7 Credit Score Myths Busted

Ed. Note: We’re lucky to have Rob Berger of Dough Roller as a guest blogger on Block Talk this week. Enjoy!

One of the most important personal finance tools is also the most misunderstood: credit scores.

These 3-digit numbers can have a significant impact on your finances. They determine the interest rate on mortgages, car loans and credit cards, and affect the cost of car insurance premiums. And what most people don’t know is that they can even be the deciding factor in whether an employer hires a job applicant or not.

Will cancelling your credit cards really improve your score? (Photo: jcolman via Flickr)

But these scores need not be shrouded in mystery anymore — today, we bust 7 myths about credit scores.

Myth #1: You have one credit score

The truth is that each individual with a credit file has multiple credit scores. There are three major credit-reporting agencies (Equifax, Experian, and TransUnion), and each of them has slightly different information about each consumer. Because the information is not identical, the FICO scores they generate based on the data they have vary from one agency to the next.

In addition, there are multiple versions of FICO scores. Different industries evaluate risk in different ways, and the makers of the FICO score have customized the mathematical formula to fit these needs. As a result, a mortgage lender and auto loan company may see different FICO scores for the same consumer.

Myth #2:  You can get your credit score for free

Thanks to a federal law, consumers can get a free copy of their credit report at www.annualcreditreport.com. But the report you get will not include your credit scores.

There are some sites that offer a free credit score, such as Credit Karma or Credit Sesame.  Called “educational scores,” these scores can help you understand how creditors see you as a risk. But they aren’t the actual scores that most creditors look at while evaluating a loan application. To get your FICO scores, you’ll have to pay for them.

Myth #3:  Your credit score only matters if you get a loan

I cringe every time I hear somebody say this! Car insurance companies use credit scores to assess risk and set premiums; employers check credit reports and scores during the application process, particularly if the job involves finances or handling money. And some banks will use credit scores when potential customers apply for a savings or checking account.

Myth #4:  A FICO credit score is the only one that matters

Most creditors use a version of the FICO score, making it the gold standard of scores. As a result, non-FICO scores are sometimes referred to as FAKO scores. But educational credit scores still provide a reasonably clear picture of a consumer’s credit risk. As noted above, they are offered for free from several websites, and the scores include information on the factors affecting the score. Armed with this information, consumers can begin to improve their credit scores, including their FICO scores.

Myth #5:  It’s hard to improve your score

While improving your credit score takes discipline and time, it’s not impossible. The key factors that affect your FICO score are (1) payment history, (2) amounts owed, (3) length of credit history, (4) new credit, and (5) types of credit used. Just paying your bills on time and working to lower debt will improve credit scores very quickly for most consumers. There are, of course, extreme circumstances like a foreclosure or bankruptcy that will lower a credit score substantially, but one can significantly improve their credit score even after bankruptcy by managing finances responsibly.

Myth #6:  Cancelling credit cards will improve your score

Getting out of debt will improve your credit score. But cancelling credit cards, at least in the short term, can actually hurt your score. The reason is that one factor considered in the FICO formula is the amount of a consumer’s available credit – and by cancelling a credit card, you reduce the amount of available credit.

Myth #7:  Checking your score lowers your credit score

One factor affecting your FICO score is credit inquiries. When a potential lender checks your report and score as part of a credit application, it’s called a “hard pull,” and this type of inquiry can temporarily lower your score. This is particularly true when a person applies for a lot of credit in a short period of time.

But not all credit inquiries are alike.  FICO knows when the inquiry is the result of a credit application and when it’s the result of a consumer checking his or her own score. Called a “soft pull,” checking your own credit will not hurt your score.

Rob Berger is a personal finance blogger at Dough Roller, where he seeks to simplify finance for his readers by giving helpful hints and uncovering little-known financial facts. Before uploading a post, he tests it by asking himself if his teen kids will find it useful when they start managing their own money.

Tags: , , , ,