Having good credit is a big deal. Your credit score not only tells a lender if you’re worthy of credit or not, but it also tells them how much of a premium they should charge on the money they lend you. For someone house hunting and planning to finance a couple hundred thousand dollars, one percentage point can make a huge difference. In fact, it often determines whether someone can afford their dream home or has to turn back to their rental with their tail between their legs. Unfortunately, there is a lot of uncertainty around what exactly determines one’s score. The topic can seem taboo- some people seem to think that even talking about it could reduce their scores. Thankfully, we’re here to clear some of the air around this topic by debunking some of the most common credit score myths. Hopefully, writing this blog won’t send my score plummeting (Spoiler: it won’t!)
Myth 1: Closing a credit card will improve your credit score
It is a common misconception that closing a credit card will boost your credit score. In reality, closing a credit card can actually have a negative impact. One of the key factors that determine your credit score is your credit utilization ratio, which is the amount of available credit you are currently using. In general, you don’t want to exceed 30% credit utilization. When you close a credit card, your available credit decreases, which can increase your credit utilization ratio. This, in turn, can lower your credit score. It's generally advisable to keep old credit card accounts open, especially if they have a positive payment history, as they contribute to the length of your credit history.
Myth 2: Checking your credit score will hurt your credit
Contrary to popular belief, checking your own credit score will not harm your credit. When you check your own credit score, it is considered a "soft inquiry," which does not impact your credit rating. Soft inquiries are only visible to you and do not affect lenders' decisions. However, it's important to note that when a lender or creditor checks your credit during the application process, it is considered a "hard inquiry," which can have a slight negative impact of only a few points on your credit score. Having a significant amount of lenders checking your score in a short period can indicate that you’re seeking loans and credit cards that you can’t pay back and could decrease your score by more than a few points. However, regularly monitoring your credit score is a responsible financial practice and does not have any adverse effects on your creditworthiness. We encourage you to obtain your free yearly report at this link.
Myth 3: You need to carry a balance on your credit card to build credit
Many believe that carrying a balance on their credit card from month to month will help build their credit. However, this is not true. In fact, carrying a balance and paying interest on it is unnecessary and can be costly – the average interest rate is above 20%! If you do owe a significant balance on your credit cards, at least ensure that you pay the minimum payment. Your payment history and responsible credit usage, such as making on-time payments and keeping your credit utilization low, are the primary factors that influence your credit score. You can build a positive credit history by using your credit card regularly and paying off the balance in full each month. This demonstrates your ability to manage credit responsibly.
Myth 4: Closing a negative account will remove it from your credit report
Closing a negative account does not erase it from your credit report. When you close an account, the account history, including any negative information, remains on your credit report for a long time. Most negative information, such as late payments or collections, can stay on your credit report for up to seven years. Closing an account may stop any further negative activity on that account, but it will not eliminate its impact on your credit history. As long as the account doesn’t have a sizable annual fee, the best course of action is to address and resolve any issues with the account, keep it open, and effectively decrease your credit utilization ratio, boosting your score.
Myth 5: Your income affects your credit score
Your income is not a direct factor in determining your credit score. Credit reporting agencies do not consider your income when calculating your creditworthiness. Your credit score is based on your credit history, payment behavior, credit utilization, length of credit history, and other related factors. However, your income can indirectly influence your creditworthiness when it comes to applying for new credit. For example, banks will often request your income information if you are applying for a mortgage. Lenders may consider your income as a factor in determining your ability to repay new debt, but it is not directly tied to your credit score. Nonetheless, investing in yourself and increasing your income is one of the fastest ways to reach financial independence and increase your ability to borrow.
Myth 6: Having too many credit cards hurts your credit score
Most people hold the belief that there is a certain sweet spot when it comes to how many credit cards they use. However, when managed responsibly, having a significant amount of credit cards can be beneficial to your score. Some of our clients have more than 20 active credit cards, yet still have a near perfect credit score. Multiple credit cards provide a diversified credit mix, which is viewed favorably by credit scoring models. Additionally, having more available credit can result in a lower credit utilization ratio, improving your credit score. However, it's crucial to exercise discipline, make timely payments, and avoid excessive debt. By practicing responsible credit management, having multiple credit cards can actually benefit your credit profile.
Myth 7: Using debit cards is better than using credit cards
If people are uncertain of whether to use a debit or credit card, they often opt for a debit card, not realizing the benefits using a credit card can provide. Usually, it is better to pay for most of your expenses with a credit card. Not only does responsible credit card use build a positive credit history, but credit cards are often safer and provide rewards. If someone steals your debit card and goes on a spending spree, there’s a chance that your bank may not offer sufficient fraud protection and you may be held liable for the transactions. Protection against fraud liability is typically higher with credit cards. Additionally, credit cards often pay you back in the form of rewards if you use one for your main source of spending. When I pay my bill each month, I save anywhere from $25-100!
Understanding these common credit score myths is essential for gaining a clear understanding of how credit works and how to navigate this financial landscape effectively. It's crucial to focus on responsible credit behavior, including making timely payments, maintaining low credit card balances, and diversifying your credit mix. Building and maintaining a healthy credit profile takes time and effort, but by understanding the truth behind credit score myths, we can pave the way for a stronger financial future. For more information on what credit is and how to effectively manage it, please check out these earlier blogs we’ve written on the topic: Give Me Some CREDIT!& How to Build Credit Effectively. As always, if you have any questions about attaining, improving, and using your credit, reach out to a trusted friend at DWM.