Easy access to credit reports and scores is a relatively new development.
It’s been barely a decade since the first states started giving consumers the right to see their credit scores. Free annual credit reports, meanwhile, have been required only since 2003, with the passing of the Fair and Accurate Credit Transactions Act.
Since then, consumers have had had a chance to educate themselves about credit scores — and also to form some persistent urban legends about them. Here are five of the most common myths to look out for:
Myth 1: If you have a good income and manage your finances well, you will have a good credit score.
The reality: Credit scores don’t reflect your financial status; they are purely a measure of how well you use credit. As an example, guess which of the following two people would have the best credit score?
- A person who earns $200,000 a year and pays all bills on time, but who has never taken out any loans or credit cards or,
- A person earning $40K a year with three to four credit cards used responsibly for many years.
If you guessed the latter, you’re right — the person with a long history of responsible credit use would come out the winner.
If this seems counter-intuitive, keep in mind that credit scores are meant to give lenders a picture of how well you handle credit, not how much money you make. It is a system that rewards people who take out credit and manage credit well. Unfortunately, this means that, while being cautious and avoiding debt may be good for your financial health, it’s not necessarily the best for your credit score.
Myth 2: Having a lot of credit cards will help your credit score.
The reality: While some experts recommend that people take out and use several credit cards to help establish or improve their credit score, you can get too much of a good thing.
“One of the most common myths we see is people thinking that having a lot of credit cards will help their credit score,” says Chad Gentry, executive director of Colorado debt counseling service mPowered. “Too many credit cards will drop your score from a risk model point of view, because you could go to Vegas and spend it all.”
In other words, you won’t boost your credit further by having 10 credit cards. Two to four cards are plenty.
Myth 3: Credit inquiries hurt your credit score.
The reality: There are two types of credit inquiries — soft and hard. While soft inquiries (such as when a credit card company checks your credit to preapprove you for an offer) won’t ding your score, hard inquiries (such as when a lending company checks on you after you apply for a loan or credit card) might.
Multiple hard inquiries within a short period of time may be viewed as a sign that you are in dire need of a loan. That makes you look riskier to lenders and can lower your credit scores. Even so, there are exceptions to that rule. Someone shopping around for a single mortgage loan with many different lenders, for example, is less likely to be punished. According to Gentry, the key lies in the timing of the inquiries.
“A 14-day window is one hit,” Says Gentry. “So if you go to six [mortgage] places in 14 days, it will be one hit. But if you go to multiple places over a year, it will affect you.”
Your credit score will not get punished if you check your own credit report or credit score, as that’s considered a soft inquiry. In fact, you are entitled to a free copy of your credit reports from all three credit bureaus (TransUnion, Experian and Equifax) once a year at AnnualCreditReport.com.
Myth 4: Settling past-due debt will be cleared from your credit report.
The reality: It might seem that paying off accounts in collections, past-due balances, tax liens or judgments would remove the blotch from your credit reports. Yet , negative activity remains on your credit report for seven years.
“A lot of collection agencies will tell people that if they pay off collection accounts, it will come off their credit,” says Gentry. “However, in reality, that collection is going to stay on for seven years even after payment.”
The silver lining? Even though a negative item stays on your report for seven years, its impact on your credit score decreases over time if it is outweighed by other, more positive, actions. That means paying off the debt will definitely leave you better off than leaving it unpaid.
Myth 5: The greater your debt, the lower your credit score.
The reality: While it might seem that you’d be punished for taking on large debt loads to buy a house and a car, the FICO scoring model actually rewards people who show they can manage many different types of credit. In fact, 10 percent of your FICO score is determined by your credit diversity.
Don’t confuse lots of debt on multiple credit cards with credit diversity, however. Carrying large balances across multiple credit cards is viewed as an indication that your spending may be out of hand. In general, it is best to keep credit card balances below 30 percent of the credit limit.
You can purchase your FICO score from myFICO.com for $19.95.