Have you ever found yourself trying to decipher the rules surrounding personal finance, only to be confused by the algorithms that determine your credit score?
In a world where credit scores wield immense influence over our financial lives, it's essential to separate fact from fiction and equip ourselves with knowledge. Misconceptions about credit scores abound, and debunking these myths is a crucial step if we wish to achieve a solid financial footing.
According to a survey conducted by the National Foundation for Credit Counseling, a staggering 48% of respondents had at least one misconception about credit scores. Such misconceptions can lead to poor financial decisions, missed opportunities, and unnecessary stress.
This article aims to unravel the truth behind some of the most prevalent credit myths, armed with accurate information that shed light on what genuinely impacts your credit score.
Read more: 8 reasons why your credit score is important
The Importance of Credit Scores and Understanding the Factors
In the modern financial landscape, credit scores have a significant impact on various aspects of our lives. Whether you're applying for a mortgage, seeking an auto loan, or even trying to secure favorable insurance premiums, your credit score plays a pivotal role.
Despite its importance, there is a cloud of confusion surrounding what truly influences this critical number. Your credit score is a three-digit number that reflects your creditworthiness. It's used by lenders to assess the risk of lending money to you.
A higher credit score indicates a lower risk, making you more likely to qualify for loans and receive better interest rates. To demystify the factors that affect your credit score, we're here to debunk some of the most common credit myths and provide you with accurate information.
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The Fundamentals of Credit Score Calculation
Before we clarify your doubts about how a credit score works, let's explore the fundamental components that determine it. While credit scoring models may vary slightly, the FICO score, one of the most widely used credit scores, relies on five key factors:
- Payment History (35%): This is the record of your on-time and late payments on credit accounts, including credit cards, mortgages, and other loans
- Credit Utilization (30%): This factor measures the percentage of available credit you're currently using. A lower utilization ratio is generally better for your score
- Length of Credit History (15%): The longer your credit history, the better. This factor considers the age of your oldest and newest accounts, as well as the average age of all your accounts
- Types of Credit (10%): Having a mix of different types of credit, such as credit cards, mortgages, and installment loans, can positively impact your score
- New Credit (10%): Opening several new credit accounts within a short period can indicate higher risk and potentially lower your score
With these fundamentals in mind, let's debunk some of the common myths that have been circulating about credit scores.
Myth 1: Checking Your Credit Score Lowers It
One of the most persistent credit myths is that checking your own credit score will negatively impact it. Thankfully, this is far from the truth. When you check your own credit score, it's considered a "soft inquiry" or a "consumer-initiated inquiry." These inquiries are not factored into your credit score calculation and are completely harmless.
On the other hand, "hard inquiries" occur when a lender checks your credit as part of a loan application. Multiple hard inquiries within a short period can indeed lower your score slightly, as they might suggest you're seeking credit from various sources.
However, the impact is usually minimal and fades quickly. So, feel free to regularly monitor your credit score without any fear of adversely impacting your chances of securing loans.
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Myth 2: Closing Old Accounts Boosts Your Score
It might seem logical that closing old, unused accounts would improve your credit score by decluttering your credit history. However, this is another credit myth. In reality, closing old accounts can potentially harm your score.
A significant factor in calculating your credit score is your credit utilization ratio, which is the amount of credit you're using compared to your total credit limit. Closing old accounts can reduce your available credit, causing your utilization ratio to increase. This, in turn, could negatively impact your score.
Additionally, the length of your credit history matters; older accounts contribute positively to this factor. So, keeping those old accounts open (as long as they're in good standing) can be beneficial for your credit score.
Myth 3: Income Affects Your Credit Score
Your credit score is a reflection of your creditworthiness, which is determined by your credit behavior, not your income. While lenders may consider your income during the loan application process to assess your ability to repay, it's not a direct factor in calculating your credit score.
The main components that influence your credit score are payment history, credit utilization, length of credit history, types of credit, and new credit inquiries. These factors focus on how you manage credit and debt, rather than how much money you earn. Therefore, having a high income won't automatically result in a better credit score.
Myth 4: Closing Credit Cards Improves Your Score
If you're trying to streamline your finances or keep your spending under control, closing a credit card could seem like a smart move. Your credit score may suffer unintentional effects from this move, though.
As was already discussed, a key element in calculating your credit score is your credit utilization ratio. Your total credit limit decreases when you close a credit card, which could result in a rise in your utilization percentage.
Your credit score could suffer if you owe money on other cards. Consider paying off a card's balance and occasionally using it to keep it active rather than closing it.
Read more: Closing a Credit Card? When Should You Do?
Myth 5: Only Carrying a Balance Builds Credit
This myth can lead to unnecessary interest payments and debt accumulation. The idea that you need to carry a balance on your credit card to build credit is simply false. Making timely payments and using your credit responsibly is what really matters.
