Credit scores are complicated, and some people mix you up on purpose. We break it down for you in plain English
Yesterday, we unraveled five of the great credit score myths. If you missed it, catch up here, then read on…
6. “You have to go into debt and stay in debt to get good credit”
This is a lie.
And the sad part is, it comes straight from the website of financial guru, Dave Ramsey, in an article ironically titled “The Truth About Your Credit Score”…
The only way to have a good credit score is to go into debt, stay in debt, and continually pay your accounts perfectly — without adding too much debt or paying too much off. In other words, stay in debt for as long as you can.
Uh, no. Sorry, Dave.
Reality: The only thing right about Ramsey’s statement is that you have to play to win. It’s also true if you play without knowing the rules, you’re going to lose. But in general, good credit scores belong to people with less debt.
Take what FICO calls a credit utilization rate. That’s the percentage of available credit you’ve tapped — so if you have a credit card limit of $5,000 on one or across multiple cards, and your statement(s) show a balance of $1,500, your rate is 30 percent. Having a rate below that is good for your credit score, since it shows you are in control of your finances and not a desperate gambling addict.
In the same vein, not paying off your debt, not paying on time, and having too many credit cards can hurt your score.
Sure, you can argue using credit cards at all will mean you’re going into debt even if you pay off the balance in full every month. You could also argue that you’re continually in debt to the phone and utility companies because you pay those bills on a monthly basis. But that’s dumb.
You don’t have to go into debt to get good credit. If you’re responsible, you can build credit and make money doing it.
7. “Closing a credit card hurts your score”
This is a half-truth.
If you get a new card with a higher limit, better terms, or more rewards, you might not use the old card as much — or at all. But closing it won’t help your credit, and it might hurt.
Reality: Remember that thing called credit utilization rate? Closing a card hurts it and could also hurt your score unless you start spending less.
Say you have a card with a credit limit of $3,000, and you get a new one with a limit of $2,000. Now when you use $1,000 of the credit available, your rate is 20 percent. Close that old card, and your rate becomes 50 percent. You suddenly look riskier for spending the same amount of money and taking the seemingly responsible step of dropping a card you don’t need.
On the other hand, it might not hurt your score much if you manage your utilization rate, or if the new card more than makes up for the credit limit of the old one. And it certainly doesn’t make sense to keep a card you don’t plan to use if it has an annual fee.
8. “FICO is a government agency”
This is a delusion.
The acronym FICO sure sounds like it stands for something like Federal Institute of Credit Opportunity, and you can’t be blamed for thinking something as essential as credit would be run by the government. But it’s not.
Reality: FICO was previously known as the Fair Isaac Corporation, after founders Bill Fair and Earl Isaac. TransUnion, Experian, and Equifax are also private companies. The federal Consumer Financial Protection Bureau can regulate the industry, and there are already laws like the Fair Credit Reporting Act that set out rules for credit reports and prevent discrimination. But there’s nothing saying they have to explain exactly how credit scoring works, and they don’t.
9. “Credit scores work the same for everybody”
This is a delusion.
When people explain how credit scores work, they usually give this breakdown from FICO…
- Payment history — 35 percent
- Amounts owed — 30 percent
- Length of credit history — 15 percent
- Types of credit in use — 10 percent
- New credit — 10 percent
What they tend to leave out is where FICO says this: “These percentages are based on the importance of the five categories for the general population.”
Reality: As FICO tells it, the importance of any particular factor depends on your overall credit profile. People who haven’t been using credit for long don’t have much of a payment history (whether you paid on time) or a credit history (how old your accounts are). All their credit is new credit — so the percentages above are different for them.
“As the information in your credit report changes, so does the importance of any factor in determining your FICO Score,” the company says.
How different? And how much of that is misdirection to keep people from figuring out the exact formula? There’s no telling, since FICO doesn’t offer a similar pie chart for any other group of people. They want you to learn the principles of good credit, not how to game their system.
The closest the company gets to revealing how credit mistakes affect people differently is this chart, which gives a credit background for two people, their initial scores, and what happens to their scores after they max out a credit card, make a late payment, or go bankrupt.
10. “There isn’t just one credit score, there are dozens, so your score doesn’t matter”
This is a half-truth.
John Ulzheimer, a credit expert who used to work for both FICO and Equifax, is known for saying there are tons of different FICO credit scores. Not one, not three, but more like 50 variations. Some people take that to mean credit scores are all in the eye of the beholder, but he doesn’t say that.
Reality: There are indeed tons of credit scores, just like there are multiple versions of Windows and iPhones. The scoring model gets changed over time and can be altered to focus on different things for different kinds of credit, such as auto loans or mortgages. Then the credit bureaus all have their own variations of those different models.
That means the odds are poor the scores you purchase are the exact same scores lenders see. The odds are even worse if you’re not looking at a FICO score, which is the industry standard, but some other kind of free score estimate or alternative model. For instance, the credit bureaus have developed the VantageScore to challenge FICO. Totally different model.
But all those variations only matter when you’re on the threshold between an OK loan and a good one, and actually plan to seek that loan in the next few months. The rest of the time, the exact number doesn’t matter — because the ways to boost it are the same. Like losing weight, you don’t want to fret over the number daily. Just keep doing the things you know will move the needle over time.
Art by Mike Grandchamp