Perhaps no area of personal finance is more confusing than credit. That's because some of the basic tenets of credit scoring seem illogical.
How can a billionaire have a worse credit score than his butler? Why does it help my credit scores if I have many credit accounts but hurts my scores if I cancel a credit card?
Liz Weston, author of four editions of the book “Your Credit Score,” said she hasn't had to rewrite the chapter on credit myths over the past 10 years. “I keep hearing the same misinformation over and over and over,” she said.
But it behooves us to separate fact from fiction.
Not only will a better credit rating help consumers get the loans they want, those loans will cost less because the best financing rates go to those with the best credit. And credit reports have started to be used for other purposes, such as hiring and setting insurance premiums.
“Credit can be a wealth builder,” said Adam Levin, co-founder of Credit.com.
Here are some of the most important myths to dispel:
Your credit is out of your control. “I think the biggest myth of all, and people have to get it through their heads, is that credit is not something that happens to you,” Levin said. “Consumers can play a role so their credit report is a resume and not a rap sheet.”
Your credit reports are simply a record of your actions — the credit accounts you have opened, such as credit cards, mortgages and car loans, and whether you pay those bills on time.
You can check your credit reports once a year for free at each of the big three credit agencies, Experian, Equifax and TransUnion. Check those reports at AnnualCreditReport.com, or call 877-322-8228, and report any errors that might look bad to lenders. Checking your own reports is also a good way to monitor whether you're a victim of identity theft — if someone has opened new credit accounts in your name.
Information from your reports — three main credit-reporting companies maintain the important ones — is funneled into a formula that can spit out a three-digit credit score. The score is a shorthand way for lenders to assess your reports quickly without actually reading them.
Credit scores are simply a numerical snapshot, usually ranging from 300 to 900, of what's contained in your reports that day. If you're curious to see how you stack up against other people, access a free score online from such sites as Credit.com, CreditKarma.com CreditSesame.com and Quizzle.com. Be aware that your credit is tied to your Social Security number, so you'll have to provide that number to get reports and scores from these websites. Ignore sales pitches, especially for credit monitoring.
Having too many credit accounts hurts your rating. Oddly, the opposite is usually true. Common sense might suggest that if you have more credit accounts open, you have more ability to get into debt trouble and not pay your bills on time. But that's not the way scoring formulas look at it.
Weston said that's probably the most persistent myth. “In fact, the FICO credit scoring formula — the one used by most lenders — typically treats lots of credit accounts as a positive,” she said. “As long as you're handling your credit responsibly, you won't pay a penalty for having lots of them.”
Instead of looking at how much credit you have, scoring systems look at your “credit utilization,” how much of your available credit you're actually using at any given time. Credit experts are usually reluctant to say exactly what the ideal credit use is, but when pressed, Levin said it's 10 percent, as ridiculous as that sounds.
A simple example: If you have two credit cards with $5,000 limits each, you want to keep charges on those cards below a combined $1,000, which is 10 percent of the total $10,000 credit line. Again, the 10 percent rule is to maximize your score. You can still have a great score — and get approved for the loans you want — if you use more than 10 percent of your available credit.
Another reason creditors like to see more accounts is it gives them more data on which to decide whether to lend you money or not — or approve you for a wireless phone contract or rent you an apartment.
“They need to get a picture of how you operate, and the less data that's provided to them, the more difficult it is for a lender to make a decision,” Levin said. “So they take the easy way out, figuring ‘I would rather say no if I just don't know, rather than explore further.'“