgage. These can slightly lower your credit score, but the impact is usually minimal and temporary, typically disappearing within a few months.
Soft inquiries occur when you check your own credit report, or when lenders pre-approve you for offers. These have no impact on your credit score.
- Example: Checking your credit score on Credit Karma, Experian.com, or through your bank’s online platform is a soft inquiry and will not affect your score. Applying for a mortgage will result in a hard inquiry.
- Actionable Takeaway: Regularly monitor your credit report and score using free services without fear of negatively impacting your credit. Knowing where you stand is the first step to improving your credit.
Why Monitoring Your Credit Is Essential
- Detect Errors: Checking your credit report allows you to identify and correct any inaccuracies that could be negatively impacting your score. According to a study by the Federal Trade Commission, approximately 5% of consumers have errors on their credit reports that could result in less favorable terms on loans.
- Identify Fraud: Early detection of fraudulent activity can prevent significant financial damage. If you spot unfamiliar accounts or transactions, report them immediately.
- Track Progress: Monitoring your score provides valuable feedback on your credit-building efforts. You can see how your actions, such as paying down debt or making timely payments, are affecting your score.
Myth 2: Closing Credit Cards Improves My Credit Score
The Impact of Credit Utilization
- Credit utilization is the ratio of your outstanding credit card balances to your total credit card limits. It’s a major factor in determining your credit score, typically accounting for around 30% of your FICO score.
- Closing a credit card: Closing a credit card reduces your overall available credit, which can increase your credit utilization ratio, especially if you have balances on other cards. This increased utilization can negatively impact your score.
- Example: Suppose you have two credit cards, each with a $5,000 limit, and you have a $2,000 balance on one card. Your credit utilization is 20% ($2,000 / $10,000). If you close the card with no balance, your total available credit drops to $5,000, and your utilization jumps to 40% ($2,000 / $5,000).
When Closing a Credit Card Might Be Okay
- High Annual Fees: If you have a card with a high annual fee that you’re not utilizing, the fee may outweigh the benefit of keeping the card open.
- Irresponsible Spending: If you’re tempted to overspend on a particular card, closing it might be a responsible choice for managing your finances, even if it slightly impacts your credit score.
- Low Credit Limit/No Spending: If the credit card has a very low credit limit and you never use it, it may not contribute much to your overall credit profile. In this case, closing it may have a minimal impact.
- Actionable Takeaway: Before closing a credit card, consider its impact on your credit utilization. If possible, keep the card open and use it sparingly to maintain a low utilization ratio. Aim to keep your utilization below 30%.
Myth 3: Carrying a Balance on My Credit Card Will Improve My Credit Score
Pay Your Balance in Full Each Month
- Interest is unnecessary: The myth that carrying a balance improves your credit score is completely false. You only need to demonstrate responsible credit usage by making timely payments. Carrying a balance simply means you’re paying unnecessary interest charges.
- Payment history is king: Payment history is the most important factor in your credit score, accounting for about 35% of your FICO score. Paying your credit card balance in full and on time every month is the best way to build a positive payment history.
- Example: Paying the minimum payment each month might keep your account in good standing, but it won’t significantly improve your credit score and will result in substantial interest charges. Always aim to pay the full statement balance.
The Danger of Revolving Debt
- High Interest Rates: Credit cards typically have high interest rates, so carrying a balance can quickly lead to accumulating debt.
- Debt Cycle: Revolving debt can create a vicious cycle where you’re constantly paying interest and struggling to pay down the principal.
- Actionable Takeaway: Treat your credit card like a debit card and only charge what you can afford to pay off in full each month. Set up automatic payments to ensure you never miss a due date.
Myth 4: My Income Affects My Credit Score
What Lenders Consider
- Income is not a factor: Your income is not a direct factor in calculating your credit score. Credit scores are based on your credit history, including your payment history, amounts owed, length of credit history, credit mix, and new credit.
- Lenders consider income for approval: However, when you apply for credit, lenders will consider your income to assess your ability to repay the debt. A higher income can increase your chances of being approved and may allow you to qualify for better terms.
- Example: Two people with the same credit score might have different outcomes when applying for a loan. The person with a higher income is more likely to be approved and might receive a lower interest rate.
Focus on Creditworthiness
- Build credit history: Even without a high income, you can build a strong credit score by managing your debt responsibly and making timely payments.
- Secured credit cards: If you have limited credit history, consider applying for a secured credit card. These cards require a security deposit, which typically becomes your credit limit. By using the card responsibly and making timely payments, you can establish a positive credit history.
- Actionable Takeaway: Focus on building a solid credit history, regardless of your income. Use credit responsibly and make timely payments to demonstrate your creditworthiness.
Myth 5: I Don’t Have Any Debt, So I Must Have a Good Credit Score
The Importance of Credit History
- No credit history = No credit score: While it sounds counterintuitive, having no debt or credit accounts can actually be detrimental to your credit score. A credit score is based on your credit history, so if you have no history, you won’t have a score.
- Building a credit profile: To establish a credit score, you need to open and use credit accounts responsibly. This can include credit cards, loans, or other types of credit.
- Example: Someone who always pays in cash and never uses credit might think they are being financially responsible, but they won’t have a credit score to show for it. This can make it difficult to rent an apartment, get a car loan, or even open a bank account in some cases.
Starting to Build Credit
- Secured Credit Card: A secured credit card is an excellent way to build credit if you have no or limited credit history.
- Credit-Builder Loan: Some financial institutions offer credit-builder loans, which are small loans designed to help you establish credit.
- Become an Authorized User: Ask a trusted family member or friend with good credit to add you as an authorized user on their credit card. Their positive payment history can help boost your credit score.
- Actionable Takeaway: If you have no credit history, take steps to establish a credit profile by opening a credit account and using it responsibly. Even small credit lines can help you build a solid foundation.
Conclusion
Understanding the truth about credit scores is essential for making informed financial decisions. By debunking these common myths, you can take control of your credit and build a strong financial future. Remember to monitor your credit report regularly, manage your credit utilization, pay your bills on time, and avoid unnecessary debt. With the right knowledge and habits, you can achieve and maintain a healthy credit score.
