Editor’s note: The second part of this story is published here.
Credit often feels a lot like magic.
It can make scary things appear out of thin air. It sometimes involves shuffling cards, with a sleight of hand that even those watching closely can’t spot. Some people say it’s the work of the devil. Others just don’t believe in it at all.
But credit is real. Bad credit makes it pricier or even impossible to buy a car or a house. Good credit not only helps you borrow money for less, it can actually make you money.
But there’s a lot of nonsense about how it all works, so let’s clear the smoke and break the mirrors. Here are the 10 lies, delusions, and half-truths you’ll hear most often about credit. Let the secrets be revealed…
1. “Credit scores and reports are the same thing”
This is a half-truth.
Credit scores and credit reports closely related, and credit reporting agencies will bundle them together – to make more money off you. Here’s an example…
Equifax offers a $40 package that provides a “One 3-Bureau Credit Report with scores that reflects your entire credit profile in a simple, consolidated view.” But as you’ll read below, most of this information can be had for free.
The reality: Credit reports and credit scores are mostly the same thing in a different format – like water and ice. Reports are most useful for consumers, and scores are most useful for lenders. The big differences between a credit report and a credit score are cost and transparency…
- A credit report documents your credit history, including credit accounts with your borrowing limit or loan amount, the account balance, and whether you make payments on time. It also includes requests for credit and information on accounts in collection, bankruptcies, and foreclosures. You can get these free every year, and you can review and report any errors you find.
- A credit score is a numerical summary of all the information in the report, and it’s derived using a semi-secret formula that varies over time and between credit bureaus. You can get a ballpark estimate of your score by knowing what’s in your report. You usually pay for a peek at your scores, with a few exceptions. Last year, First National Bank of Omaha and Barclaycard U.S. became the first to offer customers truly free credit scores, according to Consumer Reports. Meanwhile, FICO will sell you access for $15* a month — that asterisk means you agree to buy a minimum of three months, by the way — or you can buy one of the score-report-and-more bundles mentioned above.
2. “You have to pay for a credit report”
This is a lie.
It’s a deliberate deception peddled by the credit bureaus themselves. Go to any of their websites – Equifax, Experian, or TransUnion – and you’ll find them trying to sell you a report (sometimes bundled with something else like a score or credit monitoring) for anywhere from $1 to $50.
FICO, the creator of the most widely used credit-scoring method, even has something amusingly called Suze Orman’s FICO Kit Platinum. It costs $50 for reports, scores, and some other features, sold under the banner of a popular “personal financial guru.”
Reality: You can start with the free stuff and then decide if you need anything else. And while the credit bureaus sometimes tout “free” credit reports, they’re really just free trials to monthly subscription services.
But the credit bureaus don’t exactly highlight the fact each of them owes you a free, no-strings-attached report every twelve months. (All three have a tiny link at the bottom of the homepage alluding to it.) The federal government forces them to do it.
The official website to get your free credit reports from all three credit bureaus is AnnualCreditReport.com. Make sure you get that name down, because there are a lot of fakes that try to charge you. FreeCreditReport.com, for instance, is run by Experian and claims the free report can take up to two days to arrive. The paid version is, of course, instant. What a crock.
3. “Credit scores discriminate”
This is a half-truth.
FICO is quick to rattle off several things it doesn’t include in credit scores: race, color, religion, national origin, sex, and marital status. (Because that’s the law.) It also mentions a 2010 Federal Reserve study that concluded credit scores don’t treat people differently based on race, ethnicity, or gender. So all that’s factual. But then, so are the results of a recent Harris poll, which found more than a third of even white Americans believe black and Hispanic people are discriminated against in multiple ways.
Reality: The bigger picture is more muddled, as Lisa Rice and Deidre Swesnik from the anti-discrimination group National Fair Housing Alliance recently argued in the Suffolk Law Review. They say that there’s a historical double standard in the market that unfairly affects the credit of minorities even if they’re judged by the same criteria — they get the same treatment but different results.
Why? The scoring model itself might not be discriminatory, but when somebody else discriminates ,it can taint the data. The authors cite a 2011 Justice Department settlement with mortgage lender Countrywide, which allegedly charged more than 200,000 black and Hispanic borrowers higher fees and interest rates than it did white people.
“Thousands of families who should have received prime loans were steered to subprime loans,” the authors say. “It is reasonable to assume that their credit scores were negatively impacted by the mere fact that they received a more expensive subprime loan.” (Lest you think that was an isolated incident, check out the many more recent instances of widespread discrimination in this list from the Justice Department.)
Some U.S. senators make a similar argument about using credit reports for hiring. They argue it disproportionately disqualifies women and minorities, and they’re proposing legislation to stop the practice. Dozens of civil rights groups, from the NAACP to the National Organization for Women, back it.
4. “Checking your own credit hurts it”
This is a delusion.
Some people believe checking your report, your score, or both, hurts your creditworthiness. Neither is true.
Reality: A credit check is known in the industry as a credit inquiry, and it comes in two types: soft and hard. Soft inquiries appear on your credit report, but they don’t affect your score because they’re invisible to everyone but you. They include your own requests, checks by companies you already have accounts with, and checks by companies that send you those annoying pre-qualified credit offers. (Yep, that’s how they know you’re pre-qualified.)
Hard inquiries, on the other hand, can and do affect your score. Each time you apply for some kind of credit, you’re giving permission to check your score — which shows up on your report and affects your score, although not as much as you might think.
5. “Asking for credit hurts your credit”
This is a half-truth.
Hard credit inquiries can hurt, but usually not much, and the damage is temporary. While bankruptcies can stay on your report for 10 years and late payments for seven, inquiries affect you for two or less.
Reality: The more credit and credit history you have, the less inquiries matter. If you’re a credit newbie, it’s a bigger deal — but you have less to lose by asking, anyway.
For many people, one additional credit inquiry may not affect their FICO score at all. For others, one additional inquiry would take less than 5 points off their FICO score. Inquiries can have a greater impact, however, if you have few accounts or a short credit history.
You just don’t want to get carried away. The more inquiries lenders see, the more scared they are that you’re credit crazy and likely to go bankrupt. In their eyes, every additional inquiry is potential extra debt that hasn’t shown on your report yet.
The exceptions are home and auto loan inquiries. Because you’re expected to comparison shop on big purchases like these, FICO’s formula lumps together all the inquiries from a 30-day period.
Art by Mike Grandchamp