Let’s debunk 8 credit myths and uncover the facts behind them.
Credit Myths #1: Credit is evil. I should pay cash for everything.
The Facts: Some experts believe you should only ever purchase something if you can pay cash for it. They believe all debt, and by extension credit, is a bad thing. Credit itself is not evil – abuse of credit is where borrowers get in trouble.
Use credit as a tool in your financial toolkit and be sure to optimize the various types of credit. This way you make conscious decisions about how to build your financial house and, as a result, how it will appear to potential lenders and creditors.
Credit Myths #2: ‘Pulling’ a credit report reduces my credit score
The Facts: Pulling your own credit report and credit score, often referred to as a soft “pull” or inquiry, will not impact your credit score. In fact, you are encouraged to check your credit report regularly, or, at the very least, once per year.
Request your free credit report from www.annualcreditreport.com today. You’re entitled to one free report from each of the three major credit bureaus every 12 months.
However, when a lender runs your credit report, this is known as a hard “pull” or inquiry, and these will affect your credit score. The effect of these hard inquiries varies. myFICO reports, “[f]or most people, one additional credit inquiry will take less than five points off their FICO Scores.” Generally, you’ll want to make sure you don’t apply for too many new accounts within a short amount of time to mitigate the effects of hard inquiries.
Credit Myths #3: I need to carry a balance to build (or rebuild) my credit
The Facts: Carrying a balance could hurt your credit score; namely, if you’re using a high amount of your total available credit. Payment history and debt-to-credit ratio are the two most important components in building (or rebuilding) your credit. Paying off your debts has a positive effect on your overall credit health. It shows potential lenders and creditors you fulfill your financial obligations – that you’re a good customer for them. So, if you’re able to pay off your balance in full, do it.
Credit Myths #4: Paying off debt removes it from my credit report
The Facts: Accounts on your credit report are not automatically removed when they’ve been paid off nor would you want them to be. An open account with a zero balance contributes history (aka time) to your payment history (see Myth #3) and impacts your credit utilization ratio (see Myth #5). And if those open accounts are marked paid in full and paid on time, that helps your credit score.
Also, you want your credit report to reflect your ability to use credit responsibly, and having a variety of account types – revolving, credit cards, lines of credit, loans – on your credit report adds to your credibility as a good customer. In other words, you don’t want to have too many of one type of account.
Credit Myths #5: Closing inactive accounts improves my credit score
The Facts: Closing an old or inactive (zero balance) account can negatively impact your credit score. Often, those unused accounts are your oldest, which directly affects the history (aka time) component of your credit score.
For example, Jane Smith has 1 department store charge card, an AMEX, a VISA, 1 mortgage, and 1 auto loan on her credit report. The very first account she opened was the department store card in 1998. It currently has a zero balance and she used it last year. Her next oldest account is the auto loan for which she obtained financing in 2008. If Jane closes the rarely used account she opened in 1998, her credit history would be shortened by 10 years!
In addition to the history (or time) component, Jane’s credit utilization ratio would also be affected. Based on the above 3 credit card accounts, Jane’s total available credit is $35,000. Jane’s total balance for those 3 accounts is $10,000. The department store card has a $20,000 limit with a zero balance. If she closes the department store card, Jane’s debt-to-credit ratio goes from 29% to 67%! (Remember, a credit utilization ratio of less than 30% is recommended.) So, Jane would go from looking like a good risk to perhaps too risky for most lenders.
Credit Myths #6: One spouse’s good credit will lock in lower interest rates
The Facts: While each spouse has their own individual credit report and credit score, the spouse with a low score will impact interest rates on JOINT accounts.
Credit Myths #7: A divorce has no impact on credit scores
The Facts: While a divorce itself has no direct impact, if joint accounts don’t stay current AFTER the divorce, the late payments will impact BOTH scores.
Even if the divorce decree assigns responsibility for an account to one spouse, if the lender has not changed the terms of the original contract, which included both spouses, if the spouse named as the responsible party in the divorce decree is unable (or unwilling) to pay, the delinquent account will show up on BOTH credit reports.
The best strategy is for one spouse to remove their name from the account; or, close the account altogether, then open a new account in their name alone.
Credit Myths #8: A low credit score means I’ll never be approved for anything
The Facts: Thankfully, poor credit health isn’t permanent. While it’s true that negative records – such as bankruptcy, paying late, tax liens, missing payments – remain on your credit report 7-10 years, responsible use of your credit going forward will have a positive, albeit gradual, impact on your credit score. Don’t be discouraged, time is on your side.
Knowledge Is Power
Now that you know the facts behind these 8 common credit myths, you’re better prepared to review your credit score and credit report, and take action to make improvements, if necessary.
We’ll be back next time to share insights about the importance of daily money management, even for high income homes.