Learn the basics of credit, the difference between good credit and bad credit, and debunk the top four myths about credit
Before we dive on into credit myths, let’s take a moment and get warmed up. Credit cards, credit reports, credit scores—the list goes on—can be overwhelming if not properly understood. Many people think that credit cards automatically ensure credit card debt and bad credit scores. FALSE! Credit cards can be great vehicles of building credit—if done appropriately.
Let’s start off with the basics: do you know what a credit score is, and how it can affect you?
What is a “credit score”
Typically when we talk about credit scores, we refer to the most common credit calculations like the FICO which ranges from 300 to 850. The higher the score, the better.
Your credit score is a “grade” that tells potential lenders how reliable you are when it comes to borrowing money. In other words, your credit score shows lenders how likely you are to pay off or default on a loan, based on your credit history. Your credit score is calculated based on a few factors including your prior credit card history, your prior lending history, how timely you made payments to your lenders, and a few other things. So, if you tend to pay your rent late, carry credit card balance month over month and open new credit cards on a whim, lenders will see that you’re not the most reliable candidate to which they’d want to lend money. Not only would your credit score be lower, but it’d be harder to prove that you’re a responsible borrower who wouldn’t bring the lender extra risk.
Who makes a credit score?
In the US, there are three major credit reporting agencies: Equifax, Experian, and TransUnion. These organizations are for-profit businesses and possess no government affiliation. By law, consumers are entitled to a free annual credit report from each of these three agencies.
How important is a good credit score?
TL;DR: Very! With a good credit score, you’ll get better interest rates on future loans, become more attractive to future lenders and, ultimately, keep more of your hard-earned cash by paying (err, throwing away!) less money in interest.
Good credit impacts everything around lending. With better credit, you can expect better interest rates on future auto loans, credit cards and a mortgage. A good credit score also increases your chances of being approved for new loans.
With better credit, you can also expect higher credit card limits, faster and more likely approval for rental houses and apartments, lower premiums on auto insurance, and lower finance charges on credit card balances..
And, you guessed it: lower credit means less trust and more interest. If you have a lower credit score, you’ll likely pay higher interest rates and finance charges. It’s also common that you’d be required to pay a security deposit on bills such as utilities. To make matters even worse, folks with lower credit are also less likely to be approved for future loans. So, the cycle will only continue.
Do you know your (approximate) credit score?
It might be a good idea to know the ballpark of your credit score. Periodically checking your credit report and credit score is a great practice to develop. First, knowing your credit score will help you keep yourself in check. Do you need to make some changes to boost your credit score? (See: How to build good credit.) Another great reason to check your credit report every now and then is to make sure you don’t end up with any accidental or fraudulent dings on your credit report that negatively impact your credit score.
Top Myths about Credit
Alright, now that you’re warmed up, let’s get down to brass tacks. Credit can be an overwhelming and scary thing but, as we’ve explained, it doesn’t have to be that way. Some predatory lenders (or misinformed friends and family members) will tell you one of the following top myths about credit. Don’t fall for this trap!
Checking a Credit Report Will Hurt Your Score—FALSE!
Pulling your own credit report results in what is called a "soft pull," or "soft inquiry,” and does not impact your credit. You can pull this report—for free—once each year. By law, you are able to pull a free and complete credit report once per year from all three credit reporting agencies. If you’re interested in pulling your credit score more frequently, there are other resources that help you keep tabs on your credit score throughout the year.
Regularly checking your credit report will help you make sure that your personal and financial information is accurate. It will also help you to sniff out any fraudulent activity, like if someone opened a fake account in your name. If you find errors (fraudulent or simple mistakes) on your credit report, contact the relevant credit bureau to set things straight. And, don’t delay on this one.
Now, while soft inquiries like checking your own score will not affect your credit scores, some hard inquiries will. Hard inquiries are when a lender runs your credit score before agreeing to a loan. This is a common practice when you rent or buy a home, purchase a car, sign up for a new credit card, etc. While these actions are not bad, doing many of them back-to-back might make lenders a tad weary of lending you more money.
Education Level Can Affect a Person's Credit Score—FALSE!
Nope! It doesn’t matter if you have a PhD in aeronautical engineering or a GED. Your education level does not affect your credit score; only your past credit activity affects your credit score. Remember, your credit score shows lenders how likely you are to pay off or default on a loan, based on your credit history—not your education, race, creed or political affiliation. Your credit score is calculated based on a few factors including your prior credit card history, your prior lending history, how timely you made payments to your lenders, etc.
Carrying a credit balance month over month will build your credit score—FALSE!
This couldn’t be further from the truth! Carrying a balance on your credit card month over month (and not paying it off each month) does not boost your credit score. In fact, this behavior will only show lenders that you’re not a reliable borrower and that they should reconsider lending you money for your car, house, etc.
Now, regularly charging items to your credit card and paying off the balance each month is a different story. This behavior shows lenders that you are a reliable borrower who can borrow money and pay it back in a very timely manner. This type of behavior builds your credit.
So, regularly charing your card—and paying it off—is good. Racking up—and keeping—a balance is bad.
Once you have bad credit you’ll always have bad credit—FALSE!
Having bad credit will bring you a whole host of sticky situations, ranging from having trouble renting or buying a home to not getting approved for a car loan. But, just like they say, “This too shall pass.” If you work on building your credit, you won’t be down in the dumps for long!
Build your credit by showing lenders that you’re a reliable borrower. A baby step? Get a credit card, use it regularly, and pay it off each month. This shows lenders that you can be trusted with their money because you pay back what you borrow each month.
Find more ways to boost your credit score: How to Build Your Credit.