Credit confusion
Americans appear to have a handle on some credit scoring basics, according to a new Bankrate Money Pulse survey. But there are some more nuanced aspects of credit that still have many consumers confused.
It’s not necessarily their fault.
There is “a lot of opaqueness about how creditors look at the borrower’s profile and what is good and bad from a borrower’s standpoint,” says Joseph Toms , president of Freedom Financial Asset Management in San Mateo, California. To explain a lender’s point of view, he compares a person’s credit profile to a health physical.
A heavy cough, for instance, is an obvious sign of illness to anyone, but a doctor uses other subtle measures — such as temperature — to assess your overall health. Similarly, a missed payment clearly indicates you might not pay back a loan as agreed. But other subtle factors, such as the diversity of your credit profile, give prospective lenders a clearer picture of your financial stability.
To help you better understand the vital signs of your credit report, we debunk the most persistent credit score myths identified in our survey.
A big balance is OK if you pay on time
Yes, it is absolutely imperative to pay all of your credit card bills on time. Payment history holds the most weight among all credit scoring models. But don’t be fooled — along with 51% of consumers in our survey — into thinking that carrying a high balance is good for your credit health.
High balances negatively skew your credit utilization rate — essentially how much debt you are carrying versus how much credit collectively and on individual cards has been extended to you — which is the second most important factor when it comes to calculating your score.
“It’s best to keep your utilization as low as possible,” says Thomas Nitzsche, a certified credit counselor with ClearPoint Credit Counseling Solutions, a nonprofit organization in Atlanta.
Experts generally recommend consumers keep credit card balances below 30% of their available limit. (You can see where your credit utilization is by pulling your credit report. Check yours for free at myBankrate.) However, an even better practice from a money management and credit scoring perspective is to pay off all purchases in full by the end of each month.
“The basic principle should be to always step into a debt when you’re going pay it off in a defined period at the lowest cost possible,” Toms says.
You have to carry a balance
Don’t feel too bad if you’re among the 37% of consumers who erroneously believe you need to carry a balance on a credit card in order to improve a score.
“The average person we meet with just thinks credit card debt is normal,” Nitzsche says. “They feel like if they don’t have credit or they’re not using the card, they’re not building credit.”
Just know that simply having the credit card will benefit your credit history and your credit utilization rate, specifically if your balance is low to nonexistent. (Plus, you’ll avoid needlessly paying interest on purchases, Nitzsche says.)
Ultimately, using the payment method responsibly will help launch your score higher.
“Consumers who don’t revolve a balance on a credit card can build great credit scores by consistently paying their bills on time, lowering the overall amount of debt across all of their obligations and judiciously applying for new credit,” says Can Arkali, principal scientist for popular credit scoring model FICO.
Closing old accounts won’t hurt you
It seems harmless — if not helpful — enough: Close out old cards so you won’t be inclined to run up charges you can’t afford. But the act itself can do damage to your credit utilization rate, particularly if all your other credit cards are bumping up against their limits.
Plus, it’s not going to make any prior delinquencies on the cards go away.
” That information doesn’t vaporize,” Nitzsche says. Negative information generally takes 7 years to age off a credit report. (Closed accounts in good standing stay on reports for 10 years.)
Of course, any potential negative consequences shouldn’t automatically dissuade you from cutting ties with a troublesome account, particularly if you don’t plan on going loan shopping anytime soon.
“Always do what’s best for your financial situation,” Toms say. Though your credit score may take an initial hit, it will improve over the long term if you’re able to better manage your accounts as a result of the closure.
A short credit history won’t hurt you
Sorry, millennial, but holding off on entering the credit marketplace will come back to haunt you. Length of credit history (essentially how long you’ve been taking out loans) accounts for 15% of the FICO score.
The lack of data prevents lenders from seeing whether you’ve previously been able to pay back loans “and they feel uncomfortable extending credit,” Toms says. “If you do want to avail yourself of credit, you will get better terms if you’ve established a pattern of using credit responsibly.”
If you’re credit-shy, start small by asking a parent or guardian to add you as an authorized user to their existing credit card account.
Consumers who have run into trouble before can also rebuild credit “by starting with a secured card,” Nitzsche says.
A secured card requires the cardholder to put down a cash deposit that serves as collateral if the bill isn’t paid on time. They typically carry fees, but after a few months of responsible use, you may be able to graduate to a more traditional line of credit.
Having multiple credit accounts won’t help
Some 31% of consumers believe limiting themselves to 1 credit account will benefit their scores. Again, while this may be a smart idea from a money-management standpoint, most scoring models reward you for having more than 1 type of credit account on file.
For instance, “FICO scores will consider your mix of credit cards, retail accounts, installment loans and mortgage loans,” Arkali says.
Why? Well, different types of loans send lenders different signals, Toms says.
A revolving account, like a credit card, is managed by the consumer, who essentially controls how much — or how little — they are going to pay each month. On the other hand, an installment loan, like an auto loan or mortgage, requires a person to pay a set amount over a fixed period of time.
“If I have a mortgage, I have stability and income,” Toms says. “The credit card only leaves the creditor a little unclear about why you don’t have these other things in your life and whether you can afford (them.)”
Of course, all these accounts won’t help a score if you’re missing payments, running up big bills and applying for every credit card out there in a short amount of time.
“The key driver of a good FICO score is the individual’s behavior on all of their credit obligations,” Arkali says.
