Credit may be a big part of most consumers’ lives, but that doesn’t mean everyone fully understands the industry.
“For many people, credit is a weird thing,” says Todd Albary, CEO of credit education site Quizzle.com. He believes many consumers are intimidated by the notion that there is a “secret system used to generate a score that follows you all over the place.”
In an attempt to help you become more credit savvy in 2012, we spoke to experts to clear up some common misconceptions about credit cards and credit scores.
Myth: Paying on Time Guarantees a Good Score
Paying your bills on time is an important component to your credit score, but it’s not a surefire way to a perfect score, especially if you’re prone to bumping up against your credit limits before making a payment.
In addition to payment history, “credit bureaus see the balance on your last statement,” says Adrian Nazari, CEO of Credit Sesame. If this balance is extremely high, it can negatively affect your credit utilization ratio – the amount of credit you are using versus the amount of credit you have available to you – and can cost you some points in that category.
This is why it’s a good idea to “pay [your issuer] a few days ahead of your credit card statement date,” Nazari says, which will ensure a low balance gets reported to the bureaus each month.
Myth: Carrying a Balance Helps Build Credit
The credit bureaus are privy to your payment history and the balance on your monthly credit card bill, “but they don’t know if you’re paying interest or not,” Nazari says. This means deciding to pay the minimum each month isn’t going to do much more than cost you money, especially if you’re carrying a particularly high annual percentage rate. The lesson? Don’t forgo payments just to carry a balance month to month.
Myth: All Credit Scores Are the Same
Most consumers are probably familiar with the FICO scoring model, which calculates your score on a scale of 300 to 850, but the truth is there are many other credit score models available to consumers and the lenders who service them. Pulling one or another isn’t going to guarantee that you’re going to see the same score that the lender does.
“Many of the scores calculated for and used by lenders are not available to consumers,” says Susan Papp, a spokeswoman for credit card comparison site Credit Donkey. “Consumers unaware of the variety of scores may purchase a score believing it is their ‘true’ score and when in reality the score that lenders are seeing is quite different.“
This is why it is important to pay more attention to the information on your credit report (as opposed to its accompanying score) and the risk level that the service you are using to view the information assigns you.
Myth: Your Income Affects Your Score
People tend to assume that the more money they make, the higher their credit score will be, but that’s not the case. While it’s true your income may affect your ability to pay your bills on time, it has no bearing on your credit score, Albary says.
Your income can, however, influence a lender’s decision to approve you for a loan. This is because lenders often compare the income you’ve listed on your application to the debts listed on your credit report in an attempt to judge your ability to make monthly payments.
Myth: You Should Cut Up the Cards You Don’t Use
Those who have accumulated significant debt may be inclined to close credit card accounts as they pay them down, but doing so may hurt your score – in a few ways.
“You risk lowering your credit utilization ratio,” Nazari says. Instead of cutting up unused cards if customers consistently bump up against their credit limits, Nazari adds, it is better to keep your cards open and restrict use to one or two small payments a year to keep your utilization ratio intact and your payment history stellar.
Myth: Using Only Cash Will Help Your Score
Sorry to break it to you, but consumers have to use credit to build credit. Credit scores are a way for lenders to predict whether you will pay back money you’ve borrowed, and one of the best ways to demonstrate your creditworthiness is to show you’ve paid off some type of debt before. Sticking to cash only may seem like the responsible thing to do, but it won’t help you establish a payment history with lenders. This can be problematic when you need to buy a big-ticket item such as a car or house.
“If you don’t have or use credit, you may have no credit history at all, and if you do, your credit score won’t be as good as someone who consistently demonstrates responsible use of credit over time,” Albary says.
Myth: A Store Card Will Boost Your Score
If you’re looking to build credit, you’re better off adding a card backed by a major credit card issuer than a store card being advertised at the point of purchase. While credit bureaus don’t award extra points for taking out a line of credit from a big bank, store cards typically have lower limits than traditional credit cards, Nazari says. This can lead to a higher utilization ratio if it’s among one of the only cards you have in your arsenal.
Myth: Paying Off Debt Will Instantly Change Your Score
Getting up to date on delinquent accounts is certainly a good idea, but a score of 580 isn’t going to turn into a 700 overnight no matter what you do.
“Negative information on your credit report that is accurate can only be removed over time,” Papp says. “For example, credit delinquencies will stay on your credit report for seven years and bankruptcy information will stay on your credit report for 10 years.”