Paying off your credit card balance in full and on time demonstrates good credit behavior. Carrying a balance and paying interest only benefits the credit card company, not your credit score. In fact, consistently carrying a high balance relative to your credit limit can negatively impact your credit utilization ratio, potentially lowering your score.
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Myth 6: Closing Accounts Removes Negative History
Closing an account doesn't erase its history from your credit report. Positive information, like on-time payments, can remain on your report for years and contribute to your credit history even after closing the account. Negative information, however, doesn't disappear immediately.
Late payments, defaults, and other negative marks can stay on your credit report for up to seven years, depending on the type of information. Closing the account doesn't speed up this process. The best way to improve your credit is to practice responsible credit behavior over time and wait for the negative information to naturally be struck off your report.
Myth 7: All Debt Is Equal in the Eyes of Credit Scoring
Not all debts are treated equally by credit scoring models. There's a distinction between "revolving" credit, like credit cards, and "installment" credit, like mortgages and auto loans. Understanding this difference is essential for managing your credit effectively.
Revolving credit involves variable payments based on the balance, while installment credit has fixed monthly payments. Credit scoring models consider the mix of credit types you have.
A healthy mix, including both revolving and installment credit, can have a positive impact on your score. However, missing payments on installment loans could potentially have more severe consequences than missing payments on credit cards.
Myth 8: Closing Accounts Removes Hard Inquiries
Hard inquiries occur when you apply for credit, such as a loan or a new credit card. These inquiries remain on your credit report for up to two years. Some people believe that closing the accounts associated with these inquiries will remove them from the report, but this is not the case.
Closing an account does not erase the history of inquiries associated with it. Those inquiries will continue to be listed on your credit report until they naturally age off after the specified time period. However, the impact of hard inquiries on your credit score diminishes over time, and their significance is generally minor compared to other factors.
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Myth 9: Credit Counseling Hurts Your Score
If you're struggling with debt, seeking credit counseling or enrolling in a debt management plan can be a responsible step toward improving your financial situation. Contrary to the myth, credit counseling itself does not negatively impact your credit score.
When you enter a debt management plan, creditors may close or restrict your accounts, which can affect your credit utilization ratio.
However, this is a short-term impact, and as you make consistent payments through the plan, your score can gradually improve. The positive effect of managing your debt effectively and avoiding further delinquencies outweighs any initial negative impact.
Myth 10: Bankruptcy Ruins Your Credit Forever
Bankruptcy is undoubtedly a serious financial situation with significant consequences, but the idea that it permanently dooms your credit is an oversimplification. While a bankruptcy filing can stay on your credit report for seven to ten years, it doesn't mean your credit will be impaired for that entire duration.
With responsible financial behavior and a plan to rebuild your credit, you can start to see improvements within a few years. Securing a secured credit card, making consistent payments, and practicing good credit habits can gradually rebuild your creditworthiness after bankruptcy.
Understanding the reality behind these credit myths is essential for maintaining and improving your credit score. Your credit score is a reflection of how well you manage your credit and debt, and responsible financial behavior is the key to achieving a healthy score.
Regularly monitoring your credit report, making timely payments, keeping your credit utilization low, and maintaining a diverse credit mix are the most effective strategies for ensuring your credit health. By steering clear of these common myths, you are better equipped to make informed decisions about your financial future.
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Q. Can closing a credit card improve my credit score?
No, closing a credit card account might actually have a negative impact on your credit score. One factor that affects your score is your credit utilization ratio, which is the ratio of your credit card balances to your credit limits. Closing a credit card reduces your available credit, potentially increasing your utilization ratio. It's usually better to keep old accounts open, especially if they have a positive payment history.
Q. Will settling a debt remove it from my credit report?
Settling a debt does not remove it from your credit report. The fact that you settled a debt instead of paying it in full will remain on your report, and it can have a negative impact. Lenders may view settled debts as a sign of credit risk. It's often better to negotiate with creditors to update your account status to "paid in full" or "paid as agreed" if possible.
Q. How often should I check my credit report?
Regularly checking your credit report is a good habit. You're entitled to one free credit report from each of the three major credit bureaus (Equifax, Experian, and TransUnion) every year. Monitoring your report helps you catch errors, identify unauthorized accounts, or notice potential identity theft risks. It's also a way to track your credit progress and ensure your financial information is accurate.
Q. Will my credit score drop if I refinance a loan?
Refinancing a loan, whether it's a mortgage, auto loan, or student loan, can result in a hard inquiry on your credit report. While a single hard inquiry usually has a minor impact, multiple inquiries within a short period could slightly lower your credit score. However, the long-term benefits of refinancing, such as lower interest rates and reduced monthly payments, could outweigh any temporary score decrease.
Q. Can paying off a collection account improve my score immediately?
Paying off a collection account is a responsible step to take, but it might not lead to an immediate improvement in your credit score. The negative record of the collection account will remain on your credit report, even if it's marked as paid. Over time, as the collection account ages, its impact on your score will diminish. Focus on building positive credit habits to see gradual score improvement.